Legal Environment of Business, 9th edition Henry R Cheeseman Solution Manual

Instructors Manual for Legal Environment of Business Revised by: Jeffrey Penley Legal Environment of Business Ninth Edition

Henry R. Cheeseman

Chapter 1 Legal Heritage and the Information Age What is the meaning of “It’s the law”?

I. Teacher to Teacher Dialogue One of the most common dilemmas facing instructors of business law is the issue of topic choice. By the very nature of the subjects we teach, the breadth of materials is so wide that choosing what to focus on in the limited classroom time we have with our students can be a most daunting task. This problem is especially complicated when the topics we are dealing with are all of deep interest and can stand alone as separate courses.

In this chapter, for example, we are asked to introduce students to topics ranging from the definitions and purposes of law to how our system affects business decisions, to some of the most important provisions found in the United States Constitution. Any one of these subparts can provide the raw materials for an entire course at the law school level. Our job must start with a self-evident, but sometimes forgotten, point: this is not law school. We are here not to train future lawyers but rather students who need to know enough about these issues to recognize that they are issues. The technical legal problems they may be facing later will ultimately need to be resolved using law and other practitioners.

The plus side of this dilemma is that because we have such a diverse menu to select from, we are able to pick and choose our areas of emphasis. For example, if your particular teaching and research interests lie in the area of ethics and the schools of jurisprudential thought from which they are derived, then by all means, run with it! Rather than trying to be all things to all people, it is better to focus your efforts on your strengths. This does not mean that you can shortchange the other material. All key objectives of the chapter should be fully outlined and incorporated in both your lecture and materials outline. But if you have a particular interest and expertise in, for example, the Law and Economics School of jurisprudential thought, then use them as focal points of comparison in the evolutionary process that seeks to distinguish the older schools of jurisprudence from newer approaches to these issues. In any event, remember that philosophical studies of what law is and what its role is in the larger scheme of things have always posed questions virtually impossible to answer. This chapter represents attempts by great thinkers to answer the unanswerable. It would be far too presumptuous for us to think that we can teach, in a few hours, what the great philosophers of the world have tried to do over hundreds of years. Perhaps this is an early lesson in what wisdom is really all about: the more we know of history, the more we know of our own limitations. If we can get that point across, the course is off to a good start!

II. Chapter Objectives 1. Define law.

2. Describe the flexibility of the law.

3. List and describe the schools of judicial thought.

4. Learn the history and development of American law.

5. List and describe the sources of law in the United States.

6. Describe the doctrine of stare decisis.

7. Describe how existing laws are being applied to the digital environment and how new laws are being enacted that specifically address issues of the information age.

8. Learn what critical legal thinking is and how to apply it to analyzing legal cases.

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9. Learn how the material, cases, and lessons of this book will apply to your future career.

III. Key Question Checklist  What is law?  Once you have identified the kind of societal expectation of behavior, what standard of behavior is most appropriate? Does law codify the standard? Do one or more of the schools of jurisprudence support the standard?  What are the sources of law in the United States?  What bodies of law and/or ethical standards apply?  How would you apply these standards to the facts?

IV. Chapter Outline The first chapter objective is an introduction to the historical underpinnings of jurisprudential thought. This would include not only the functions of law listed in the summary, but also an early opportunity to introduce the role of ethics based on the various schools of jurisprudence discussed.

Introduction to Legal Heritage and the Information Age Businesses that are organized in the United States are subject to its laws. They are also subject to the laws of other countries in which they operate. Businesses organized in other countries must obey the laws of the United States when doing business here. In addition, businesspeople owe a duty to act ethically in the conduct of their affairs, and businesses owe a responsibility not to harm society. This chapter discusses the nature and definition of law, theories about the development of law, and the history and sources of law in the United States.

What Is Law?  Law consists of rules that regulate the conduct of individuals, businesses, and other organizations within society.  It is intended to protect persons and their property against unwanted interference from others.  Law forbids persons from engaging in certain undesirable activities.  It is often, but not always, fair.  Law must be flexible.

Definition of Law – According to Black’s Law Dictionary, “Law, in its generic sense, is a body of rules of action or conduct prescribed by controlling authority, and having binding legal force.

That which must be obeyed and followed by citizens subject to sanctions or legal consequences is a law.”

Functions of the Law  Keeping the peace – e.g., making certain activities crimes  Shaping moral standards – e.g., enacting laws that discourage drug and alcohol abuse  Promoting social justice – e.g., enacting statutes that prohibit discrimination in employment  Maintaining the status quo – e.g., passing laws preventing the forceful overthrow of the government  Facilitating orderly change – e.g., passing statutes only after considerable study, debate, and public input  Facilitating planning – e.g., well-designed commercial laws allow businesses to plan their activities, allocate their resources, and assess their risks

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 Providing a basis for compromise – e.g., approximately 95 percent of all lawsuits are settled prior to trial  Maximizing individual freedom – e.g., the rights of freedom of speech, religion, and association granted by the First Amendment to the U.S. Constitution Fairness of the Law – Overall, the United States legal system is one of the most comprehensive, fair, and democratic systems of law ever developed and enforced. However, some misuses and oversights of our legal system, including abuses of discretion and mistakes by judges and juries, unequal applications of the law, and procedural mishaps, allow some guilty parties to go unpunished.

Flexibility of the Law – U.S. law has evolved and grown as a reflection of changes in society, technology, and commerce. The same general principles that established the foundation of our nation still exist; however, legal modifications exhibit the flexibility and maturity of our system to be able to adapt to the changing commercial, social, and ethical environments.

Critical Legal Thinking: Brown v. Board of Education This section discusses the United States Supreme Court’s rejection of the “separate but equal” doctrine that endorsed separate schools for black children and white children.

Schools of Jurisprudential Thought  Natural Law School – Postulates that law is based on what is “correct” and that law should be based on morality and ethics  Historical School – Believes that law is an aggregate of social traditions and customs  Analytical School – Maintains that law is shaped by logic  Sociological School – Asserts that law is a means of achieving and advancing certain sociological goals  Command School – Believes that law is a set of rules developed, communicated, and enforced by the ruling party  Critical Legal Studies School – Maintains that legal rules are unnecessary and that legal disputes should be solved by applying arbitrary rules based on fairness  Law and Economics School – Believes that promoting market efficiency should be the central concern of legal decision making Global Law: Command School of Jurisprudence of Cuba In 1959, Fidel Castro led a revolution in Cuba. What followed was a communist/socialist government that expropriated and nationalized much private property, and installed a command economy and system of jurisprudence. Economic productivity fell substantially in Cuba as a result, with major shortages of essential goods and services. Cuba is now permitting limited freemarket measures, but approximately 90 percent of workers are still government employees.

History of American Law When the American colonies were first settled, the English system of law was generally adopted as the system of jurisprudence. This was the foundation from which American judges developed a common law in America.

English Common Law  Law developed by judges who issued their opinions when deciding a case  The principles announced in these cases became precedent for later judges deciding similar cases  The English common law can be divided into cases decided by the: 3 .

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Law courts Chancery (Equity) courts Merchant courts

Landmark Law: Adoption of English Common Law in the United States Common law is discussed in this section. In the United States, law, equity, and merchant courts have been merged. Most U.S. courts permit the aggrieved party to seek both legal and equitable orders and remedies.

Global Law: Civil Law System of France and Germany Romano-Germanic civil law system is the model for countries adopting civil codes. The Civil Code and the parliamentary statutes that expand and interpret it are the sole sources of law in most civil law countries. The adjudication of a case is the application of the code or the statutes to a particular set of facts. In some civil law countries, court decisions do not have the force of law.

This is in contrast to Anglo-American common law, where laws are created by the judicial system and through congressional legislation.

Sources of Law in the United States In the more than 200 years since the founding of the United States and the adoption of the English common law, U.S. lawmakers have developed a substantial body of law. The sources of modern law in the United States include the federal and state constitutions, federal treaties, federal and state statutes, local ordinances, executive orders, regulations and orders of administrative agencies, and judicial decisions.

Constitutions  The U.S. Constitution establishes the federal government and enumerates its powers  Powers not given to the federal government are reserved to the states  State constitutions establish state governments and enumerate their powers Treaties – The president, with the advice and consent of the Senate, may enter into treaties with foreign governments.

Federal Statutes – Statutes are written laws that establish and enforce certain courses of conduct.

Congress enacts federal statutes, while state legislatures enact state statutes. Federal statutes are organized by topic into code books. This is often referred to as codified law. Federal statutes can be found in these hardcopy books and online.

State Statutes – State legislatures enact state statutes. Such statutes are placed in code books.

State statutes can be assessed in these hardcopy code books or online.

Contemporary Environment: How a Bill Becomes Law The U.S. Congress is composed of two chambers, the U.S. House of Representatives and the U.S. Senate. Thousands of bills are introduced in the U.S. Congress each year, but only a small percentage of them becomes law. First, a bill must be sponsored by a member of the U.S. House of Representative or the U.S. Senate. It is then referred to the appropriate committee for review and study. Bills that receive the vote of a committee are reported to the full chamber, where they are debated and subjected to vote. If the bill receives a majority vote from the full chamber and a subsequent second chamber, it is then forwarded to the U.S. president. The bill becomes law when it is signed by the president.

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Ordinances – State legislatures often delegate lawmaking authority to local government bodies, including cities and municipalities, counties, school districts, water districts, and such. These governmental units are empowered to adopt ordinances. Ordinances are also codified.

Executive Orders – The executive branch of the government (the U.S. president) is empowered to issue executive orders.

Regulations and Orders of Administrative Agencies – Administrative agencies are created by the legislative and executive branches of government. They may adopt administrative regulations and issue orders that regulate the conduct of covered parties.

Judicial Decisions – When deciding individual lawsuits, federal and state courts issue judicial decisions. In these written opinions, a judge usually explains the legal reasoning used to decide the case. These opinions often include interpretations of statutes, ordinances, and administrative regulations and the announcement of legal principles used to decide the case.

Priority of Law in the United States – The U.S. Constitution and treaties take precedence over all other laws, followed by federal statutes and federal regulations. Federal law takes precedence over conflicting state law, which has precedence over local laws. Similarly, state constitutions take precedence over state statutes and regulations.

Doctrine of Stare Decisis – Based on common law tradition, past court decisions become precedent for deciding future cases. Lower courts must follow the precedent established by higher courts. All federal and state courts in the United States must follow the precedents established by U.S. Supreme Court decisions. Adherence to precedent is called the doctrine of stare decisis (“to stand by the decision”). The doctrine of stare decisis promotes uniformity of law within a jurisdiction, makes the court system more efficient, and makes the law more predictable.

Law in the Information Age – The electronic age arrived before new laws were written that were unique and specific for this environment. Courts have applied existing laws to the new digital environment by requiring interpretations and applications. In addition, new laws have been written that apply specifically to this new environment. The U.S. Congress has led the way, enacting many new federal statutes to regulate the digital environment.

Critical Legal Thinking Critical thinking in law courses, referred to as critical legal thinking, is significant because in the law there is not always a “bright-line” answer. The need for critical thinking is especially important in solving legal disputes.

Defining Critical Legal Thinking Critical legal thinking is a method of thinking that consists of investigating, analyzing, evaluating, and interpreting information to solve a legal issue or case.

Socratic Method – The Socratic method is a process that consists of a series of questions and answers and a “give-and-take” inquiry and debate between a professor and students.

IRAC Method – The IRAC method is used to examine a law case. IRAC is an acronym that stands for issue, rule, application, and conclusion. The process is dictated by four questions: 1. (I) What is the legal issue in the case?

2. (R) What is the rule (law) of the case?

3. (A) What is the court’s analysis and rationale?

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4. (C) What was the conclusion or outcome of the case?

V. Key Terms and Concepts  Administrative agencies—Agencies (such as the Securities and Exchange Commission and the Federal Trade Commission) that the legislative and executive branches of federal and state governments are empowered to establish.  Administrative rules and regulations—Used by administrative agencies to enforce statutes. These rules and regulations have the force of law.  Analytical School—School of jurisprudence maintaining that the law is shaped by logic.  Bills—Many bills are introduced each year in the U.S. Congress, from which only a few eventually become law.  Brown v. Board of Education—A landmark Supreme Court case in which a unanimous decision reversed prior judicial precedent and held that the “separate but equal” doctrine violated the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution. The decision led to the banning of school segregation.  Chamber—The U.S. Congress is composed of two chambers, the U.S. House of Representatives and the U.S. Senate.  Civil Law—A code of laws applicable to Romans. Also known as the Romano-Germanic civil law system.  Code book—Federal statutes are organized by topic into code books.  Codified law—Federal statutes that have been organized into code books.  Command School—School of jurisprudence that believes that the law is a set of rules developed, communicated, and enforced by the ruling party rather than a reflection of the society’s morality, history, logic, or sociology.  Committee—Bills from either of the two chambers of the U.S. Congress are reviewed and studied by an appropriate committee. The committee may reject the bill, report it to the full chamber for a vote, not act on it, or send it to a subcommittee for further study.  Conference committee—A committee made up of members of both the U.S. House of Representatives and the U.S. Senate.  Constitution of the United States of America—The supreme law of the United States.  Court of Chancery (equity court)—Court that granted relief based on fairness.  Critical Legal Studies School—School of jurisprudence that proposes legal rules are unnecessary and are used as an obstacle by the powerful to maintain the status quo.  Critical legal thinking—A method of thinking that consists of investigating, analyzing, evaluating, and interpreting information to solve a legal issue or case.  English common law—Law developed by judges who issued their opinions when deciding a case. The principles announced in these cases became precedent for later judges deciding similar cases.  Executive branch (president)—A branch of the U.S. government that has the power to enforce the law.  Executive orders—An order issued by a member of the executive branch of the government.  Federal statute—Written laws, enacted by the U.S. Congress, that regulate foreign and interstate commerce.  French Civil Code of 1804 (the Napoleonic Code)—One of the models used by countries that adopted civil codes. In most countries adhering to a civil law system, the civil code and parliamentary statutes are the sole sources of law.

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German Civil Code of 1896—One of the models used by countries that adopted civil codes. In most countries adhering to a civil law system, the civil code and parliamentary statutes are the sole sources of law.

Historical School—School of jurisprudence that believes the law is an aggregate of social traditions and customs that have developed over the centuries.

IRAC method—A method used to examine a law case. “IRAC” stands for issue (What is the legal issue in the case?), rule (What is the law pertaining to the case?), application (What is the court’s analysis and rationale?), and conclusion (What was the conclusion or outcome of the case?).

Judicial branch (courts)—A branch of the U.S. government that has the power to interpret and determine the validity of the law.

Judicial decision—A decision about an individual lawsuit issued by federal and state courts.

Jurisprudence—The philosophy or science of law.

Law—That which must be obeyed and followed by citizens, subject to sanctions or legal consequences; a body of rules of action or conduct prescribed by a controlling authority and having binding legal force.

Law and Economics School (Chicago School)—School of jurisprudence that believes that promoting market efficiency should be the central goal of legal decision making.

Law courts—Courts that developed and administered a uniform set of laws decreed by the kings and queens after William the Conqueror; in this system of jurisprudence, legal procedure was emphasized over the particular merits of a case.

Law Merchant—Rules based on based on common trade practices and usage that were applied by merchants around England and Europe, during the Middle Ages, to solve commercial disputes. Also known as the “law of merchants.”

Legislative branch (Congress)—A branch of the U.S. government that has the power to enact the law.

Merchant Court—The separate set of courts established to administer the “law of merchants.”

Moral theory of law—Theory proposing that the law should be based on morality and ethics.

Natural Law School—School of jurisprudence postulating that the law is based on what is “correct.”

Order—A decision of an administrative agency.

Ordinance—Laws enacted by local government bodies, such as cities and municipalities, counties, school districts, and water districts.

Precedent—A rule of law established in a court decision. Lower courts must follow the precedent established by higher courts.

Romano-Germanic civil law system—Legal system dating back to 450 BCE when Rome adopted the Twelve Tables, a code of laws applicable to the Romans. Commonly known as civil law.

Sociological School—School of jurisprudence asserting that the law is a means of achieving and advancing certain sociological goals.

Socratic method—A process that consists of a series of questions and answers, and a give-and-take inquiry and debate between a professor and students.

Stare decisis—Latin for “to stand by the decision.” Adherence to precedent.

State constitution—Constitution that establishes the legislative, executive, and judicial branches of state government and the powers of each branch.

State statute—Statute enacted by state legislatures and placed in code books.

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Statute—Written law enacted by the legislative branch of the federal and state governments that establishes certain courses of conduct to which covered parties must adhere.

Subcommittee—Studies bills sent by the committee. After review, the subcommittee may either let the bill expire or report it back to the full committee.

Treaties—Compacts made between two or more nations.

U.S. Congress—Branch of the government that creates federal law by enacting statutes.

U.S. House of Representatives—One of two chambers of the U.S. Congress.

U.S. Senate—One of two chambers of the U.S. Congress.

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Chapter 2 Ethics and Social Responsibility of Business What is “right”?

I. Teacher to Teacher Dialogue The study of ethics and law has been interwoven from the onset. Both disciplines stress the moral underpinnings of their respective efforts at defining proper human behavior. In spite of this long interaction, using business ethics issues as a freestanding chapter in mainline business law texts is a relatively recent phenomenon. The reasons for this vary, but one of them is, no doubt, the difficulty many traditional law teachers have had in adapting to the language of philosophers and other related social scientists. Given the obvious need for more emphasis on ethics training in all aspects of business education, this increase in emphasis on law/ethics issues has come none too soon.

In this chapter, the author clearly outlines the key schools of ethical studies and then provides excellent case examples in which to test the various approaches discussed in the text.

II. Chapter Objectives 1. Describe how law and ethics intertwine.

2. Describe and apply the moral theories of business ethics.

3. Describe and apply the theories of the social responsibility of business.

4. Define public benefit corporation and describe the social purposes served by these corporations.

III. Key Question Checklist  When corporate behavior is questioned, which school of ethics would be most appropriate to examine?  Is the behavior unethical?  What standard of ethical behavior should be applied?  How could the corporate entity have prevented the behavior?  If you were in a position of judgment to respond, what would you do?

IV. Chapter Outline The study of ethics revolves around the examination of rules, conduct, and character through a morally-tinted microscope. That law should be grounded in some sort of morality-based foundation is self-evident. The goals of all the ethical schools of thought are to identify some sort of morally-based rationale for human behavior. This rationale may be found in outside sources as seen in schools of ethical fundamentalism, or in the rule that provides the greatest good to society as illustrated by utilitarianism. Others such as Kant and Rawls have sought to devise formulas of behavior based on universal rules or social contract, respectively. In all these systems, a morallybased methodology is sought as a guidepost for human behavior. If these guideposts are universally accepted, the odds are very high that they will no longer be advisory, but rather required by law. The process by which morally-based ethical behavior is first desired, then expected, and finally mandated is really the evolution of law.

Because so many of our legal and economic activities are conducted in the corporate format, juristic (law-made) business entities cannot ignore this constant and dynamic tug and pull between ethics and law. The bottom line in the study of ethics is ultimately personal, and our job 9 .

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as teachers is to help students prepare for these ethical challenges in both their professional and personal lives.

Introduction to Ethics and Social Responsibility of Business  Businesses organized in the United States are subject to its laws  They are also subject to the laws of other countries in which they operate  Business persons owe a duty to act ethically in the conduct of their affairs  Businesses owe a social responsibility not to harm society Ethics and the Law  Ethics – A set of moral principles or values that governs the conduct of an individual or a group – doing what is right  What is lawful conduct is not always ethical conduct  In some situations, the law may permit an act that is ethically wrong Business Ethics There do seem to be some universal rules about what conduct is ethical and what conduct is not.

Five major theories of ethics include: (1) ethical fundamentalism; (2) utilitarianism; (3) Kantian ethics; (4) Rawl’s social justice theory; and (5) ethical relativism.

Ethical Fundamentalism – Persons look to an outside source or central figure for ethical rules or commands.

Utilitarianism – Dictates that people must choose the action or follow the rule that provides the greatest good to society. This moral theory does not necessarily ensure the greatest good for the greatest number of people.

Kantian Ethics – A set of universal rules that establishes ethical duties. The rules are based on reasoning and require (1) consistency in application and (2) reversibility. Its proponent, Immanuel Kant, would have people behave according to the categorical imperative “Do unto others as you would have them do unto you.” Kantian ethics is also called duty ethics.

U.S. Supreme Court Case Case 2.1 Moral Theory of Law and Ethics: POM Wonderful, LLC v. Coca-Cola Company Facts: POM Wonderful, LLC (POM) produces and sells a pomegranate-blueberry juice blend that consists of 85% pomegranate and 15% blueberry juices. The Coca-Cola Company (CocaCola) produces and sells a competing juice blend with a label that conspicuously displays the words “POMEGRANATE” and “BLUEBERRY.” Coca-Cola’s pomegranate blueberry juice is actually made of five different juices: 0.3% pomegranate, 0.2% blueberry, 0.1% raspberry, and 99.4% apple and grape juices. POM sued Coca-Cola under Section 43 of the federal Lanham Act, which allows one competitor to sue another to recover damages for unfair competition arising from false and misleading product descriptions. The U.S. district court and the U.S. court of appeals held in favor of Coca-Cola. POM appealed to the U.S. Supreme Court.

Issue: Can a private party bring an unfair competition lawsuit under the Lanham Act against a competitor that challenges the truthfulness of a food label?

Decision: The U.S. Supreme Court held that POM may proceed with its Lanham Act unfair competition lawsuit against Coca-Cola and remanded the case for further proceedings.

Reason: The Lanham Act creates a private cause of action for unfair competition through misleading advertising and labeling.

Ethics Questions: The facts do appear to indicate that Coca-Cola was trying to trick customers into buying cheaper apple-grape juice by prominently labeling it pomegranate10 .

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blueberry juice. There is a strong argument to be made that Coca-Cola did not act ethically in this case.

Rawls’s Social Justice Theory – Moral duties are based on an implied social contract. This implied contract states, “I will keep the rules if everyone else does.” Fairness is the essence of justice. Rules are established from an “original position.” This means that the principles of justice should be chosen by persons who do not yet know their station in society—thus, their “veil of ignorance” would permit the fairest possible principles to be selected.

Ethical Relativism – Individuals decide what is ethical based on their own feelings as to what is right or wrong. Thus, there are no universal ethical rules to guide a person’s conduct.

U.S. Supreme Court Case Case 2.2 Nondisclosure of Evidence: Goodyear Tire & Rubber Company v. Haeger Facts: The Haegers sued the Goodyear Tire & Rubber Company to recover monetary damages for injuries they suffered after the family’s motorhome swerved off the road and flipped over. The plaintiffs alleged that a Goodyear G159 tire on the vehicle caused the accident because the tire was not designed to withstand the level of heat generated when the tire was used on a motorhome at highway speeds. The plaintiffs repeatedly demanded that Goodyear turn over internal test results for the G159, but the company’s responses were both slow and unrevealing in content.

The parties finally settled the case for an undisclosed sum.

Later, the plaintiffs’ lawyer learned that Goodyear had disclosed a set of test results in another case that had not been disclosed to the plaintiffs that showed that the G159 tire got unusually hot at speeds between 55 and 65 miles per hour. The plaintiffs sued Goodyear to recover their entire lawyer’s fees of $2.7 million they expended on their case. The U.S. district court awarded the plaintiffs this amount of damages, and the U.S. court of appeals affirmed the judgment. Goodyear appealed to the U.S. Supreme Court, alleging that the award of lawyer’s fees should not be the entire amount expended by the plaintiffs, but should be limited to an amount determined to be related to Goodyear’s misconduct.

Issue: Should the plaintiffs recover their entire lawyer’s fees of $2.7 million?

Decision: The U.S. Supreme Court held that the plaintiffs could not automatically recover the entire lawyer’s fees they spent on the case but could recover the amount of lawyer’s fees caused

by Goodyear’s withholding of evidence.

Reason: The U.S. Supreme Court agreed with the lower court that Goodyear had engaged in a years-long course of bad-faith behavior, and that the company’s conduct arose to a truly egregious level. The Court believed, however, that an award of attorney’s fees must be specifically limited to those fees incurred because of the conduct at issue, and that no such determination had been made with respect to the $2.7 million award.

Ethics Questions: Although the record does indicate an ethical breach by Goodyear, the U.S. Supreme Court’s decision appears sound in terms of limiting the award of attorney’s fees to an amount specifically related to the ethical breach.

Social Responsibility of Business  Business does not operate in a vacuum  Decisions made by business have far-reaching effects on society  In the past, many business decisions were made solely on a cost-benefit analysis  Such decisions may cause negative externalities for others  Corporations are considered to owe some degree of social responsibility for their actions Maximize Profits – The traditional view of the social responsibility of business is that businesses should maximize profits for shareholders. This view holds that the interests of other 11 .

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constituencies, such as employees, suppliers, and residents of the communities in which businesses are located, are not important in and of themselves.

Critical Legal Thinking: Volkswagen Emissions Scandal In the early 2000s, Volkswagen produced a new diesel engine, but it was unable to develop one that met United States environmental standards which limited the amount of nitrogen oxide (NOx) pollution that an automobile could emit. In order to sell its new diesel cars in the United States, Volkswagen built into their diesel cars a device and software that could detect when their diesel automobiles were being tested by equipment of the U.S. Environmental Protection Agency (EPA). The company’s automobiles were programmed to falsely indicate that their emissions met EPA standards, when in fact Volkswagen’s diesel engines spewed NOx emissions 40 times greater than permitted by law.

The U.S. government brought civil fraud and criminal charges against Volkswagen, and consumers who purchased the affected vehicles—which could not be driven because they violated emission standards—brought civil class action lawsuits against the company.

Volkswagen eventually agreed to pay $16 billion to settle the class action civil claims, and in a 2017 settlement reached with the U.S. government, Volkswagen pleaded guilty to 3 criminal counts and agreed to pay $4.3 billion in civil and criminal fines. Six of the company’s executives were criminally indicted for their participation in the deception.

Moral Minimum – This theory of social responsibility contends that a corporation’s duty is to make a profit while avoiding causing harm to others. If a business avoids or corrects the social injury it causes, it has met its duty of social responsibility.

Stakeholder Interest – Under this theory of social responsibility, a corporation must consider the interests of all stakeholders, including stockholders, employees, suppliers, customers, creditors, and the local community.

Global Law: Is the Outsourcing of U.S. Jobs to Foreign Countries Ethical?

U.S. companies often outsource the production of many goods that are eventually sold in the United States, primarily because it is much less expensive to produce goods in foreign countries.

Usually, there are substantial labor cost savings abroad due to lower wages and lax workplace regulations (for example, occupational safety, workers’ compensation, and fair labor standards laws). This section questions whether it is ethical for U.S. companies to capitalize on foreign workers who have few of the legal protections afforded workers in the United States.

Ethics: Sarbanes-Oxley Act Requires Public Companies to Adopt Codes of Ethics The Sarbanes-Oxley Act of 2002, with its strict enforcement and punishment provisions against corporate financial fraud, should prompt companies and their officers to be more ethical.

However, the entire corporate culture may need to change before an organization can be more ethical.

Corporate Citizenship – This theory of social responsibility argues that business has a responsibility to do well, and is therefore responsible for helping to solve social problems it did little, if anything, to cause.

Public Benefit Corporations This is a new form of corporation often referred to as a benefit corporation, B corporation, or B corp. A public benefit corporation is a for-profit corporation, but with missions additional to the pure profit motive. Such missions include general-public benefits like considering social issues and protecting the environment, and can include specific public benefit purposes such as reducing 12 .

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the company’s carbon footprint, engaging in sustainability efforts, and giving a designated percentage of the company’s profits to charity.

V. Key Terms and Concepts  Code of ethics—A code adopted by a company wherein the company sets forth rules of ethics for the company’s managers and employees to follow when dealing with customers, employees, suppliers, and others.  Corporate citizenship—A theory of social responsibility that says a business has a responsibility to do good.  Ethical fundamentalism—When a person looks to an outside source for ethical rules or commands.  Ethical relativism—A moral theory that holds individuals must decide what is ethical based on their own feelings as to what is right or wrong.  Ethics—A set of moral principles or values that govern the conduct of an individual or a group.  Ethics and the law—Ethics and the law are intertwined. Sometimes the rule of law and the rule of ethics demand the same response by a person confronted with a problem.  Kantian ethics (duty ethics)—A moral theory that says people owe moral duties based on universal rules such as the categorical imperative “Do unto others as you would have them do unto you.”  Law—A set of enforceable standards that establishes a minimum degree of conduct expected by persons and businesses in society.  Maximize profits—A theory of social responsibility that says a corporation owes a duty to take actions that maximize profits for shareholders.  Moral minimum—A theory of social responsibility that says a corporation’s duty is to make a profit while avoiding harm to others.  Public benefit corporation (benefit corporation or B corporation or B corp)—A corporation that requires its directors and officers to make decisions that accomplish general-public benefits and stipulated specific public benefits stated in its articles of incorporation, and to consider stakeholders other than the company’s shareholders, such as employees, customers, suppliers, and the community, when making corporate decisions.  Rawls’s social justice theory—A moral theory that says each person is presumed to have entered into a social contract with all others in society to obey moral rules that are necessary for people to live in peace and harmony.  Sarbanes-Oxley Act of 2002—Makes certain conduct illegal and establishes criminal penalties for violations.  Section 406 of the Sarbanes-Oxley Act—A section that requires a public company to disclose whether it has adopted a code of ethics for senior financial officers.  Social responsibility of business—Requires corporations and businesses to act with an awareness of the consequences their decisions will have on others.  Stakeholder interest—A theory of social responsibility that says a corporation must consider the effects its actions have on persons other than its stockholders.  Utilitarianism—A moral theory that dictates people must choose the action or follow the rule that provides the greatest good to society.

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Chapter 3 Courts, Jurisdiction, and Administrative Law See you in Court!

I. Teacher to Teacher Dialogues Twenty-first century technological advances have provided our students with all kinds of instant access to information. These devices have provided students with a variety of preconceptions.

Among these is the average undergraduate’s notion of how trials are conducted and the role of attorneys in that process. Invariably these perceptions center on popular television series such as Law and Order and Better Call Saul. This is not all bad. Current media focus on numerous lawrelated issues has generated a whole new wave of public interest in the workings of our legal system. The downside is that the media has created many myths on the folklore of law and lawyers.

In the world of pop culture, no one knows until the end who really did it until a surprise witness shows up to identify the bad guy. In more modern versions, the attorney first has a business relationship with the client and then proceeds to get him or her acquitted. Regardless of the outcome, the process is always full of glamour and intrigue.

The problem is that a trial rarely resembles the goings on found in the entertainment media.

Trials are long, tedious, emotionally and financially draining processes for all parties concerned. In many ways, a trial represents a failure by the parties to reach some sort of satisfactory solution of the issue beforehand. Rarely do the parties actually want to go through a labyrinth of pleadings, motions, and the like, feeling all the while totally dependent on the sometimes questionable competence of their attorneys. Unlike the make-believe world of entertainment, the job of an attorney is to keep his or her client out of court. (This often needs some reinforcement with the student.) The attorney’s professional advice should anticipate and resolve potential legal problems before, rather than after the fact if at all possible.

It is against this backdrop that we should try to present a more realistic picture of how our system works. We can basically start by discussing how few controversies actually get to the trial stage and how even fewer of those are actually reported in the National Reporter System.

Additionally, a fair amount of time should be spent reviewing the growing trend towards alternative dispute resolution (ADR). Personal experience examples might be helpful in illustrating the growing trends towards ADR. To complete the cycle, we can then proceed to itemize the key steps used in a court trial.

Anyone who has dealt with a large governmental bureaucracy can readily appreciate the frustrations of trying to get through the maze with sanity intact. The government’s burgeoning growth of administrative agencies at every level is indeed cause for concern for its constituents.

According to statistics published by the U.S. Congress, the federal government alone has over 2 million civilian employees working as of 2018. In spite of constant calls to reduce the size of government’s role in the average person’s affairs, that role has grown tremendously as reflected in these statistics. The media headlines may be focused on the goings on in the capitol, but the real functions of government are carried out “in the trenches” by this “fourth branch of government” every day. This chapter seeks to outline the basic ground rules about how the agencies are created, how they are authorized to act, and what controls have been put in place so as to protect the rights of both citizens and the government.

The basic function undertaken by these administrative agencies is to carry out the ministerial functions necessary to the operation of the government. These functions are first authorized by what are called organic statutes, which create the agency, and enabling statutes, which delegate certain 14 .

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powers to the agency to act for the executive, legislative, or judicial branches of government. It is interesting to note at the outset that the “clean functional lines” of the executive, legislative, and judicial branches can and do often become quickly blurred when examining the breadth and scope of administrative agency activities.

Once the existence of the agency is settled upon and its scope of authority is established, you must then look to see if it is acting within the scope vis-à-vis the particular issue at hand. Remember the basic assumption here is that the executive branch, legislative branch, or judicial branch has chosen to designate and delegate a certain portion of its authority to act. This delegation is based on the presumption that the agency can be expected to have certain levels of expertise, scales of economy, and attention to detail which could not be readily expected of the policy makers. The next step is to see if the power in question was in fact truly delegated, and if so, is it being properly exercised by the agency?

The mechanisms for control of agency powers are relatively sparse given the scope of agency activity. The key provisions for control of agency powers are found in the executive branch chain of command and in the overview powers vested in the judiciary. In addition, there have been a number of specific information access type statutes such as the Freedom of Information Act, Government in the Sunshine Act, and the Administrative Procedure Act to help persons dealing with these agencies to get through the labyrinth.

II. Chapter Objectives 1. Describe state court systems.

2. Describe the federal court system.

3. Describe the U.S. Supreme Court and the types of cases it decides.

4. Explain the jurisdiction of federal courts and compare it with the jurisdiction of state courts.

5. Define standing to sue, jurisdiction, and venue.

6. Explain how jurisdiction is applied to digital commerce.

7. Describe administrative agencies and the main features of administrative law.

III. Key Question Checklist  If the dispute or controversy needs to be resolved in a court of law, which court has jurisdiction?  Once jurisdiction is established, was the proper sequence of pretrial steps taken?  Was the trial sequence properly followed?  After the trial is completed, are any appeals from the decision applicable?  Define administrative law.  List and explain the functions of administrative agencies.  Describe the provisions of the Administrative Procedure Act. IV. Chapter Outline The chapter discusses the federal court system, state court systems, jurisdiction of courts, and administrative agencies.

Introduction to Courts, Jurisdiction, and Administrative Law There are two major court systems in the United States: (1) the federal court system and (2) the court systems of the 50 states, Washington, DC (District of Columbia), and territories of the United States. Each of these systems has jurisdiction to hear different types of lawsuits.

State Court Systems Most state court systems include the following: (1) Limited-jurisdiction trial courts; (2) General-jurisdiction trial courts; 15 .

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(3) Intermediate appellate courts; and (4) A highest state court.

Limited-Jurisdiction Trial Courts – Hear matters of a specialized nature  Traffic courts  Juvenile courts  Justice-of-the-peace courts  Probate courts  Family law courts  Courts that hear misdemeanor criminal law cases General-Jurisdiction Trial Courts – Hear cases of a general nature that are not within the jurisdiction of limited jurisdiction courts. Testimony and evidence at trial are recorded and stored for future reference.

Intermediate Appellate Courts – Intermediate courts that hear appeals from trial courts. Review the trial court record to determine if there have been any errors at trial that would require reversal or modification of the decision.

Highest State Court – Hears appeals from intermediate state courts.

Business Environment: Delaware Court Specializes in Business Disputes Delaware has created a special Chancery Court to decide business litigation, with a reputation for handling corporate matters. Delaware’s laws also tend to favor corporate management, so together with the Chancery Court, the state has created an environment that encourages incorporation in that state. Other states are beginning to follow suit and create their own variation of Delaware’s Chancery Court.

Federal Court System  Special federal courts  U.S. district courts  U.S. courts of appeals  U.S. Supreme Court Special Federal Courts – Federal courts that hear matters of specialized or limited jurisdiction.

They include: (1) U.S. Tax Court—hears cases that involve federal tax laws (2) U.S. Court of Federal Claims—hears cases brought against the United States (3) U.S. Court of International Trade—hears civil cases arising out of customs and international trade laws of the United States (4) U.S. Bankruptcy Court—hears cases that involve federal bankruptcy laws (5) U.S. Court of Appeals for the Armed Forces—exercises appellate jurisdiction over members of the armed services (6) U.S. Court of Appeals for Veterans Claims—exercises jurisdiction over decisions of the Department of Veterans Affairs Contemporary Environment: Foreign Intelligence Surveillance Court In 1978, Congress created the Foreign Intelligence Surveillance (FISA) Court, which is located in Washington, DC. The FISA Court hears requests by federal law enforcement agencies, such as the Federal Bureau of Investigation (FBI) and National Security Agency (NSA), for warrants, called

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FISA warrants, to conduct physical searches and electronic surveillance of Americans or foreigners in the United States who are deemed a threat to national security.

U.S. District Courts – The federal court system’s trial courts of general jurisdiction  Most federal cases originate in federal district court  They are empowered to:  Impanel juries  Receive evidence  Hear testimony  Decide cases U.S. Courts of Appeals – The federal court system’s intermediate appellate courts  These courts hear appeals from the district courts located in their circuit  These courts review the record of the lower court or administrative agency proceedings to determine if there has been any error that would warrant reversal or modification of the lower court decision  No new evidence or testimony is heard Supreme Court of the United States The United States Supreme Court is composed of nine justices who are nominated by the president and confirmed by the U.S. Senate. The president appoints one as the chief justice who is responsible for the administration of the Court, while the other eight are considered associate justices.

Contemporary Environment: Process of Choosing a U.S. Supreme Court Justice The president appoints Supreme Court justices, with the advice and consent of the Senate (majority vote). This allows a form of balance of power between the executive and legislative branches of the government.

Jurisdiction of the U.S. Supreme Court – The Supreme Court hears appeals from the federal district courts and from the highest state courts. Legal briefs are filed, oral arguments are made, lower court records are reviewed, but neither new evidence nor testimony is heard. The Supreme Court’s decision is final.

Decisions of the U.S. Supreme Court – The U.S. Constitution gives Congress the authority to establish rules for the appellate review of cases by the Supreme Court, except in the rare case in which mandatory review is required. Congress has given the Supreme Court discretion to decide what cases it will hear. Petitioners file a petition for certiorari asking for the Supreme Court to review their case. If the court decides to consider the matter, it issues a writ of certiorari. The court hears about 100 cases each year.

The U.S. Supreme Court can issue several types of decisions:  Unanimous decision – In this case, all of the justices voting agree as to both the outcome and the reasoning. Such a decision becomes precedent.  Majority decision – A decision by the Supreme Court is considered a majority decision if a majority of the justices agree on the outcome and reasoning. This decision becomes precedent.  Plurality decision – A plurality decision is when the majority of the justices agree on the outcome, but not the reasoning. This settles the case, but does not serve as precedent.  Tie decision – In this case, the winner in the lower court prevails. This does not serve as precedent.

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Concurring opinion – When a justice agrees with the outcome of the majority but not the reasoning, the justice will issue a concurring opinion explaining his or her stand.

Dissenting opinion – Any justice who does not agree with the decision may state his or her opinion.

Contemporary Environment: “I’ll Take You to the U.S. Supreme Court!”

This discusses the process necessary to win a review by the U.S. Supreme Court. Having a case heard by the nation’s highest court is rare. Each year, approximately 10,000 petitioners ask the Supreme Court to hear their cases, while fewer than 100 of these cases are accepted for full review in a particular term.

Jurisdiction of Federal and State Courts Article III, Section 2 of the United States Constitution sets forth the jurisdiction of federal courts.

Federal courts have limited jurisdiction to hear cases involving a federal question or diversity of citizenship.

Federal Question – Federal courts have limited jurisdiction to hear cases involving federal questions with no dollar amount limit.

Diversity of Citizenship – The federal courts have jurisdiction to hear cases involving diversity of citizenship. Diversity of citizenship occurs if a lawsuit involves (1) citizens of different states or (2) a citizen of a state and a citizen or subject of a foreign country. The amount in controversy must be over $75,000.

Jurisdiction of State Courts – State courts hear cases that the federal courts do not have the jurisdiction to hear. Federal courts may have concurrent jurisdiction with state courts to hear cases involving diversity of citizenship.

Full Faith and Credit Clause Under the Full Faith and Credit Clause of the United States Constitution (Article IV, Section 1), a judgment of a court of one state must be given “full faith and credit” by the courts of another state.

Standing to Sue, Jurisdiction, and Venue To bring a lawsuit in a court, the plaintiff must have standing to sue, the court must have personal jurisdiction or other jurisdiction to hear the case, and the case must be brought in the proper venue.

Standing to Sue – The plaintiff must have a stake in the outcome of the lawsuit.

In Personam Jurisdiction – In personam jurisdiction over the person is achieved by the plaintiff filing a lawsuit with a court and by serving a summons on the defendant. If personal service is unavailable, notice of the case by mail or publication in newspapers is allowed. Defendants disputing the jurisdiction of a court may make a special appearance to argue their case, and cannot be served while making this appearance.

Long-Arm Statute In most states, a state court can obtain jurisdiction in a civil lawsuit over persons and businesses located in another state or country through the state’s long-are statute. These statutes extend a state’s jurisdiction to nonresidents who are not served a summons within the state. The nonresident defendant in the civil lawsuit must have had some minimum contact with the state such that the maintenance of that lawsuit in that state does not offend traditional notions of fair play and substantial justice.

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Critical Legal Thinking: International Shoe Company v. State of Washington In this case, the United States Supreme Court addressed the question of how far a state can go to require a person or business to defend him-, her-, or itself in a court of law in that state. The International Shoe Company was a Delaware corporation that had its principal place of business in St. Louis, Missouri. In the state of Washington, the company’s sales representative did not have a specific office but sold the shoes door-to-door and sometimes at temporary locations.

The state of Washington assessed an unemployment tax on International Shoe. International Shoe made a special appearance in the Washington court to argue that it did not do sufficient business in Washington to warrant having to pay unemployment taxes in that state.

In its decision, the Supreme Court stated that in order to comply with “traditional notions of fair play and substantial justice,” due process only requires that a defendant have “minimum contacts” with a particular state in order for the court of that state to subject the defendant to in personam jurisdiction. The “minimum contacts” standard is not a “bright-line” test, so if in personam jurisdiction is challenged in a particular case, the facts of that case will determine whether such jurisdiction exists.

In Rem Jurisdiction – Courts may have jurisdiction over property found within the state, based on in rem jurisdiction (“jurisdiction over the thing”).

Quasi in Rem Jurisdiction – Attachment jurisdiction occurs when a plaintiff who has obtained a judgment attempts to satisfy the judgment by attaching property located in another state.

Venue – The court with the jurisdiction that is located closest to where the incident occurred or where the parties live should hear the lawsuit. Pretrial publicity may prejudice jurors and may lead to a request for a change of venue in order to get a more impartial jury. Forum shopping is the process of looking for a more favorable court without a valid reason, and is frowned upon by most courts.

Forum-Selection and Choice-of-Law Clauses – Because many business agreements are formed between people from different states and different countries, many contracts have clauses that specifically address the state’s or country’s laws that will be applied in case of a dispute, in what are known as choice-of-law clauses. Additionally, through a forum-selection clause, the parties agree which court will have jurisdiction over a dispute if one should arise in their course of dealings.

Federal Court Case Case 3.1 Forum-Selection Clause: Carter’s of New Bedford, Inc. v. Nike, Inc. Facts: Nike, Inc. is a worldwide seller of shoes, apparel, and other items carrying the Nike brand.

Nike’s headquarters is in Beaverton, Oregon. Carter’s of New Bedford, Inc. is a family-owned retail clothing and footware business that operates two stores in Massachusetts. Carter’s has sold Nike products for 28 years. The agreement between Nike and Carter’s is contained in the invoices that Nike provides to Carter’s, which are agreed to by both parties. The invoice agreements include a forum-selection clause that requires any claims that Carter’s has with Nike to be brought in Oregon, not Massachusetts. When Nike notified Carter’s that it was terminating the parties’ business relationship, Carter’s sued Nike in Massachusetts court alleging that Nike breached its agreement with Carter’s. Nike argued that any claim Carter’s has against Nike must be brought in Oregon pursuant to the forum-selection clause and moved to have Carter’s Massachusetts lawsuit dismissed.

The U.S. district court dismissed the lawsuit, and Carter’s appealed.

Issue: Is the forum-selection clause enforceable?

Decision: The U.S. Court of appeals affirmed the district court’s decision that enforced the forumselection clause and dismissed Carter’s Massachusetts lawsuit against Nike.

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Reason: The court concluded that Carter’s did not meet its burden to show that the forum-selection clause would deprive Carter’s of its day in court. Carter’s failed to persuade the court that enforcement of the forum-selection clause would make it practically impossible for it to litigate in Oregon.

Ethics Questions: While it is legal for Nike to contractually require its business affiliates to litigate against the company only in Oregon, some may question the ethics of such a requirement.

Nevertheless, Nike’s business affiliates are charged with the responsibility of reading the terms of any proposed contract with Nike, and understanding that a forum-selectin clause is generally binding as a matter of contract law.

Jurisdiction in Digital Commerce Today, with the advent of the internet and the ability of persons and businesses to reach millions of people in other states electronically, particularly through websites, modern issues arise as to whether courts have jurisdiction in cyberspace. Zippo Manufacturing Company v. Zippo Dot Com, Inc. is an important case that established a test for determining when a court has jurisdiction over the owner or operator of an interactive, semi-interactive, or passive website.

Information Technology: Jurisdiction Over an Internet eBay Seller Odil Ostonakulov, a resident of Tennessee, operates Motorcars of Nashville, Inc. (MNI), a Tennessee corporation. The company sells used automobiles to residents of 50 states on eBay, averaging 12-35 cars for sale every day on eBay. Samantha Guffey, a resident of Oklahoma, was the winning bidder on a used Volvo automobile listed by MNI on eBay. In addition to Guffey, MNI made sales of vehicles to other residents of Oklahoma. After receiving the automobile, Guffey determined that the automobile was not in the condition advertised and sued Ostonakulov and MNI in Oklahoma court alleging that the defendants had committed fraud. The defendants filed a motion with the Oklahoma court to have the case dismissed, alleging that Oklahoma lacked personal jurisdiction over the defendants because they did not possess minimum contacts with Oklahoma to be subject to Oklahoma’s long-arm statute. The trial court dismissed the lawsuit, finding that Oklahoma lacked personal jurisdiction over the defendants. Guffey appealed.

The Supreme Court of Oklahoma held that Oklahoma possessed personal jurisdiction over the Tennessee defendants. The court stated, “Internet forums such as eBay expand the seller’s market literally to the world and sellers know that, and avail themselves of the benefits of this greatly expanded marketplace. Sellers cannot expect to avail themselves of the benefits of the internetcreated world market that the purposely exploit and profit from without accepting the concomitant legal responsibilities that such an expanded market may bring with it.” Guffey v. Ostonakulov, 321 P.3d 971 (Supreme Court of Oklahoma, 2014) Administrative Law Administrative law is a combination of substantive law and procedural law.

Administrative Agencies – Federal administrative agencies are created by either Congress or the executive branch, and have broad regulatory powers. State administrative agencies have a profound effect on business. State administrative agencies are empowered to enforce state statutes. They have the power to adopt rules and regulations to interpret the statutes they are empowered to administer.

Local governments such as cities, municipalities, and counties create local administrative agencies to administer local regulatory law.

Cabinet-Level Departments – These are federal departments that advise the president and are responsible for enforcing specific administrative statutes enacted by the U.S. Congress.

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Powers of Administrative Agencies – The delegation doctrine states that an administrative agency can be delegated powers to act in the stead of the legislative, executive, or judicial branches. Acts outside their assigned scope have been declared unconstitutional.  Rule-making – Statutes have given administrative agencies the power to issue substantive rules, provided that they follow the procedures established by the APA. They can also issue rules that interpret existing statutes, as well as statements of policy explaining their proposed courses of action.  Judicial authority – Administrative agencies often have the power to adjudicate issues through administrative procedures, provided the procedural Due Process Clause of the federal and state governments is followed.  Executive power – Administrative agencies are usually granted powers of investigation and prosecution of violations of statutes and administrative rules and orders. They are also granted subpoena power in order to acquire the necessary information.  Licensing – In order to enter into certain types of industries, statutes often require licenses be acquired from administrative agencies.

Landmark Law: Administrative Procedure Act The Administrative Procedure Act (APA) enacted by the U.S. Congress in 1946, establishes procedures federal administrative agencies must follow in conducting their affairs. The APA establishes notice requirements of actions a federal agency plans on taking. It requires hearings to be held in most cases, and requires certain procedural safeguards and protocols to be followed at these proceedings.

Administrative Law Judge – Administrative proceedings employ an employee of the agency, an ALJ, as the sole determiner in each case. They issue an order stating the reason for their decisions, which become final if not appealed.

Global Law: Judicial System of Japan Comparatively speaking, there are much fewer lawyers and lawsuits in Japan than in the United States. Culturally, Japan believes that confrontation should be avoided. In Japan, clients must usually pay a large, up-front fee (rather than a contingency fee) for lawyers to represent them, and plaintiffs must pay a court filing fee based on the amount claimed (rather than a flat fee).

V. Key Terms and Concepts  Administrative agencies—Agencies that the legislative and executive branches of federal and state governments establish.  Administrative law—Law that governments enact to regulate industries, businesses, and professionals.  Administrative law judge (ALJ)—A judge, presiding over administrative proceedings, who decides questions of law and fact concerning the case.  Administrative order—An ALJ’s decision is issued in the form of an administrative order.

The order must state the reasons for the ALJ’s decision. The order becomes final if it is not appealed.  Administrative Procedure Act (APA)—An act that establishes certain administrative procedures that federal administrative agencies must follow in conducting their affairs.  Administrative subpoena—An order that directs the subject of the subpoena to disclose the requested information.  Article III of the U.S. Constitution— Provides that the federal government’s judicial power is vested in one “Supreme Court.” This court is the U.S. Supreme Court.

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Associate Justices of the U.S. Supreme Court—The eight other justices apart from the Chief Justice of the U.S. Supreme Court.

Cabinet-level federal departments—Federal departments that advise the president and are responsible for enforcing specific administrative statutes enacted by Congress.

Change of venue—In certain circumstances, when pretrial publicity may prejudice jurors, a change of venue may be requested so that a more impartial jury can be found.

Chief Justice of the U.S. Supreme Court—Appointed by the president and responsible for administration of the U.S. Supreme Court.

Choice-of-law clause— A contract provision that designates a certain state’s law or country’s law that will be applied in any dispute concerning nonperformance of the contract.

Circuit—The geographical area served by each U.S. court of appeals.

Concurrent jurisdiction—Jurisdiction shared by two or more courts.

Concurring opinion—An opinion that can be issued by a justice of the Supreme Court who agrees with the outcome of a case but not the reason proffered by the other justices.

Delaware Court of Chancery—A special court which decides cases involving corporate governance, fiduciary duties of corporate officers and directors, mergers and acquisitions, and other business issues.

Dissenting opinion—An opinion which sets forth the reason why a justice of the Supreme Court does not agree with a decision.

District—The geographical area served by a U.S. district court.

Diversity of citizenship—A case between (1) citizens of different states and (2) a citizen of a state and a citizen or subject of a foreign country.

En banc review—A review that can be requested by a petitioner in the U.S. court of appeals after a decision is rendered by a three-judge panel.

Exclusive jurisdiction—Jurisdiction held by only one court.

Executive power—Administrative agencies are usually granted executive powers, such as the power to investigate and prosecute possible violations of statutes and rules. This often includes the power to issue an administrative subpoena to a business or person to obtain information.

Federal administrative agencies—Agencies created by the federal government to enforce federal regulatory statutes. Examples include the Food and Drug Administration (FDA), the National Labor Relations Board (NLRB), and the Equal Employment Opportunity Commission (EEOC).

Federal question case—A case arising under the U.S. Constitution, treaties, and federal statutes and regulations.

FISA warrant—Empowers a federal administrative agency, such as the Federal Bureau of Investigation (FBI) or the National Security Agency (NSA), to conduct physical searches and electronic surveillance of Americans or foreigners in the United States who are deemed a threat to national security.

Forum-selection clause (choice-of-forum clause)—Contract provision that designates a certain court to hear any dispute concerning nonperformance of the contract.

Forum shopping—Looking for a favorable court without a valid reason.

Full Faith and Credit Clause—A clause of the U.S. Constitution under which a judgment of a court of one state must be given “full faith and credit” by the courts of another state.

General-jurisdiction trial court (court of record)—A court that hears cases of a general nature that are not within the jurisdiction of limited-jurisdiction trial courts. Testimony and evidence at trial are recorded and stored for future reference.

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Highest state court—The highest court in a state court system; it hears appeals from intermediate appellate state courts and certain trial courts.

In personam jurisdiction (personal jurisdiction)—Jurisdiction over the parties to a lawsuit.

In rem jurisdiction—Jurisdiction to hear a case because of jurisdiction over the property of the lawsuit.

Intermediate appellate court (appellate court or court of appeals)—An intermediate court that hears appeals from trial courts.

International Shoe Company v. State of Washington—A landmark U.S. Supreme Court case that established the minimum contacts standard.

Judicial authority—Authority of an administrative agency to adjudicate cases in an administrative proceeding.

Judicial review of administrative agency actions—Where an enabling statute does not provide for review, the APA authorizes judicial review of federal administrative agency actions.

License—Many administrative agencies are empowered to issue a license before a person can engage in certain professions or businesses. For example, the Office of the Comptroller of the Currency (OCC), a federal government agency, issues charters for national banks.

Limited-jurisdiction trial court (inferior trial court)—A court that hears matters of a specialized or limited nature.

Local administrative agencies—Agencies created by cities, municipalities, and counties to administer local regulatory law.

Long-arm statute—A statute that extends a state’s jurisdiction to nonresidents who were not served a summons within the state.

Majority decision—A decision of the U.S. Supreme Court where a majority of the justices agree as to the outcome and reasoning used to decide a case.

Minimum contact—A nonresident defendant in a civil lawsuit must have had some minimum contact with the state such that the maintenance of that lawsuit in that state does not offend traditional notions of fair play and substantial justice.

Petition for certiorari—A petition asking the Supreme Court to hear one’s case.

Plurality decision—A decision of the U.S. Supreme Court where a majority of the justices agree as to the outcome of a case but not as to the reasoning for reaching the outcome.

Procedural administrative law—Establishes the procedures that must be followed by an administrative agency while enforcing substantive laws.

Quasi in rem jurisdiction (attachment jurisdiction)—Jurisdiction allowed a plaintiff who obtains a judgment in one state to try to collect the judgment by attaching property of the defendant located in another state.

Rule of four—The votes of four justices are necessary to grant an appeal and schedule an oral argument before the Supreme Court.

Rules and regulations—Adopted by administrative agencies to interpret the statutes that they are authorized to enforce.

Service of process—A summons is served on the defendant to obtain personal jurisdiction over him or her.

Small claims court—A court that hears civil cases involving small dollar amounts.

Special federal courts—Federal courts that hear matters of specialized or limited jurisdiction.

Standing to sue—The plaintiff must have some stake in the outcome of the lawsuit.

State administrative agencies—Administrative agencies that states create to enforce and interpret state law.

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State courts—A separate court system that is present in each state, Washington, DC and each territory of the United States. It includes limited-jurisdiction trial courts, generaljurisdiction trial courts, intermediate appellate courts, and a supreme court.

State supreme court—The highest court in a state court system; it hears appeals from intermediate state courts and certain trail courts.

Substantive administrative law—Law that an administrative agency enforces—federal statutes enacted by Congress or state statutes enacted by state legislatures.

Substantive rules—Rules issued by an administrative agency that have the force of law and to which covered persons and businesses must adhere.

Supreme Court of the United States (U.S. Supreme Court)—The highest court in the land, located in Washington, DC. Tie decision—A Supreme Court decision where the number of votes cast by the justices leads to a tie and the decision of the lower court is affirmed. It occurs when all nine judges are not present.

Unanimous decision—A Supreme Court decision where all of the justices voting agree as to the outcome and reasoning used to decide a case.

U.S. Bankruptcy Court—A special federal court that hears cases involving federal bankruptcy laws.

U.S. Court of Appeals—The federal court system’s intermediate appellate court.

U.S. Court of Appeals for the Armed Forces—A special federal court that exercises appellate jurisdiction over members of the armed services.

U.S. Court of Appeals for the Federal Circuit—A U.S. Court of Appeals in Washington, DC that has special appellate jurisdiction to review the decisions of the Court of Federal Claims, the Patent and Trademark Office, and the Court of International Trade.

U.S. Court of Appeals for Veterans Claims—A special federal court that exercises jurisdiction over decisions of the Department of Veterans Affairs.

U.S. Court of Federal Claims—A special federal court that hears cases brought against the United States.

U.S. Court of International Trade—A special federal court that handles cases involving tariffs and international trade disputes.

U.S. district courts—The federal court system’s trial courts of general jurisdiction.

U.S. District of Columbia Circuit—The 12th circuit court, located in Washington, DC. U.S. Foreign Intelligence Surveillance Court (FISA Court)—A court located in Washington, DC that hears requests by federal law enforcement agencies, such as the Federal Bureau of Investigation (FBI) and the National Security Agency (NSA), for FISA warrants.

U.S. Foreign Intelligence Court of Review (FISCR)—If the U.S. Foreign Intelligence Surveillance Court (FISA Court) denies a government application for a FISA warrant, the government may appeal the decision to this entity.

U.S. Tax Court—A special federal court that hears cases involving federal tax laws.

Venue—A concept that requires lawsuits to be heard by the court with jurisdiction that is nearest the location in which the incident occurred or where the parties reside.

Writ of certiorari—An official notice that the U.S. Supreme Court will review one’s case.

Zippo Manufacturing Company v. Zippo Dot Com, Inc.—An important case that established a test for determining when a court has jurisdiction over the owner or operator of an interactive, semi-interactive, or passive website.

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Chapter 4 Judicial, Alternative, and E-Dispute Resolution Why don’t I want to see you in court?

I. Teacher to Teacher Dialogue Only a small percentage of cases make it to trial. The reality is that most cases settle at some point in the process. Settling is safer, quicker, and usually less costly. In my practice, I can remember having several cases settle while the jury was out deliberating.

I try to present a more realistic picture of how our system works. I basically start by presenting statistics on how few controversies actually get to the trial stage and how even fewer of those are actually reported in the National Reporter System. In addition, I spend a fair amount of time reviewing the growing trend toward alternative dispute resolution (ADR). I illustrate the key identifying features of each method of ADR, and I use both experiential examples, as well as local statutory enactments, to help illustrate the increasing use of ADR. Given the reality that litigants may not resolve their dispute through ADR, and that civil litigation may be inevitable in a particular case, it is important to itemize the key steps used in a court trial. For those of you who are practicing trial attorneys or who have worked in that arena before coming to academia, this material gives you an obvious area of focus and further elaboration. In any event, I always try to use this opportunity to ask students about their own personal contact with our court system. I do, however, preface these conversations with the caveat that they need not volunteer information that might be embarrassing, confidential, or inappropriate.

II. Chapter Objectives 1. Describe how attorneys are compensated.

2. Describe the pretrial litigation process.

3. Define complaint, summons, and answer, and describe the pleading process.

4. Define class action and describe the requirements for bringing a class action lawsuit.

5. Describe the discovery process and the various methods of discovery.

6. Contrast the different types of pretrial motions.

7. Describe the goals and procedures of a settlement conference.

8. Describe the trial process.

III. Key Question Checklist  Does the dispute or controversy lend itself to an out-of-court resolution?  If the dispute or controversy needs to be resolved in a court of law, which court has jurisdiction?  Once jurisdiction is established, was the proper sequence of pretrial steps taken?  Was the trial sequence properly followed?  After the trial is completed, are any appeals from the decision applicable?

IV. Chapter Outline Introduction to Judicial, Alternative, and E-Dispute Resolution One objective of this chapter is to familiarize students with the court trial sequence. Litigation is the process of bringing, maintaining, and defending lawsuits. Because it is often difficult and 25 .

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expensive, people turn to various forms of non-judicial dispute resolution, or alternative dispute resolution.

Attorney Representation Lawyers most often charge an hourly rate for their services. The fees charged reflect the attorney’s experience, cost of operations, and the location of his or her practice. Attorneys often require a client to pay a retainer, a specified dollar amount deposited by the client before the lawyer proceeds, which is placed in a trust account. The lawyer’s fees are taken from the trust account as he or she provides hourly services. Fees are also charged for paralegals who work on the case, for expenses such as copying documents, filing fees with the court, fees for expert witnesses, and other fees associated with the case or legal transaction.

Where a legal matter is straightforward and well-defined, attorneys often charge a flat fee. This fee arrangement is often used to draft wills and trusts, form small corporations and limited liability companies, file simple bankruptcy proceedings, settle uncontested divorces, and the like.

In certain types of cases, attorneys work on a contingency-fee basis. Under this arrangement, the lawyer receives a percentage of the amount recovered by winning or settling a case.

In criminal cases, the government is represented by a prosecutor. A defendant in a criminal case can hire his or her own attorney. If the defendant cannot afford an attorney, the government will provide an attorney to represent the defendant free of charge.

Pretrial Litigation Process The pretrial litigation process can be divided into the following major phases: pleadings, discovery, pretrial motions, and settlement conference.

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Pleadings The paperwork filed to initiate and respond to a lawsuit is known as the pleadings. These include the complaint and summons, the answer, and any cross-complaints and replies, as well as interventions and consolidation requests.

Complaint and Summons – To initiate a lawsuit, the party who is suing (the plaintiff) must file a complaint in the proper court. A summons is a court order directing the defendant to appear in court and answer the complaint. The complaint and summons are served on the defendant. This is called service of process.

Answer – The defendant, the party who is being sued, must file an answer to the plaintiff’s complaint.

Cross-Complaint and Reply – A defendant who believes he or she has been injured by the plaintiff can file a cross-complaint against the plaintiff in addition to an answer. The original plaintiff must file a reply (answer) to the cross-complaint.

Intervention and Consolidation – If other persons have an interest in a lawsuit, they may intervene and become parties to the lawsuit. This is called intervention. If several plaintiffs have filed separate lawsuits stemming from the same fact situation against the same defendant, the court can consolidate the cases into one case if doing so would not cause undue prejudice to the parties.

Critical Legal Thinking: Statute of Limitations A statute of limitations establishes the period during which a plaintiff must bring a lawsuit against a defendant. If a lawsuit is not filed within this time, the plaintiff loses the right to sue. A statute of limitations begins to “run” at the time the plaintiff first has the right to sue the defendant.

Class Action – A class action occurs when a group of plaintiffs collectively bring a lawsuit against a defendant.

Class Action Fairness Act (CAFA) – In 2005, the U.S. Congress enacted the Class Action Fairness Act that gives federal courts jurisdiction to hear class action lawsuits that would otherwise be heard by state courts. The act is designed to reduce many abuses in class action lawsuits previously brought in state courts, particularly plaintiffs forum shopping for sympathetic state courts.

U.S. Supreme Court Case Case 4.1 Class Action: Tyson Foods, Inc. v. Bouaphakeo Facts: Tyson Foods, Inc. is a major food processor that operates a pork processing plant in Storm Lake, Iowa. The plaintiff employees slaughter and trim hogs and prepare the meat for shipment.

Tyson paid these employees for the 40 hours they worked each week, but did not pay them for time spent donning and doffing their protective gear. The affected employees filed a class action lawsuit in U.S. district court alleging that Tyson violated the overtime pay requirements of the Fair Labor Standards Act (FLSA) by not paying them overtime pay for the time spent putting on and taking off their protective equipment.

Tyson argued that the class should not be certified and that the plaintiffs’ only recourse is to bring individual lawsuits against Tyson. The U.S. district court certified the class and the jury awarded $2.9 million in compensatory damages against Tyson for violation of the FLSA. The U.S. court of appeals upheld the U.S. district court’s decision, and Tyson appealed to the U.S. Supreme Court.

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Issue: Should the class action be certified?

Decision: The U.S. Supreme Court upheld the U.S. court of appeal’s decision to certify the class.

Reasoning: The U.S. Supreme Court noted that before a class is certified, a district court must find that questions of law or fact common to class members predominate over any questions affecting only individual members. In the subject case, the Court noted that each employee worked in the same facility, did similar work, and was paid under the same policy.

Ethics Questions: While some students may argue that the sufficient commonality of interest requirement for certification of a class action is a legitimate question on appeal in this case, others may contend that the question is easily resolved by the fact that all employees were affected by Tyson’s practice of not paying them for the time they spent putting on and taking off their protective equipment. Arguably, Tyson’s attempt to block the class action certification and thereby require that the plaintiffs pursue individual lawsuits was simply an attempt by the corporation to dissuade litigation.

Discovery A legal process during which both parties engage in various activities to discover facts of the case from the other party and from witnesses prior to trial. Examples include depositions and interrogatories.

Deposition – A deposition is oral testimony given by a party or witness prior to trial. The person giving a deposition is called the deponent.

Interrogatories – Interrogatories are written questions submitted by one party to a lawsuit to another party.

Production of Documents – One party to a lawsuit may request that the other party produce all documents that are relevant to the case prior to trial. This is called production of documents.

Information Technology: E-Discovery Electronic discovery, or e-discovery, is the process whereby relevant electronic documents are discovered, exchanged, collected preserved, and processed during a lawsuit. Rule 34 of the Federal Rules of Civil Procedure requires that electronically stored information (ESI) be produced by the parties in federal court proceedings. Discoverable ESI includes Microsoft Word documents, Excel spreadsheets, emails, instant messages, text messages, and the like.

Information Technology: Cellphone Texts are Discoverable Evidence in an Automobile Accident Case A vehicle driven by Tabitha Antico collided with a truck owned by Sindt Trucking, Inc. Antico was killed in the accident. The personal representative of Antico brought a civil wrongful death action against Sindt Trucking. The company denied liability, alleging that Antico was either solely or partially at fault for the accident because she was distracted by texting or otherwise using her cellphone while driving. Testimony from two witnesses and responding troopers indicated that Antico had been utilizing her cellphone at the time of the accident. Sindt made a motion to the trial court to permit an expert to inspect the cellphone’s data, including text messages, internet website access history, and other use of Antico’s cellphone on the day of the accident. The plaintiff countered that the discovery would violate Antico’s privacy rights. The trial court approved the discovery of the cellphone data, limiting the discovery to the 9-hour period preceding and including the time of the accident.

The court of appeals affirmed the trial court’s ruling permitting inspection of the cellphone for a 9-hour period on the day of the accident. The court stated, “Petitioner considers the inspection an improper fishing expedition in a digital ocean. Contrary to petitioner’s argument, privacy rights 28 .

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do not completely foreclose the prospect of discovery of data stored on electronic devices.”

Antico v. Sindt Trucking, Inc., 148 So.3d 163, 2014 Fla. App. Lexis 16746 (District Court of Appeal of Florida 2014) Information Technology: Social Media Postings and Photographs are Discoverable Evidence Maria Nucci claimed that when she was in a store owned by Target Corporation, she slipped and fell on a foreign substance on the store’s floor. Nucci sued Target to recover damages for her alleged injuries. Nucci claimed that she was seriously injured, experiences pain from the injury, suffers emotional pain and suffering, and suffers permanent and continuing injuries. After the incident, Target obtained surveillance videos that showed Nucci carrying heavy items and doing other physical acts that refute her claim of serious personal injury.

Target served Nucci with a Request for Production of Electronic Media to obtain photographs of her from her social media accounts for the two years prior to the date of the incident to the present. The trial court issued an order compelling discovery of the photographs from Nucci’s social media sites. In upholding the order, the court of appeals stated, “The information sought, photographs of Nucci posted on Nucci’s social media sites, is highly relevant. If a photograph is worth a thousand words, there is no better portrayal of what an individual’s life was like than those photographs the individual has chosen to share through social media.” Nucci v. Target Corporation, 162 So.3d 146, 2015 Fla. App. Lexis 153 (District Court of Appeal of Florida 2015) Physical or Mental Examination – In cases that concern the physical or mental condition of a party, a court can order the party to submit to certain physical or mental examinations to determine the extent of the alleged injuries.

Pretrial Motions Pretrial motions like a motion for judgment on the pleadings and a motion for summary judgment are used to try to dispose of all or part of the lawsuit prior to trial.

Motion for Judgment on the Pleadings – Motion that alleges that if all the facts presented in the pleadings are taken as true, the party making the motion would win the lawsuit when the proper law is applied to these asserted facts.

Motion for Summary Judgment – Motion asserting that there are no factual disputes to be decided by the jury; if so, the judge can apply the proper law to the undisputed facts and decide the case without a jury.

State Court Case Case 4.2 Summary Judgment: Wade v. Wal-Mart Stores, Inc. Facts: Leslie Wade and her two children went shopping at a Wal-Mart store in Savoy, Illinois.

Wade parked her SUV in the Wal-Mart parking lot. At approximately 7:30 p.m., Wade and her children returned to the SUV with a cart full of groceries. It was a clear, dry night, and the parking lot was well lit. After Wade unloaded the groceries into the SUV and returned the shopping cart, her left foot fell into a pothole, causing her to fall and suffer a broken foot. The pothole was a couple of feet long and a few inches deep. Wade sued Wal-Mart, seeking compensation for her injuries. Wal-Mart filed a motion for summary judgment, arguing that it did not owe Wade a duty because the pothole was an open and obvious hazard. The trial court granted summary judgment in Wal-Mart’s favor, and Wade appealed.

Issue: Should Wal-Mart be granted summary judgment?

Decision: The appellate court affirmed the trial court’s grant of summary judgment in WalMart’s favor.

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Reason: According to the court, the record definitively established that a reasonable person in Wade’s position, exercising ordinary perception, intelligence, and judgment, would have avoided the open and obvious hazard posed by the pothole. The “open and obvious” doctrine provides that a possessor of land is not liable to his invitees for physical harm caused to them by any activity or condition on the land whose danger is known or obvious to them.

Ethics Questions: Although some students may view a summary judgment granted in the defendant’s favor as an unfair way to avoid liability that denies a plaintiff his or her right to a jury trial, the “open and obvious” doctrine is well-settled law, and the judicial record does lend support to the court’s conclusion that a reasonable person in the plaintiff’s position would have avoided the open and obvious hazard posed by the pothole.

Settlement Conference Many courts require that the parties appear for a pretrial hearing known as a settlement conference in order to identify relevant issues and attempt settlement.

Contemporary Environment: Cost-Benefit Analysis of a Lawsuit Plaintiffs should always perform a cost-benefit analysis before filing a lawsuit, taking into account both the tangible and intangible costs of the suit and weighing these against the expected return. Similarly, the defendant should consider all costs because it may prove to be more expedient to settle the suit.

Trial Pursuant to the Seventh Amendment to the U.S. Constitution, a party to a civil action at law is guaranteed the right to a jury trial in a federal court case. Most state constitutions contain a similar guarantee for state court actions. The phases of a trial include:  Jury Selection  Opening Statements  The Plaintiff’s Case  The Defendant’s Case  Rebuttal and Rejoinder  Closing Arguments  Jury Instructions, Deliberation, and Verdict  Entry of Judgment Jury Selection Individuals are selected to hear specific cases through a process called voir dire (“to speak the truth”). Lawyers for each party and the judge can ask prospective jurors questions to determine whether they would be biased in their decisions. Individuals who are determined to be biased are prohibited from serving as a juror.

Opening Statements During opening statements, an attorney usually summarizes the main factual and legal issues of the case and describes why he or she believes the client’s position is valid. The information given in this statement is not considered as evidence.

The Plaintiff’s Case A plaintiff bears the burden of proof to persuade the trier of fact of the merits of his or her case.

The plaintiff’s attorney calls witnesses to give testimony through direct examination. Documents and other evidence can be introduced through each witness. After the defendant cross-examines the plaintiff’s witness, the plaintiff’s attorney can engage the witness in re-direct examination.

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The Defendant’s Case This occurs after the plaintiff has concluded his or her case. The defendant’s case must (1) rebut the plaintiff’s evidence, (2) prove any affirmative defenses asserted by the defendant, and (3) prove any allegations contained in the defendant’s cross-complaint.

Rebuttal and Rejoinder After the defendant’s attorney has finished calling witnesses, the plaintiff’s attorney can call witnesses and put forth evidence to rebut the defendant’s case. This is called a rebuttal. The defendant’s attorney can call additional witnesses and introduce other evidence to counter the rebuttal. This is called the rejoinder.

Closing Arguments After the presentation of the evidence, each party’s attorney is permitted to make a closing argument, also called a closing statement, to the jury. Each attorney tries to convince the jury to render a verdict for his or her client by pointing out the strengths in the client’s case and the weaknesses in the other side’s case. Information given by the attorneys in their closing statements is not evidence.

Jury Instructions, Deliberation, and Verdict Once the closing arguments are completed, the judge reads jury instructions (or charges) to the jury. These instructions inform the jury about what law to apply when they decide the case. After jury instructions, the jury retires to the jury room to consider the evidence and attempt to reach a decision. This is called jury deliberation. During deliberation, the jury attempts to reach a verdict.

Entry of Judgment After the jury has returned its verdict, in most cases the judge enters a judgment to the successful party based on the verdict. This is the official decision of the court.

Ethics: Nondisclosure of Evidence by Wal-Mart Holly Averyt, a commercial truck driver, slipped in grease while making a delivery to a Wal-Mart store in Greeley, Colorado. Averyt ruptured a disc in her spine and injured her shoulder and neck, leaving her unable to perform many daily functions. Averyt sued Wal-Mart Stores, Inc., alleging negligence and premises liability. Averyt’s attorney sought evidence from Wal-Mart documenting the grease spill, but Wal-Mart denied the existence of the grease spill and did not turn over documents to Averyt. At trial, Averyt’s attorney introduced a memorandum produced by the City of Greeley that documented the grease spill and its cleanup.

The next day, Wal-Mart informed the court that it had located an assistant manager who remembered the grease spill and disclosed documents that confirmed the existence of the spill, including documents from three companies that were involved in cleaning up the spill. Wal-Mart ceased to deny the existence of the grease spill but instead asserted that it had exercised reasonable care to clean up the spill.

The jury found in Averyt’s favor and the court awarded her $11 million in damages. On appeal, the Colorado Supreme Court upheld Wal-Mart’s liability and the award of damages. The court stated, “Any prejudice that the jury may have harbored was due to Wal-Mart’s initial refusal to produce evidence of or admit the evidence of the grease spill. We do not find that the jury’s award was the result of unfair prejudice.” Averyt v. Wal-Mart Stores, Inc., 265 P.3d 456, 2011 Colo. Lexis 857 (Supreme Court of Colorado, 2011)

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E-Courts – An electronic court, or “e-court,” is a court that either mandates or permits the electronic filing of pleadings, briefs, and other documents related to a lawsuit. An e-court is also called a virtual courthouse.

Appeal – In a civil case, either party can appeal the trial court’s decision, once a final judgment is entered. In a criminal case, only the defendant can appeal. Notice of appeal must be filed within a prescribed time after judgment is entered to the appropriate appellate court Global Law: British Legal System English law is based on common law; that is, law made by judges who decide cases by applying legal precedent established in prior cases (stare decisis) and their common sense. The court system of England consists of trial courts that hear criminal and civil cases and appellate courts.

The House of Lords, in London, is the supreme court of appeal.

Alternative Dispute Resolution  Nonjudicial means of resolving legal disputes  Developed in response to the expense and difficulty of bringing a lawsuit  ADR usually saves time and money of costly litigation Negotiation – A procedure by which the parties to a dispute try to voluntarily settle their dispute.

This is usually done through a series of offers and counteroffers. Successful negotiations will culminate in a settlement agreement.

Arbitration – An impartial third party hears evidence and testimony and decides the dispute in arbitration. Arbitration clauses have become common in labor union agreements, franchise agreements, and commercial contracts.

Landmark Law: Federal Arbitration Act Enacted in 1925, this act provides that commercial agreements calling for arbitration are valid, irrevocable, and enforceable.

Arbitration Procedure – The arbitration agreement usually describes the procedures that must be followed, including the notices that must be given and how the arbitrator will be selected.

The arbitrator issues an award after the hearing. The parties usually agree that this will be a binding decision. If a party fails to abide by the decision in binding arbitration, the other party may file an action in court to enforce the decision.

Mediation – Mediation calls for a neutral third party to act as a mediator, but not a decisionmaker. His or her job is to encourage settlement between the parties. If the two sides choose an interested third party to act as a mediator, he or she is considered a conciliator.

E-Dispute Resolution Electronic technologies have made it possible to settle disputes online. This is referred to as electronic dispute resolution, or e-dispute resolution. E-dispute resolution includes electronic arbitration (e-arbitration), the arbitration of a dispute using online arbitration services, and electronic mediation (e-mediation), the mediation of a dispute using online mediation services.

V. Key Terms and Concepts  Affirmative defense—May be asserted by a defendant along with an answer to a complaint.

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Alternative dispute resolution (ADR)—Methods of resolving disputes other than litigation.

Answer—The defendant’s written response to the plaintiff’s complaint that is filed with the court and served on the plaintiff.

Appeal—The act of asking an appellate court to overturn a decision after the trial court’s final judgment has been entered.

Appellant (petitioner)—The appealing party in an appeal.

Appellee (respondent)—The responding party in an appeal.

Arbitration—A form of alternative dispute resolution in which the parties choose an impartial third party to hear and decide the dispute.

Arbitration clause—A clause contained in many international contracts stipulating that any dispute between the parties concerning the performance of the contract will be submitted to an arbitrator or arbitration panel for resolution.

Arbitrator—The neutral party in an arbitration.

Binding arbitration—The type of arbitration where the parties agree to be bound by an arbitrator’s decision and remedy.

Burden of proof—Borne by the plaintiff to persuade the trier of fact of the merits of his or her case.

Class action—A lawsuit where a group of plaintiffs with common claims collectively brings a lawsuit against a defendant.

Class Action Fairness Act (CAFA)—Gives federal courts jurisdiction to hear class action lawsuits that would otherwise be heard by state courts.

Class action waiver—A clause in an arbitration agreement whereby a party agrees not to join a class action to pursue a defendant in an arbitration proceeding.

Closing argument (closing statement)—An argument made to the jury by each party’s attorney at the conclusion of the presentation of evidence.

Complaint—The document the plaintiff files with the court and serves on the defendant to initiate a lawsuit.

Consolidation—The act of a court to combine two or more separate lawsuits into one lawsuit.

Cost-benefit analysis—Performed by both the plaintiff and defendant to determine whether to bring or defend a lawsuit in court.

Contingency fee—A fee arrangement with a client whereby a lawyer receives a percentage of the amount recovered by winning or settling a lawsuit. If the lawyer does not win or settle the case in the client’s favor, the lawyer receives nothing.

Cross-complainant—The defendant who files a cross-complaint against the plaintiff.

Cross-complaint—Filed by the defendant against the plaintiff to seek damages or some other remedy.

Cross-defendant—The original plaintiff against whom a cross-complaint has been filed.

Cross-examination—The opportunity to question an adversarial witness. For example, after the plaintiff’s attorney engages his or her witness in direct examination, the defendant’s attorney can then cross-examine the witness.

Default judgment—Entered against a defendant if he or she fails to answer to a complaint.

Defendant—The party who is being sued.

Defendant’s case—Proceeds after the plaintiff’s case. It must rebut the plaintiff’s evidence, prove any affirmative defenses asserted by the defendant, and prove any allegations contained in the defendant’s cross-complaint.

Deponent—Party who gives his or her deposition.

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Deposition—Oral testimony given by a party or witness prior to trail. The testimony is given under oath and is transcribed.

Direct examination—Examination carried out by the plaintiff’s attorney, during the plaintiff’s case, after a witness has been sworn in.

Discovery—A legal process during which both parties engage in various activities to discover facts of the case from the other party and witnesses prior to trial.

Electronic arbitration (e-arbitration)—The arbitration of a dispute using online arbitration services.

Electronic court (e-court)—A court that either mandates or permits the electronic filing of pleadings, briefs, and other documents related to a lawsuit. Also called a virtual courthouse.

Electronic discovery (e-discovery)—The process whereby relevant electronic documents are discovered, exchanged, collected, preserved, and processed during a lawsuit.

Electronic dispute resolution (e-dispute resolution)—The use of online alternative dispute resolution services to resolve a dispute.

Electronic filing (e-filing)—The online filing of pleadings, briefs, and other documents related to a lawsuit.

Electronic mediation (e-mediation)—The mediation of a dispute using online mediation services.

Electronically stored information (ESI)—Relevant (i.e., discoverable) evidence that is retained electronically, including Microsoft Word documents, Excel spreadsheets, emails, instant messages, text messages, cloud storage, phone records, etc.

Error of law—Error in court records which may lead an appellate court to reverse a lower court’s decision.

Federal Arbitration Act (FAA)—Provides that arbitration agreements involving commerce are valid, irrevocable, and enforceable contracts, unless some grounds exist at law or equity (e.g., fraud or duress) to revoke them.

Final judgment—A court’s decision or remedy.

Finding of fact—An appellate court will not reverse a finding of fact made by a jury, or made by a judge if there is no jury, unless such finding is unsupported by the evidence or is contradicted by the evidence.

Impanel—Once the appropriate number of jurors is selected, they are impaneled to hear the case and are sworn in.

Interrogatories—Written questions submitted by one party to another party. The questions must be answered in writing within a stipulated time.

Intervention—The act of others to join as parties to an existing lawsuit.

Judgment—A decision entered by a judge based on the verdict given by the jury.

Judgment notwithstanding the verdict (judgment n.o.v. or j.n.o.v.)—The overturning of a verdict by a court due to bias or jury misconduct.

Jury deliberation—The retiring of the jury to consider the evidence and attempt to reach a verdict.

Jury instructions (charges)—Instructions the judge gives to the jury that inform the jurors of the law to be applied in the case.

Jury trial—A trial which involves a jury.

Litigation—The process of bringing, maintaining, and defending a lawsuit.

Mediation—A form of ADR in which the parties choose a neutral third party to act as the mediator of the dispute.

Mediator—A neutral third party who assists in mediation.

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Motion for judgment on the pleadings—Motion alleging that if all the facts presented in the pleadings are taken as true, the moving party would win the lawsuit when the proper law is applied to the asserted facts.

Motion for summary judgment—Motion asserting that there are no factual disputes to be decided by the jury; if so, the judge can apply the proper law to the undisputed facts and decide the case without a jury. These motions are supported by affidavits, documents, and deposition testimony.

Negotiation—A procedure whereby the parties to a dispute engage in discussions and bargaining to try to reach a voluntary settlement of their dispute.

Nonbinding arbitration—An arbitration where the decision and award of the arbitrator can be appealed to the courts.

Nonjudicial dispute resolution—The resolution of disputes outside of the court judicial system.

Notice of appeal—Notice that must be filed by a party within a prescribed period of time after a court judgment is entered.

Opening brief—Filed by the appellant’s attorney; it sets forth legal research and other information to support his or her contentions on appeal.

Opening statement—Each party’s attorney is allowed to make an opening statement to the jury at the beginning of a trial. During the opening statement, the attorney usually summarizes the main factual and legal issues of the case and describes why he or she believes the client’s position is valid. Information in the opening statement is not considered evidence.

Peremptory challenge (peremptory strike)—Permits each party to a lawsuit to dismiss a limited number of proposed jurors from becoming jurors without having to show that the dismissed individuals were biased.

Physical or mental examination—A court may order another party to submit to a physical or mental examination prior to trial.

Plaintiff—The party who files the lawsuit.

Plaintiff’s case—A plaintiff bears the burden of proof to persuade the trier of fact of the merits of his or her case.

Pleadings—The paperwork that is filed with the court to initiate and respond to a lawsuit.

Pretrial motions—Motions a party can make to try to dispose of all or part of a lawsuit prior to trial.

Production of documents—Request by one party to another party to produce all documents relevant to the case prior to trial.

Rebuttal—After the defendant’s attorney has finished calling witnesses, the plaintiff’s attorney can call witnesses and introduce evidence to rebut the defendant’s case.

Record—An account of court proceedings.

Re-direct examination—After the defendant’s attorney completes his or her questions, the plaintiff’s attorney can ask questions of the witness.

Rejoinder—The defendant’s attorney can call additional witnesses and introduce other evidence to counter the rebuttal.

Remittitur—The judge’s decision to reduce the amount of monetary damages awarded by the jury if he or she finds the jury to have been biased, emotional, or inflamed.

Reply—Filed by the original plaintiff to answer the defendant’s cross-complaint.

Responding brief—May be filed by the appellee to answer the appellant’s contentions.

Retainer—A specified amount of money deposited by a client into a trust account for legal representation. The client’s attorney deducts fees from the trust account as he or she provides hourly services. Fees are also charged to the account for paralegals who work on 35 .

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the case, for expenses such as copying documents, filing fees with the court, fees for expert witnesses, and other fees associated with the case or legal transaction.

Sequester—The separation of the jury from family, etc. Can be done during important cases.

Service of process—A summons is served on the defendant to obtain personal jurisdiction over him or her.

Settlement agreement—An agreement that is voluntarily entered into by the parties to a dispute that settles the dispute.

Settlement conference (pretrial hearing)—A hearing before trial in order to facilitate settlement of a case.

Statute of limitations—Establishes the time period during which a lawsuit must be brought; if the lawsuit is not brought within this period, the injured party loses the right to sue.

Submission agreement—An agreement by the parties to submit a dispute to arbitration after the dispute arises.

Summons—A court order directing the defendant to appear in court and answer the complaint.

Trial brief—A court filing submitted by a litigant’s attorney that contains legal support for that party’s side of the case.

Trier of fact—The jury in a jury trial; the judge when there is not a jury trial.

Uniform Arbitration Act—Adopted by many states; promotes arbitration of disputes at the state level.

Verdict—The decision reached by a jury after deliberation.

Virtual courthouse—A court that either mandates or permits electronic filing of pleadings, briefs, and other documents related to a lawsuit.

Voir dire—The process whereby the judge and attorneys ask prospective jurors questions to determine whether they would be biased in their decision-making.

Written memorandum—It is issued by the trial court and sets forth the reasons for the judgment.

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Chapter 5 Constitutional Law for Business and E-Commerce Which rights are absolute?

I. Teacher to Teacher Dialogue I have to admit to unabashed enthusiasm when it comes to teaching the principles listed in this chapter. Constitutional law is for many legal academics not only their reason for loving to teach, but it also provides the ultimate challenge in illustrating the constant balance of competing, legitimate rights of the individual vis-à-vis the larger society. The only major drawback to this material is the frustration of having the time constraints inherent in a survey course.

Because of these time limitations, I concentrate my efforts on three main objectives: 1. The concepts of federalism, dual sovereignty, and the balancing of rights among the often competing sovereigns of federal and state government.

2. The enumeration of key individual civil liberties protections listed in the Bill of Rights, with an extrapolation of those same theories to business.

3. Socratic method case dialogues which seek not only to test the student’s own preexisting notions of what some of these key constitutional provisions mean, but also to illustrate the critical role of judicial molding of these rights in the “real world.”

I often find myself spending far more time on these materials than originally planned; yet I have never regretted the extra time spent. It is really a left-side, right-side dichotomy. We can spend a lot of time in analysis of the chemical components of paint. But the real beauty and ultimate meaning of its worth is the transformation of that paint into art. So it is with the rules found in the Constitution. These rules really transform themselves through judicial interpretation into reflecting what kind of society we are. In the end, the law is about who as a society we chose to help and who we chose to hurt and why.

The key objective of this chapter is to introduce students to the role of the U.S. Constitution and its pivotal role in the ultimate distribution of powers between the federal government and the states vis-à-vis the control of business conducted in the U.S. This aspect of the chapter will introduce students to the key terms they will be using throughout the rest of the course such as substantive and procedural due process.

In all likelihood, because of the breadth of materials covered, the lecture format will work best for purposes of illustrating as much of the material as possible in the time allowed.

II. Chapter Objectives 1. Describe the U.S. Constitution and the concepts of federalism and separation of powers.

2. Define and apply the Supremacy Clause of the U.S. Constitution.

3. Explain the Commerce Clause and the federal government’s authority to regulate interstate and foreign commerce.

4. Describe how the Commerce Clause is applied to e-commerce.

5. Describe the Bill of Rights and the process for amending the U.S. Constitution.

6. Explain how freedom of speech is protected by the First Amendment.

7. Explain how freedom of religion is protected and how the government may not promote religion.

8. Explain the equal protection doctrine and how it protects persons from unequal treatment by the government.

9. Describe the Due Process Clause and substantive and procedural due process.

10. Explain how the government can take private property but must pay just compensation for the taking.

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11. Explain how the privileges and immunities doctrine protects citizens from unfavorable treatment by the government.

III. Key Question Checklist  Is this business activity one that is specifically addressed in the U.S. Constitution?  What general direction of control may be taken by the appropriate government entity?  Are there checks and balances or power sharing?  What are a business’s courses of action if it chooses to resist the governmental action taken against it?  Do any constitutional rights apply?

IV. Chapter Outline Introduction to Constitutional Law for Business and E-Commerce The key objective of this chapter is to introduce students to the role of the U.S. Constitution and its pivotal role in the ultimate distribution of powers between the federal government and the states, vis-à-vis the control of business conduct in the U.S. Constitution of the United States of America The U.S. Constitution serves two major functions: (1) It creates the three branches of government (executive, legislative, and judicial) and allocates powers to these branches; and (2) It protects individual rights by limiting the government’s ability to restrict those rights.

Federalism and Delegated Powers – The U.S. operates as a federal state, sharing powers between the federal government and the state governments. The Constitution delegates certain enumerated powers to the federal government.

Doctrine of Separation of Powers – Articles I, II, and III of the U. S. Constitution establish the legislative, executive, and judicial branches of government, respectively.

1. Article I—Legislative Branch: The legislative branch is responsible for making federal law. This branch is bicameral; that is, it consists of the U.S. Senate and the U.S. House of Representatives.

Collectively, they are referred to as the U.S. Congress.

2. Article II—Executive Branch: The executive branch is responsible for enforcing federal law. This branch consists of the president and vice-president.

3. Article III—Judicial Branch: The judicial branch is responsible for interpreting the U.S. Constitution.

This branch consists of the U.S. Supreme Court and other federal courts.

Critical Legal Thinking: Checks and Balances Certain checks and balances are built into the U.S. Constitution to ensure that no one branch of the federal government becomes too powerful. The following are several of the major constitutional checks and balances: 1. The judicial branch has authority to examine the acts of the other two branches of government and determine whether those acts are constitutional.

2. The executive branch can enter into treaties with foreign governments only with the advice and consent of the Senate.

3. The legislative branch is authorized to create federal courts and determine their jurisdiction and to enact statutes that change judicially made law.

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4. To solve the power issue between states with large populations and those with small populations, a compromise was reached whereby the number of representatives from a state is based on its population, while each state has two senators no matter how large or small its population.

5. Within the legislative branch a bill only becomes law if the majority of its members of the Senate and the House who vote approve the identical final bill.

6. The president has veto power over bills passed by Congress. If a bill has been vetoed by the president, the bill goes back to Congress, where a vote of two-thirds of each the Senate and the House of Representatives is required to override the president’s veto.

7. The president nominates individuals to be federal judges but a majority vote of the U.S. Senate is required to confirm the nominee as a federal judge.

8. The House of Representatives has the power to impeach the president for certain activities, such as treason, bribery, and other crimes. The Senate has the power to try an impeachment case. A two-thirds vote of the Senate is required to impeach the president.

Supremacy Clause The Supremacy Clause of the U.S. Constitution establishes that the federal Constitution, treaties, federal laws, and federal regulations are the supreme law of the land. State and local laws that conflict with valid federal law are unconstitutional.

U.S. Supreme Court Case Case 5.1 Supremacy Clause: Mutual Pharmaceutical Company, Inc. v. Bartlett Facts: In 1978, the Food and Drug Administration (FDA) approved a pain reliever called sulindac. At the time, the FDA approved the labeling of the prescription drug, which contained warnings of specific side effects of the drug. The patent on the drug expired, and other pharmaceutical companies began selling generic versions of the drug. Federal laws required that generic sellers of drugs use the exact labeling as required on the original drug, without exception. Mutual Pharmaceutical Company, Inc. (Mutual) manufactured and sold a generic brand of sulindac. Karen Bartlett was prescribed the drug, she used Mutual’s generic version, and she experienced horrific side effects, including toxic epidermal necrolysis.

Mutual’s generic brand label did not mention the possible side effect of toxic epidermal necrolysis. New Hampshire required stricter warnings on prescription drugs than federal laws did. Bartlett sued Mutual for product liability under New Hampshire law, and the U.S. district court found in her favor. The U.S. court of appeals affirmed the district court verdict. Mutual appealed to the U.S. Supreme Court, asserting that the federal labeling law preempted New Hampshire law under the Supremacy Clause.

Issue: Does the federal drug labeling law preempt a stricter state drug-labeling law?

Decision: The U.S. Supreme Court held that federal drug labeling law preempted New Hampshire’s stricter labeling law under the Supremacy Clause of the U.S. Constitution.

Reason: The court noted the federal law that required generic sellers of drugs to use the exact labeling as required on the original drug, without exception. The court reasoned that under the Supremacy Clause, state laws that require a private party to violate federal law are preempted.

Ethics Questions: The public policy for having the Supremacy Clause is respect for the rule of law at the federal level. The Supremacy Clause supports the notion of a strong federal government. Pharmaceutical companies likely opposed the federal drug labeling statute (although the statute certainly helped Mutual Pharmaceutical Company in this case) due to potential consumer backlash against drug side effects.

Although Mutual prevailed at the U.S. Supreme Court level in this case, one could argue that it was unethical for Mutual to deny liability in this case. This is a “classic case” of a defendant escaping liability on a technicality. Arguably, the Supremacy Clause should apply only when state law does not meet the federal standard, as opposed to situations where (as in this case) the state law exceeds the federal standard.

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Commerce Clause The Commerce Clause of the U.S. Constitution grants the federal government the power to regulate three types of commerce: (1) Commerce with Native American tribes; (2) Foreign commerce; and (3) Interstate commerce.

Commerce with Native Americans – Many tribes of the indigenous people of the United States entered into treaties with the federal government, often under great pressure. They usually relinquished their claim on the native land and were relocated to reservations. Most of the treaties were eventually broken by the government. Although many tribes have maintained their own government, they are under the protection of the U.S. government, so they are separate nations but domestically dependent.

The Indian Gaming Regulatory Act authorized the individual tribes to operate gaming facilities. Profits from casinos have become an important source of income for members of certain tribes.

Foreign Commerce – The federal government has the exclusive power to regulate commerce with foreign nations. Direct and indirect regulation of foreign commerce by state or local federal governments that discriminates against foreign commerce is a violation of the Foreign Commerce Clause and is therefore illegal.

Interstate Commerce – The federal government regulates all activities that affect interstate commerce.

Under the “effects on interstate commerce” test, the regulated activity does not itself have to be in interstate commerce. Thus, any local (intrastate) activity that has an effect on interstate commerce is subject to federal regulation.

Critical Legal Thinking: Heart of Atlanta Motel v. United States The Heart of Atlanta motel solicited clients from outside the state through various forms of media. It refused to rent to blacks, even after the passage of the Civil Rights Act of 1964. The owner of the motel brought an action for declaratory relief in a federal district court to have the Act declared unconstitutional, arguing that Congress had exceeded its power to regulate interstate commerce. The U.S. District Court upheld the Civil Rights Act, enjoining the owner-operator from discriminating. An appeal to the U.S. Supreme Court was filed. The U.S. Supreme Court held that the Civil Rights Act of 1964 that had been enacted by Congress was constitutional. The Commerce Clause of the U.S. Constitution grants Congress the power to regulate commerce “among the several states,” i.e., interstate commerce. Originally, the Supreme Court interpreted the Commerce Clause to mean that the federal government could only regulate commerce that moved in interstate commerce. The modern rule, however, allows the federal government to regulate activities that affect interstate commerce. Applying the broad “effects test” to the case at hand, the Supreme Court held that the Civil Rights Act of 1964 was constitutional under the Commerce Clause because it regulated “interstate” commerce. The court cited the fact that the Heart of Atlanta Motel advertised in national magazines, sought out-of-state conventions, and that 75 percent of its guests were from out-of-state. The court therefore held that the federal government had the authority, pursuant to the Commerce Clause, to enact the Civil Rights Act of 1964 that prohibited racial discrimination in the renting of public accommodations by lodging establishments. Heart of Atlanta Motel v. United States, 379 U.S. 241, 85 S.Ct. 348, 1964 U.S. Lexis 2187 (Supreme Court of the United States) State Police Power – The states have the right to regulate commerce within their borders, under the authority of the states’ police power. They also have the right to enact laws that promote public health, safety, morals, and general welfare, provided that they do not unduly burden interstate commerce.

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Dormant Commerce Clause – The federal government may opt to not regulate certain areas that it has the power to regulate under the dormant Commerce Clause. The states, under the theory of police power, can enact laws regulating these areas, provided that they do not unduly burden interstate commerce.

E-Commerce and the Constitution The internet and other computer networks permit parties to obtain website domain names and conduct business electronically. This is usually referred to as electronic commerce or e-commerce. Some businesses conducting e-commerce over the internet do not have any physical locations, whereas many augment their traditional sales with e-commerce sales as well. E-commerce is subject to the Commerce Clause of the U.S. Constitution.

Information Technology: E-Commerce and the Commerce Clause Michigan law prohibited out-of-state wineries from selling directly to customers through any medium, instead requiring them to sell to Michigan wholesalers, which would handle the instate distribution of the products. Domaine Alfred, located in California, sued, claiming that the law caused an undue burden on interstate commerce, violating the Commerce Clause. The U.S. District Court ruled in favor of Michigan, but the court of appeals reversed the decision. The state appealed. The U.S. Supreme Court held that the law discriminated against out-of-state wineries and violated the Commerce Clause. Granholm, Governor of Michigan v. Heald, 544 U.S. 460, 125 S.Ct. 1885, 2005 U.S. Lexis 4174 (Supreme Court of the United States, 2005) Bill of Rights and Other Amendments to the U.S. Constitution The Bill of Rights consists of ten amendments to the U.S. Constitution ratified in 1791, which limited actions of the federal government. There have been 17 other amendments since then.

Originally, the Bill of Rights limited intrusive action by the federal government only. Intrusive actions by state and local governments were not limited until the Due Process Clause of the Fourteenth Amendment was added to the Constitution in 1868. The Supreme Court has applied the incorporation doctrine and held that most of the fundamental guarantees contained in the Bill of Rights are applicable to state and local government action.

Freedom of Speech The First Amendment to the U.S. Constitution protects only speech, not conduct.

Fully Protected Speech – Speech that the government cannot prohibit or regulate. Political speech is an example of fully protected speech.

Limited Protected Speech – Speech which the government cannot prohibit, but can regulate as to time, place, and manner, including offensive speech and commercial speech.

Unprotected Speech – Dangerous speech, fighting words, speech inciting a violent overthrow of the government, defamatory language, child pornography, and obscene speech are considered to be unprotected speech. The U.S. Supreme Court has held that unprotected speech is not protected by the First Amendment and may be forbidden totally by the government.

Information Technology: Free Speech and Video Games California enacted a state statute that prohibited the sale or rental of “violent video games” to minors. The act covered games that included killing, maiming, dismembering, or sexually assaulting an image of a human being. Members of the video games and software industries challenged enforcement of the act, alleging that the state law violated their constitutional free speech rights. The U.S. Supreme Court held that the California act violated the Free Speech Clause of the First Amendment to the U.S. Constitution.

The Court held that California had singled out the purveyors of video games for disfavored treatment—at 41 .

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least when compared to booksellers, cartoonists, and movie producers—and had given no persuasive reason why. Brown, Governor of California v. Entertainment Merchants Association, 564 U.S. 786, 131 S.Ct. 2729, 2011 U.S. Lexis 4802 (Supreme Court of the United States, 2011) Freedom of Religion The U.S. Constitution requires federal, state, and local governments to be neutral toward religion.  Establishment Clause – Prohibits the government from either establishing a state religion or promoting one religion over another  Free Exercise Clause – Prohibits the government from interfering with the free exercise of religion in the United States Equal Protection The Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution provides that a state cannot “deny to any person within its jurisdiction the equal protection of the laws.”

Standards of Review – The U.S. Supreme Court has adopted the following three different standards for reviewing equal protection cases:  Strict Scrutiny Test – applied to classifications based on a suspect class (race, national origin, and citizenship) or fundamental rights (for example, voting). Under this standard, the government must have an exceptionally important reason for treating persons differently.  Intermediate Scrutiny Test – applied to classifications based on a protected class other than a suspect class or a fundamental right (for example, gender). The government must have an important reason for treating persons differently because of their gender in order for such unequal treatment to be lawful.  Rational Basis Test – applied to classifications not involving suspect or protected classes. Under this test, the courts uphold government regulation as long as there is a justifiable reason for the law. Most government regulation of business and individuals is adopted pursuant to this test.

Due Process  The Fifth and Fourteenth Amendments to the U.S. Constitution both contain a due process clause  These clauses provide that no person shall be deprived of “life, liberty, or property” without due process of the law  Fifth Amendment Clause – Applies to federal government action  Fourteenth Amendment Clause – Applies to state and local government action U.S. Supreme Court Case Case 5.2 Due Process and Equal Protection Clauses: Obergefell v. Hodges Facts: Michigan, Kentucky, Ohio, and Tennessee define marriage as a union between one man and one woman. State officials enforced these laws and refused to marry same-sex couples. Ohio, Tennessee, and Kentucky refused to recognize same-sex marriages performed in states that permit same-sex marriage.

Petitioners—same-sex couples—challenged these state laws in U.S. district courts. Each district court ruled in the petitioners’ favor. The U.S. Court of Appeals for the Sixth Circuit consolidated the cases and reversed the judgments of the district courts.

The U.S. Supreme Court granted certiorari to hear the petitioners’ appeal. The petitioners alleged that the challenged state laws violated their liberty as guaranteed by the Due Process Clause of the Fourteenth Amendment and also violated the Equal Protection Clause of the Fourteenth Amendment.

Issue: Do the challenged states laws that do not permit or recognize same-sex marriages violate the Due Process Clause and Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution?

Decision: The U.S. Supreme Court held that state laws that prohibit same-sex marriage or that do not recognize valid same-sex marriages are unconstitutional. The Supreme Court reversed the judgment of the Court of Appeals for the Sixth Circuit.

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Reasoning: The Court opined that in unfairly restricting the right of same-sex couples to marry, the challenged state laws violated both the Due Process Clause and the Equal Protection Clause of the U.S. Constitution. According to the court, the challenged laws unconstitutionally burdened the liberty of samesex couples.

Ethics Questions: Student opinions may vary in terms of whether the Obergefell case was correctly decided. The case was decided on a 5-4 vote by the justices of the U.S. Supreme Court; the narrow majority itself indicates the contentious nature of same-sex marriage. Student opinions may also be based in whole or in part on their beliefs regarding whether same-sex marriage is ethical. Obviously, religious beliefs might very well influence opinions regarding the outcome of this case.

Substantive due process – Requires that laws be clear on their face and not overly broad in scope. The test of whether substantive due process is met is whether a reasonable person could understand the law to be able to comply with it. Laws that do not meet this test are declared void for vagueness.

Procedural due process – Requires that the government give a person proper notice and hearing of any legal action before that person is deprived of life, liberty, or property.

Government Taking of Property The Takings Clause of the Fifth Amendment to the U.S. Constitution empowers the government to acquire private property for governmental purposes. Private property can only be taken for public use.

The Just Compensation Clause of the Fifth Amendment to the U.S. Constitution requires the government to compensate the property owner when it takes private property.

Privileges and Immunities The Privileges and Immunities Clauses of the U.S. Constitution (set forth in Article IV and in the Fourteenth Amendment) prohibit states from enacting laws that unduly discriminate in favor of their residents.

Global Law: Human Rights Violations Myanmar has been accused of human rights violations, including using child labor and forced labor, eliminating political dissidents, and strict censorship. The country is ruled by a junta composed of its military generals. The United Nations has consistently censored Myanmar for human rights violations.

Recently because of improved conditions in Myanmar, the United States lifted some sanctions against trading with the country.

V. Key Terms and Concepts  Amendments to the U.S. Constitution—The U.S. Constitution provides that it may be amended.

Currently, there are 27 amendments to the U.S. Constitution.  Article I of the U.S. Constitution—Establishes the legislative branch of the federal government.  Article II of the U.S. Constitution—Establishes the executive branch of the federal government.  Article III of the U.S. Constitution—Establishes the judicial branch of the federal government.  Articles of Confederation—The articles adopted by the Continental Congress gave limited power to the newly created federal government.  Bicameral—Article I of the Constitution establishes the legislative branch of the federal government. The legislative branch is responsible for making federal law. This branch is bicameral; that is, it consists of the U.S. Senate and the U.S. House of Representatives.  Bill of Rights—The first 10 amendments to the U.S. Constitution that were added to the Constitution in 1791.  Checks and balances—A system built into the U.S. Constitution to prevent any one of the three branches of the government from becoming too powerful.

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                       

Citizenship—Any government activity or regulation that classifies persons based on a suspect class (e.g., race, national origin, and citizenship) or involves fundamental rights (e.g., voting), is reviewed for lawfulness using a strict scrutiny test.

Civil Rights Act of 1964—Federal law that makes it illegal to discriminate on the basis of race, gender, national origin, culture, or religion.

Commerce Clause—A clause of the U.S. Constitution that grants Congress the power “to regulate commerce with foreign nations, and among the several states, and with Indian tribes.”

Commercial speech—Speech used by businesses, such as advertising. It is subject to time, place, and manner restrictions.

Constitutional Convention—The Constitutional Convention was convened in Philadelphia in May 1787 to strengthen the federal government.

Declaration of Independence—The Declaration of Independence was the document that declared the American colonies’ independence from England.

Dormant Commerce Clause—A situation in which the federal government has the Commerce Clause power to regulate an area of commerce but has chosen not to regulate that area of commerce.

Due Process Clause—A clause that provides that no person shall be deprived of “life, liberty, or property” without due process of the law.

Effects on interstate commerce test—Under the effects on interstate commerce test, the regulated activity does not itself have to be in interstate commerce.

Electoral College—The president is not elected by popular vote but instead is selected by the Electoral College, whose representatives are appointed by state delegations.

Electronic commerce (e-commerce)—The internet and other computer networks permit parties to obtain website domain names and conduct business electronically.

Enumerated powers—Certain powers delegated to the federal government by the states.

Equal Protection Clause—A clause that provides that a state cannot “deny to any person within its jurisdiction the equal protection of the laws.”

Establishment Clause—A clause to the First Amendment that prohibits the government from either establishing a state religion or promoting one religion over another.

Executive branch—The part of the U.S. government that enforces the federal law; it consists of the president and vice president.

Federal Government—In 1778, the Continental Congress formed a federal government and adopted the Articles of Confederation.

Federalism—The United States’ form of government; the federal government and the 50 state governments share powers.

First Amendment—Fundamental rights guaranteed in the First Amendment include freedom of speech, freedom to assemble, freedom of the press, and freedom of religion.

Foreign Commerce Clause—Commerce with foreign nations. The Commerce Clause grants the federal government the authority to regulate foreign commerce.

Fourteenth Amendment—Amendment that was added to the U.S. Constitution in 1868. It contains the Due Process, Equal Protection, and Privileges and Immunities Clauses.

Free Exercise Clause—A clause to the First Amendment that prohibits the government from interfering with the free exercise of religion in the United States.

Freedom of religion—Freedom of religion is a key concept addressed by the First Amendment.

The First Amendment contains two separate religion clauses, the Establishment Clause and the Free Exercise Clause.

Freedom of speech—The right to engage in oral, written, and symbolic speech protected by the First Amendment.

Fully protected speech—Speech that cannot be prohibited or regulated by the government.

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  

         

     

Fundamental right—An essential right such as voting. Any government activity or regulation that classifies persons based on a fundamental right is reviewed for lawfulness using a “strict scrutiny” test.

Gender—The lawfulness of government classifications based on a protected class other than race (e.g., gender) is examined using an intermediate scrutiny test.

Heart of Atlanta Motel v. United States—In this United States Supreme Court case, the Court held that the provisions of the Civil Rights Act of 1964 that prohibit discrimination in accommodations are constitutional as a proper exercise of the commerce power of the federal government.

Incorporation doctrine—The Supreme Court has applied the incorporation doctrine and held that most of the fundamental guarantees contained in the Bill of Rights are applicable to state and local government action.

Indian Gaming Regulatory Act—Congress passed the Indian Gaming Regulatory Act, a federal statute that establishes the requirements for conducting casino gambling and other gaming activities on tribal land.

Intermediate scrutiny test—Test that is applied to classifications based on gender or age.

Interstate commerce—Commerce that moves between states or that affects commerce between states.

Intrastate commerce—The states did not delegate all power to regulate business to the federal government. They retained the power to regulate intrastate commerce and much of the interstate commerce that occurs within their borders.

Judicial branch—The part of the U.S. government that interprets the law. It consists of the Supreme Court and other federal courts.

Just Compensation Clause—A clause that requires the government to compensate a property owner when the government takes the owner’s property.

Legislative branch—The part of the U.S. government that makes federal laws. It is known as Congress (the Senate and the House of Representatives).

Limited protected speech—Speech that the government may not prohibit but that is subject to time, place, and manner restrictions.

Miller v. California—In Miller v. California, the U.S. Supreme Court determined that speech is obscene when (1) the average person, applying contemporary community standards, would find that the work, taken as a whole, appeals to the prurient interest, (2) the work depicts or describes, in a patently offensive way, sexual conduct specifically defined by the applicable state law, and (3) the work, taken as a whole, lacks serious literary, artistic, political, or scientific value.

National origin—Any government activity or regulation that classifies persons based on a suspect class (e.g., race, national origin, and citizenship) or involves fundamental rights (e.g., voting) is reviewed for lawfulness using a strict scrutiny test.

Obscene speech—Speech that (1) appeals to the prurient interest, (2) depicts sexual conduct in a patently offensive way, and (3) lacks serious literary, artistic, political, or scientific value.

Offensive speech—Speech that is offensive to many members of society. It is subject to time, place, and manner restrictions.

Police power—Power that permits states and local governments to enact laws to protect or promote the public health, safety, morals, and general welfare.

Preemption doctrine—A doctrine that provides that federal law takes precedence over state or local law.

Privileges and Immunities Clauses—Provisions in Article IV of the U.S. Constitution and in the Fourteenth Amendment that prohibit states from enacting laws that unduly discriminate in favor of their residents.

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                 

Procedural due process—Due process that requires the government to give a person proper notice and a hearing before that person is deprived of life, liberty, or property.

Protected class—A group of individuals entitled to legal protection pursuant to the Equal Protection Clause of the U.S. Constitution.

Race—A term that refers to which of the following categories a person is classified as being a member of: Asian, African American, Caucasian, Native American, and Pacific Islander.

Rational basis test—Test that is applied to classifications not involving a suspect or protected class.

Reserved powers—Any powers that are not specifically delegated to the federal government by the Constitution are reserved to the state governments.

Strict scrutiny test—Test that is applied to classifications based on race.

Substantive due process—Due process that requires that government statutes, ordinances, regulations, or other laws be clear on their face and not overly broad in scope.

Supremacy Clause—A clause of the U.S. Constitution establishing that the U.S. Constitution and federal treaties, laws, and regulations are the supreme law of the land.

Suspect class—Government classification of individuals based on race, national origin, or citizenship. Any government activity or regulation that classifies persons based on a suspect class is reviewed for lawfulness using a “strict scrutiny” test.

Takings Clause—A provision of the Fifth Amendment to the U.S. Constitution that empowers the government to acquire private property for governmental purposes (i.e., for public use).

Unduly burden interstate commerce—A concept that says states may enact laws that protect or promote the public health, safety, morals, and general welfare, as long as the laws do not unduly burden interstate commerce.

Unprotected speech—Speech that is not protected by the First Amendment and may be forbidden by the government.

U.S. Congress (Congress)—The legislative branch consists of the U.S. Senate and the U.S. House of Representatives. Collectively, they are referred to as U.S. Congress, or simply Congress.

U.S. Constitution—The fundamental law of the United States of America. It was ratified by the states in 1788.

U.S. House of Representatives—The legislative branch consists of the U.S. Senate and the U.S. House of Representatives. The number of representatives to the U.S. House of Representatives is determined according to the population of each state.

U.S. Senate—The legislative branch consists of the U.S. Senate and the U.S. House of Representatives. Each state has two senators in the U.S. Senate.

Voting—A method for the electorate to select between candidates for certain government offices and to determine whether issues presented to the electorate are approved or disapproved.

Wickard, Secretary of Agriculture v. Filburn—In this case, a federal statute limited the amount of wheat a farmer could plant and harvest for home consumption. The U.S. Supreme Court upheld the federal statute since it was designed to prevent nationwide surpluses and shortages of wheat.

The Court reasoned that wheat grown for home consumption would affect the supply of wheat available in interstate commerce.

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Torts and Strict Liability

Chapter 6 Torts and Strict Liability

How can someone be liable but not guilty?

I. Teacher to Teacher Dialogue This material provides students with their first real personal opportunity to resolve conflicts placed before them by weighing the respective rights, duties, and obligations that arise from a civil dispute in tort.

You can start by providing some background on the origins of the word “tort” and where it fits into the legal landscape vis-à-vis crimes and other disturbances of the peace. It also introduces students to the concept of the big picture where they will be asked to look at the variety of resolution paths available to them rather than just one “right” answer. This is done through the introduction of various classifications of torts, with case illustrations for each classification. In addition, remind them of the interrelationship between tort law and criminal law and how both may arise from the same act yet create entirely separate legal actions.

The other interesting aspect of teaching this material is that it introduces students to the concept of elements or components of a tort or crime or, for that matter, most legal doctrines.

Encourage them to think in terms of negligence as not the first answer, but rather as the result of a component building block process where negligence is the product of showing the elements are in place. This process may not only help students make difficult legal doctrines more comprehensible, but it also introduces them to the underlying logic of “thinking like a lawyer.”

All in all, tort law is really fun to teach because the human condition not only gives us so much incredible raw material to work with but also gives us, as teachers, real positive feedback that it is working in the minds of our students.

The products liability debate is one of the most fascinating elements of any basic undergraduate law course. The issues covered in these materials go far beyond the question of who pays for what harm and the like. These matters take students into the entire realm of how a society chooses to conduct business, how it allocates the “costs” of doing that business, and most important of all, how much value society places on the balancing process between business latitude and individual rights.

You might open this material with an historical overview that picks up where the story of ultra-hazardous activity doctrines left off in tort law. One approach might be to teach the strict liability portion of this chapter right after torts. In the end, the sequence to be used is best selected by each individual instructor. Regardless of the sequence chosen, students should eventually be exposed to the multiple paths available to remedy the victim of a products’ harm.

After going over the history of the early strict liability cases, you can go into a dichotomous listing of the arguments on the current state of affairs in the product liability arena. Possibly stress that each student must personally decide how they feel about the issues. The possibilities for debate and open-ended discussion on these matters are endless. Product liability remains one of the great socioeconomic and legal dilemmas of our day.

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II. Chapter Objectives 1. List and describe intentional torts.

2. List and describe the elements necessary to prove negligence.

3. List and describe special negligence doctrines.

4. Describe the defense of assumption of the risk.

5. Describe the difference between contributory and comparative negligence.

6. Define the doctrine of strict liability and apply it to product defects.

III. Key Question Checklist  How would you classify this tort—intentional, negligence, or strict liability?  Is this an intentional tort and if so, are there any appropriate defenses?  Is this negligence and if so, are there any appropriate defenses?  Is the duty of care an obligation? How severe is a breach of this duty?

IV. Chapter Outline Introduction to Intentional Torts and Negligence  Tort is the French word for a “wrong”  Under tort law, an injured party can bring a civil lawsuit to seek compensation for a wrong done to the party or the party’s property  Tort damages are monetary damages that are sought from the offending party  Tort law imposes a duty on persons and business agents not to intentionally or negligently injure others in society Intentional Torts  The law protects a person from unauthorized touching, restraint, or other contact  The law also protects a person’s reputation and privacy  Violations of these rights are actionable as torts Assault  The threat of immediate harm or offensive contact  Any action that arouses reasonable apprehension of imminent harm  Actual physical contact is unnecessary  Threats of future harm are not actionable Battery  Unauthorized and harmful or offensive physical contact with another person  Direct physical contact (for example, intentionally hitting someone with a fist) is battery  Indirect physical contact between the victim and the perpetrator is also battery, as long as injury results False Imprisonment – The intentional confinement or restraint of another person without authority or justification and without that person’s consent.

Shoplifting and Merchant Protection Statutes – Merchant protection statutes allow merchants to stop, detain, and investigate suspected shoplifters without being held liable for false imprisonment if (1) there are reasonable grounds for the suspicion, (2) suspects are detained for only a reasonable time, and (3) investigations are conducted in a reasonable manner.

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State Court Case Case 6.1 False Imprisonment: Wal-Mart Stores, Inc. v. Cockrell Facts: Karl Cockrell and his parents went to a store owned by Wal-Mart Stores, Inc. (Wal-Mart).

Cockrell stayed for about five minutes and decided to leave. As he was going out the front door, Raymond Navarro, a Wal-Mart loss-prevention officer, stopped him and requested that Cockrell follow him to the manager’s office. Once in the office, Navarro told Cockrell to pull his pants down. Cockrell put his hands between his shorts and underwear, shook them and nothing fell out.

Next, Navarro told him to take off his shirt. Cockrell raised his shirt, revealing a large bandage that covered a surgical wound on the right side of his abdomen. Cockrell had recently had a liver transplant. Navarro asked him to take off the bandage, despite Cockrell’s explanation that the bandage maintained a sterile environment around his surgical wound. On Navarro’s insistence, Cockrell took down the bandage, revealing the wound. Navarro let Cockrell go. Cockrell sued Wal-Mart to recover damages for false imprisonment. Wal-Mart claimed the shopkeeper’s privilege. The trial court found in favor of Cockrell and awarded him $300,000 for his mental anguish. Wal-Mart appealed.

Issue: Does the shopkeeper’s privilege protect Wal-Mart from liability under the circumstances of the case?

Decision: The court of appeals upheld the trial court’s finding that Wal-Mart had falsely imprisoned Cockrell and had not proved the shopkeeper’s privilege. The court of appeals upheld the trial court’s judgment that awarded Cockrell $300,000 for mental anguish.

Reason: No one saw Cockrell steal merchandise. Navarro had said Cockrell was acting suspicious. A jury could have concluded that Navarro did not reasonably believe a theft had occurred. Here also the manner of detainment was unreasonable.

Ethics Questions: Navarro, the Wal-Mart employee, did not act responsibly in this case, especially in terms of asking Cockrell to take off the surgical bandage. Arguably, Wal-Mart did not act ethically in denying liability in this case. All merchants are charged with the responsibility of knowing that a merchant protection statute does not give a retailer absolute immunity in terms of exercise of the shopkeeper’s privilege.

Misappropriation of the Right to Publicity – An attempt by another person to appropriate a living person’s name or identity for commercial purposes. Also known as the tort of appropriation.

Invasion of the Right to Privacy – A tort that constitutes the violation of a person’s right to live his or her life without being subjected to unwanted and undesired publicity.

Defamation of Character – False statement(s) made by one person about another. The plaintiff must prove that: (1) the defendant made an untrue statement of fact about the plaintiff; and (2) the statement was intentionally or accidentally published to a third party.

A false statement that appears in writing or another fixed medium is called libel, while an oral defamatory statement is called slander.

Disparagement – False statements about a competitor’s products, services, property, or business reputation.

Ethics: Intentional Misrepresentation (Fraud) The tort of intentional misrepresentation is also known as fraud or deceit. It occurs when a wrongdoer deceives another person out of money, property, or something else of value. A person who has been injured by intentional misrepresentation can recover damages from the wrongdoer.

To prove fraud, the plaintiff must establish that: (1) The wrongdoer made a false representation of a material fact; 49 .

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(2) The wrongdoer had knowledge that the representation was false and intended to deceive the innocent party; (3) The innocent party justifiably relied on the misrepresentation; and (4) The innocent party was injured.

Intentional Infliction of Emotional Distress – A tort that says a person whose extreme and outrageous conduct intentionally or recklessly causes severe emotional distress to another person is liable for that emotional distress.

Malicious Prosecution  A successful defendant in a prior lawsuit can sue the plaintiff if the first lawsuit was frivolous  The following elements must be proven to win a lawsuit for malicious prosecution: o The plaintiff in the original lawsuit (now the defendant) instituted or was responsible for instituting the original lawsuit; o The was no probable cause for the first lawsuit (i.e., it was a frivolous lawsuit); o The plaintiff in the original action brought it with malice; o The original lawsuit was terminated in favor of the original defendant (now the plaintiff); and o The current plaintiff suffered injury as a result of the original lawsuit.  The courts do not look favorably on malicious prosecution lawsuits Unintentional Torts (Negligence) To be successful in a negligence lawsuit, the plaintiff must prove that: (1) The defendant owed a duty of care to the plaintiff; (2) The defendant breached the duty of care; (3) The plaintiff suffered injury; (4) The defendant’s negligent act actually caused the plaintiff’s injury; and (5) The defendant’s negligent act was the proximate cause of the plaintiff’s injuries.

1. Duty of Care – The obligation we all owe to each other not to cause any unreasonable harm or risk of harm. The courts generally apply a reasonable person standard, and defendants with a particular expertise or competence are measured against a reasonable professional standard.

2. Breach of the Duty of Care – The failure to do what a reasonable person would do under the same or similar circumstances.

Ethics: Ouch! McDonald’s Coffee Is Too Hot! This section discusses the famous case of a woman, Stella Liebeck, who sued McDonald’s when she suffered burns from the company’s hot coffee. Based on the evidence presented at trial, the jury concluded that McDonald’s acted recklessly and awarded Liebeck $200,000 in compensatory damages, which was then reduced by $40,000 because of her own negligence, and $2.7 million in punitive damages. The trial court judge reduced the amount of punitive damages to $480,000, which was three times the amount of compensatory damages. Liebeck v. McDonald’s Restaurants, P.T.S., Inc. (New Mexico District Court, Bernalillo County, New Mexico, 1994) 3. Injury to Plaintiff – The plaintiff must suffer personal injury or damage to his or her property to recover monetary damages for the defendant’s negligence. The damages recoverable depend on the effect of the injury on the plaintiff’s life or profession State Court Case 50 .

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Case 6.2 Negligence: Jones v. City of Seattle, Washington Facts: Mark Jones was a firefighter for the city of Seattle assigned to Station 33 firehouse. Jones slept on the second floor of the firehouse. The firehouse had a “pole hole” leading from the second floor to the first floor, a common feature of many firehouses. Firefighters typically slide down the pole to make a quick descent from the second floor to the first. One night, Jones fell 15 feet through the fire station’s pole hole and was severely injured. He told a responding medic that he had awoken to use the bathroom, which was next to the pole hole. Jones sued, and the jury concluded that the city had been negligent in not blocking accidental access to the pole hole. The jury awarded Jones $12.75 million in damages. The court of appeals upheld the verdict, and the city appealed to the supreme court of Washington.

Issue: Is the award of damages proper?

Decision: The supreme court of Washington upheld the damage award to the plaintiff against the city of Seattle.

Reason: Credible expert testimony presented at trial established that Jones had significant and permanent cognitive impairments as a result of his fall.

Ethics Questions: Traditional pole holes in fire stations do pose a risk of harm to firefighters.

Such pole holes should be eliminated if they are not a reasonable necessity to the performance of firefighting duties. Reasonable minds might differ in terms of whether the award in this case was warranted, but the jury made its determination based on the evidence presented at trial, and there was no indication that the jury committed an error of law or abuse of discretion in rendering its verdict.

4. Actual Cause A defendant’s negligent act must be the actual cause (also called causation in fact) of the plaintiff’s injuries. The test is “but for” the defendant’s conduct, would the accident have happened? If the defendant’s act caused the plaintiff’s injuries, there is causation in fact.

5. Proximate Cause Under the law, a negligent party is not necessarily liable for all damages set in motion by his or her negligent act. The law establishes a point along the damage chain after which the negligent party is no longer legally responsible for the consequences of his or her actions. This limitation on liability is referred to as proximate cause (legal cause). The general test of proximate cause is foreseeability. A negligent party who is found to be the actual cause—but not the proximate cause—of the plaintiff’s injuries is not liable to the plaintiff.

Information Technology: Proximate Cause and Violent Video Games Michael Carneal was a 14-year-old freshman student in high school in Paducah, Kentucky.

Carneal regularly played violent interactive video and computer games that involve the player shooting virtual opponents with computer guns and other weapons. Carneal also watched violent video-recorded movies and internet sites. Carneal took a .22-caliber pistol and five shotguns into the lobby of his high school and shot several of his fellow students, killing three and wounding many others.

The parents of the three dead children sued the producers and distributors of the violent video games and movies that Carneal had watched previously to the shooting. The parents sued to recover damages for wrongful death, alleging that the defendants were negligent in producing and distributing such games and movies to Carneal. The U.S. court of appeals held that the defendants were not the proximate cause of Carneal’s actions and were not liable to the plaintiffs. James v.

Meow Media, Inc., 300 F.3d 683, 2002 U.S. App. Lexis 16185 (United States Court of Appeals for the Sixth Circuit, 2002) Special Negligence Doctrines 51 .

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Courts have developed many special negligence doctrines, the most significant of which are the following: Professional Malpractice – The liability of a professional who breaches his or her duty of ordinary care.

Negligent Infliction of Emotional Distress – A tort that permits a person to recover for emotional distress caused by the defendant’s negligent conduct.

Negligence Per Se – A tort in which the violation of a statute or ordinance constitutes the breach of the duty of care.

Res Ipsa Loquitur – A tort in which the presumption of negligence arises because (1) the defendant was in exclusive control of the situation and (2) the plaintiff would not have suffered injury but for someone’s negligence.

Gross Negligence – A doctrine that says a person is liable for harm caused by his or her willful misconduct or reckless behavior.

Attractive Nuisance – A special tort rule that imposes liability on a landowner to children who have trespassed onto the landowner’s property by an attractive nuisance and who are killed or injured on the property.

Critical Legal Thinking: Good Samaritan Laws Good Samaritan laws are state laws that relieve medical professionals from liability for ordinary negligence when they stop and render aid to victims in emergency situations. Such laws protect medical professionals only from liability for their ordinary negligence, not for injuries caused by their gross negligence or reckless or intentional conduct. Most Good Samaritan laws protect licensed doctors, nurses, and laypersons certified in cardiopulmonary resuscitation (CPR).

Assumption of the Risk A defense that a defendant can use against a plaintiff who knowingly and voluntarily enters into or participates in a risky activity that results in injury.

State Court Case Case 6.3 Assumption of the Risk: Grady v. Green Acres, Inc. Facts: Ryan Grady, age 18 and a high school senior, went snow tubing with two friends at a business operated by Green Acres, Inc. Grady had previously been snow tubing at Green Acres and at other establishments. A sign in Green Acres’ parking lot stated “TUBE SLIDING CAN BE DANGEROUS” and “TUBERS ASSUME ALL RISKS AND TAKE FULL RESPONSIBILITY FOR ANY INJURIES.” All patrons, including Grady, wore a ticket stating that “he or she is VOLUNTARILY PARTIPATING in this activity, acknowledges that snow tubing is a POTENTIALLY DANGEROUS activity, and agrees to ASSUME ALL RISK of bodily injury, death, and/or property damages sustained, including being struck by other tubers, tubes, or patrons.” While tubing, Grady alleges that he struck another tuber, who was walking at the time, and was injured in the accident. Green Acres asserted that the doctrine of assumption of the risk precluded Grady’s suit. The district court granted summary judgment in favor of Green Acres, and Grady appealed.

Issue: Does assumption of the risk preclude liability for injuries resulting from the dangers inherent in snow tubing?

Decision: The court of appeals held that the doctrine of assumption of the risk applies to snow tubing and that Green Acres was property granted summary judgment.

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Reasoning: The court noted that the record supported the district court’s conclusion that Grady knew the risk, appreciated it, and had a chance to avoid it.

Ethics Questions: Tort law recognizes that business owners are not absolute insurers of customer safety. In this case, the record clearly supports the conclusion that Grady assumed the risk. The law recognizes that the defendant is not responsible for the plaintiff’s harm if the plaintiff (1) knew of the risk, (2) appreciated the risk, and (3) had a chance to avoid the risk.

Contributory and Comparative Negligence  Contributory Negligence – A doctrine that says a plaintiff who is partially at fault for his or her own injury cannot recover against the negligent defendant  Comparative Negligence – A doctrine under which damages are apportioned according to fault; also referred to as comparative fault Strict Liability and Product Liability If a product is defective and causes injuries, the injured party can sue the product manufacturer or seller for product liability. A plaintiff can sue a responsible party—usually the manufacturer—for being negligent in producing a defective product that caused the victim’s injuries.

Another tort doctrine adopted by most states, strict liability, also applies to product defect cases.

Strict liability removes many of the difficulties for the plaintiff associated with proving a negligence case.

Liability without Fault Unlike negligence, strict liability does not require the injured person to prove that the defendant breached a duty of care. Strict liability is liability without fault. A seller or lessor can be found strictly liable even though he or she has exercised all possible care in the preparation and sale or lease of his or her product.

All in the Chain of Distribution Are Liable All parties in the chain of distribution of a defective product are strictly liable for the injuries caused by that product. The chain of distribution includes all manufacturers, distributors, wholesalers, retailers, lessors, and subcomponent manufacturers involved in a transaction.

Defect in Manufacture – A defect that occurs when a manufacturer fails to properly: (1) Assemble a product; (2) Test a product; or (3) Check the quality of the product.

Defect in Design – A defect that occurs when a product is designed improperly.

Failure to Warn – A defect that occurs when a manufacturer does not place a warning on the packaging of products that could cause injury if the danger is unknown.

Defect in Packaging – A defect that occurs when a product has been placed in packaging that is insufficiently tamperproof.

Defenses to Product Liability – Defendant manufacturers and sellers in negligence and strict liability actions may raise certain defenses to liability. Some of the most common defenses are: (1) Generally known danger—A defense which acknowledges that certain products are inherently dangerous and are known to the general population to be so (2) Abnormal misuse of the product—A defense that relieves a seller of product liability if the user abnormally misused a product 53 .

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(3) Supervening event—An alteration or a modification of a product by a party in the chain of distribution that absolves all prior sellers from strict liability

Federal Court Case Case 6.4 Supervening Event: Cummins v. BIC USA, Inc. Facts: A minor referred to as “CAP” was seriously burned when he was three years old. A BIC cigarette lighter was found at the scene and upon its examination, investigators determined that the child safety guard had been removed. The father acknowledged that he usually removed the safety guard from his cigarette lighters, but denied removing the child-resistant guard from the lighter in question. CAP’s conservator sued BIC USA, Inc. BIC defended themselves on the basis that the lighter was not defective, since someone removed the child safety guard. The case proceeded to trial, and during his closing argument to the jury, BIC’s attorney Edward Stopher commented that “(n)o one can make a…Thorproof lighter.” Stopher was referring to CAP’s father, Thor Polley. The trial court instructed the jury to disregard Stopher’s comment regarding the child’s father. The jury found that the lighter was not defective because the child-resistant guard had been removed from the lighter before the accident. The plaintiff appealed for a new trial, alleging the BIC’s lawyer’s remarks prejudiced the jury.

Issue: Did the BIC’s lawyer’s remarks in the closing statement prejudice the jury?

Decision: The U.S. court of appeals affirmed the judgment in favor of defendant BIC. Reason: The court reasoned that attorney Stopher’s comments were neither inaccurate nor inflammatory.

Ethics Questions: Arguably, attorney Stopher’s comment “(n)o one can make a Thorproof lighter” was not unethical. It was instead a creative and effective way to argue that the BIC lighter was not defective in design or production, but instead dangerous because of the father’s supervening act of removing the child safety guard.

Statute of Repose – A statute that limits the seller’s liability to a certain number of years from the date when the product was first sold. The period of repose varies from state to state.

V. Key Terms and Concepts  Abnormal misuse—A manufacturer or seller is relieved of product liability if the plaintiff has abnormally misused the product.  Actual cause (causation in fact)—The actual cause of negligence. A person who commits a negligent act is not liable unless actual cause can be proven.  Assault—The threat of immediate harm or offensive contact, or any action that arouses reasonable apprehension of imminent harm. Actual physical contact is not necessary.  Assumption of the risk—A defense in which the defendant must prove that (1) the plaintiff knew and appreciated the risk, and (2) the plaintiff voluntarily assumed the risk.  Attractive nuisance doctrine—A tort rule that imposes liability on a landowner to children who have been attracted onto the landowner’s property by an attractive nuisance and who are killed or injured on the property.  Battery—Unauthorized and harmful or offensive physical contact with another person.

Direct physical contact is not necessary.  Breach of the duty of care—A failure to exercise care or to act as a reasonable person would act.  Chain of distribution—All manufacturers, distributors, wholesalers, retailers, lessors, and subcomponent manufacturers involved in a transaction.  Comparative negligence (comparative fault)—A doctrine under which damages are apportioned according to fault.

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                    



Contributory negligence—A doctrine that says a plaintiff who is partially at fault for his own injury cannot recover against the negligent defendant.

Defamation of character—False statement(s) made by one person about another. In court, the plaintiff must prove that (1) the defendant made an untrue statement of fact about the plaintiff, and (2) the statement was intentionally or accidentally published to a third party.

Defect in design—A defect that occurs when a product is improperly designed.

Defect in manufacture—Defect that occurs when a manufacturer fails to properly (1) assemble a product, (2) test a product, or (3) check the quality of a product.

Defect in packaging—A defect that occurs when a product has been placed in packaging that is insufficiently tamperproof.

Disparagement—False statements about a competitor’s products, services, property, or business reputation.

Duty of care—The obligation people owe to each other not to cause any unreasonable harm or risk of harm.

Failure to warn—A defect that occurs when a manufacturer does not place a warning on the packaging of products that could cause injury if the danger is unknown.

False imprisonment—The intentional confinement or restraint of another person without authority or justification and without that person’s consent.

Generally known danger—Certain products are inherently dangerous and are known to the general population to be so. Manufacturers and sellers are not strictly liable for failing to warn of generally known dangers.

Good Samaritan law—Statute that relieves medical professionals from liability for ordinary negligence when they stop and render aid to victims in emergency situations.

Gross negligence—A doctrine that says a person is liable for harm that is caused by his or her willful misconduct or reckless behavior. Punitive damages may be assessed in a case involving gross negligence.

Injury—The plaintiff must suffer personal injury or damage to his or her property in order to recover monetary damages for the defendant’s negligence.

Intentional infliction of emotional distress (tort of outrage)—A tort that says a person whose extreme and outrageous conduct intentionally or recklessly causes severe emotional distress to another person is liable for that emotional distress.

Intentional misrepresentation (fraud or deceit)—The intentional defrauding of a person out of money, property, or something else of value.

Intentional tort—Occurs when a person has intentionally committed a wrong against (1) another person or his or her character, or (2) another person’s property.

Invasion of the right to privacy—A tort that constitutes the violation of a person’s right to live his or her life without being subjected to unwarranted and undesired publicity.

Liability without fault—Strict liability is liability without fault.

Libel—A false statement that appears in a letter, newspaper, magazine, book, photograph, movie, video, etc.

Malicious prosecution—A lawsuit in which the original defendant sues the original plaintiff. In the second lawsuit, the defendant becomes the plaintiff and vice versa.

Merchant protection statute (shopkeeper’s privilege)—Statutes that allow merchants to stop, detain, and investigate suspected shoplifters without being held liable for false imprisonment if (1) there are reasonable grounds for the suspicion, (2) suspects are detained for only a reasonable time, and (3) investigations are conducted in a reasonable manner.

Misappropriation of the right to publicity (tort of appropriation)—An attempt by another person to appropriate a living person’s name or identity for commercial purposes.

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                

Negligence (ordinary negligence or unintentional tort)—A doctrine that says a person is liable for harm that is the foreseeable consequence of his or her actions. The failure to do what a reasonable person would do, or doing something a reasonable person would not do.

Negligence per se—A tort in which the violation of a statute or an ordinance constitutes a breach of the duty of care.

Negligent infliction of emotional distress—A tort that permits a person to recover for emotional distress caused by the defendant’s negligent conduct.

New York Times Co. v. Sullivan—The U.S. Supreme Court held that public officials cannot recover for defamation unless they can prove that the defendant acted with “actual malice.”

Partial comparative negligence—Provides that a plaintiff must be less than fifty (50) percent responsible for causing his or her own injuries to recover under comparative negligence.

Product liability—Theory of recovery available to a consumer who is injured by a defective product.

Professional malpractice—The liability of a professional who breaches his or her duty of care.

Proximate cause (legal cause)—A point along a chain of events caused by a negligent party after which this party is no longer legally responsible for the consequences of his or her actions.

Public figure—Individuals in our society who are commonly known. Examples include movie stars, sports personalities, and other celebrities. Public figures cannot recover for defamation unless they can prove that the defendant acted with “actual malice.”

Punitive damages—Monetary damages awarded to punish a defendant who either intentionally or recklessly injured the plaintiff.

Reasonable person standard—A test used to determine whether a defendant owes a duty of care. This test measures the defendant’s conduct against how an objective, careful, and conscientious person would have acted in the same circumstances.

Reasonable professional standard—How an objective, careful, and conscientious equivalent professional would have acted in the same circumstances. In a negligence action, the defendant professional’s conduct is measured against that standard.

Res ipsa loquitur—A tort in which the presumption of negligence arises because (1) the defendant was in exclusive control of the situation, and (2) the plaintiff would not have suffered injury but for someone’s negligence.

Slander—An oral defamatory statement.

Statute of repose—A statute that limits the seller’s liability to a certain number of years from the date when the product was first sold.

Strict liability—A tort doctrine that makes manufacturers, distributors, wholesalers, retailers, and others in the chain of distribution of a defective product liable for the damages caused by the defect, regardless of fault.

Supervening event—An alteration or a modification of a product by a party in the chain of distribution that absolves all prior sellers from strict liability.

Tort—A wrong. There are three categories of torts: (1) intentional torts; (2) unintentional torts (negligence); and (3) strict liability.

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What happens to the victim of a crime?

I. Teacher to Teacher Dialogue There can be no question that our criminal law system is far from perfect, and anyone who tries to take the position that it is not grounded in reality. What is important to convey to our students is that in spite of all these problems, the underlying goal of our system is to balance the rights of the defendant with those of the larger society. As a society, we try harder than most to maintain that balance.

Try to give students some of the comparative structural differences between our system and some of the worlds’ more totalitarian regimes. Ask them to consider their own personal financial and legal ability to resist the efforts of the state that may have targeted them for prosecution. In that light, they start to see that our criminal law system, although quite flawed, is all we really have to protect us from the abuses of the sovereign. In the end, recommend to students the following thought: the easier we allow the forces of the criminal law system to be used, the less free we will all be in the end. The measure of a free society is, in many ways, how much we are willing to harness government. Too much freedom in the hands of the sovereign may bring too little freedom to those who deserve it most.

Then you might go into the general settings in which crimes against and by business have evolved over the years. Possibly focus on the emerging willingness of states to pursue, and the courts to convict, individual managers for criminal offenses committed in the name of corporate gain. Unfortunately, the daily media is able to provide us with a more than adequate supply of case scenarios to use as illustrative examples of the phenomenon.

II. Chapter Objectives 1. Define crime and describe the essential elements of a crime.

2. Describe criminal procedure, including arrest, indictment, and arraignment.

3. Describe a criminal trial and the standard of proof that must be met to find a person guilty of a crime.

4. Describe common crimes such as murder, robbery, and larceny.

5. Identify and describe business and white-collar crimes.

6. Describe regulatory crimes.

7. List and describe cybercrimes.

8. Explain the Fourth Amendment protection from unreasonable search and seizure.

9. Explain the Fifth Amendment privilege against self-incrimination and other privileges recognized in criminal matters.

10. Explain the protections provided by the Double Jeopardy Clause, the right to a public jury trial, the right to counsel, and protection against cruel and unusual punishment.

III. Key Question Checklist  All crimes are specifically defined by federal, state, or local statute. Would the behavior in question fall under the purview of the applicable statute?

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 Have procedural and substantive due process requirements been met?  If there is a problem with either substantive or procedural due process, what are the consequences to the accused and the accuser?  Is the statute in question good for the larger society as a matter of public policy?

IV. Chapter Outline Introduction to Criminal Law and Cybercrime Criminal law serves to protect people and their property from injury by other members of society.

It provides an incentive for persons to act reasonably in society and imposes penalties on persons who violate the law. A person charged with a crime in the United States is presumed innocent until proven guilty. The burden of proof in a criminal trial is on the government to prove that the accused is guilty of the crime charged. The accused must be found guilty beyond a reasonable doubt, and conviction requires a unanimous jury vote.

Definition of a Crime A crime is defined as any act done by an individual in violation of those duties he or she owes to society and for the breach of which the law provides that the wrongdoer shall make amends to the public.

Penal Codes  Statutes are the source of criminal law  Federal and state statutes define activities that are considered to be crimes within their jurisdictions Criminal Penalties The penalty for committing a crime may consist of the imposition of a fine, imprisonment, both, or some other form of punishment such as probation.

Imprisonment is imposed to: 1. Incapacitate the criminal so he or she will not harm others in society; 2. Provide a means to rehabilitate the criminal; 3. Deter others from similar conduct; and 4. Inhibit personal retribution by the victim.

Parties to a Criminal Action  In a criminal lawsuit, the government is the plaintiff  The government is represented by a lawyer called the prosecutor  The accused is the defendant  The accused is represented by a defense attorney Classification of Crimes All crimes can be classified into one of the following categories:  Felonies – most serious  Misdemeanors – less serious than felonies  Violations – the least serious of crimes, usually punishable by a fine General Intent and Specific Intent Crimes Two elements must be proven for a person to be found guilty of most crimes: 1. Criminal Act – actus reus 2. Criminal Intent – mens rea

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Specific intent crimes require that the perpetrator intended to achieve a specific result from his or her illegal act, while general intent crimes require that the perpetrator either knew or should have known that his or her actions would lead to harmful results.

Nonintent Crimes  A crime that imposes criminal liability without a finding of mens rea (intent)  Nonintent crimes are often imposed for reckless or grossly negligent conduct that causes injury to another person Strict Liability Crimes A crime that imposes criminal liability for the commission of a prohibited act without requiring proof of intent, recklessness, or grossly negligent conduct.

Contemporary Environment: Criminal Acts as the Basis for Tort Actions  Civil lawsuits are separate from the government’s criminal action against the wrongdoer  In a civil action, the plaintiff usually seeks to recover monetary damages from the wrongdoer Criminal Procedure The procedure for initiating and maintaining a criminal action includes both pretrial procedures and the actual trial.

Arrest Before the police can arrest a person for the commission of a crime, they usually must obtain an arrest warrant based on a showing of probable cause. Probable cause is defined as the substantial likelihood that a person either committed or is about to commit a crime.

Booking After a person is arrested, he or she is taken to the police station to be booked. Booking is the administrative procedure for recording an arrest which includes fingerprinting the suspect and taking a photograph of the suspect (often called a “mug shot”).

U.S. Supreme Court Case Case 7.1 Search: Maryland v. King Facts: In 2009, Alonzo King was arrested in Maryland and charged with first- and second-degree assault for menacing a group of people with a shotgun. As part of the booking procedure for serious offenses, a DNA sample was taken from King by applying a cotton swab to the inside of his cheeks. His DNA was found to match DNA taken from a 2003 rape victim. King was tried and convicted of the rape. He alleged that the DNA taken when he was booked in 2009 violated the Fourth Amendment as an unreasonable search and seizure and therefore could not be used to convict him of the 2003 rape. The court of appeals of Maryland agreed and set the rape conviction aside. The U.S. Supreme Court granted review of the case.

Issue: Did Maryland’s collection of King’s DNA during the booking procedure in 2009 constitute an unreasonable search and seizure?

Decision: The U.S. Supreme Court held that the taking of the DNA from King at the time of the booking was a reasonable search and seizure and reversed the judgment of the court of appeals of Maryland.

Reasoning: According to the Court, when officers make an arrest supported by probable cause to hold for a serious offense and they bring the suspect to the station to be detained in custody, taking and analyzing a cheek swab of the arrestee’s DNA is, like fingerprinting and

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photographing, a legitimate police booking procedure that is reasonable under the Fourth Amendment.

Ethics Questions: Arguably, privacy of the person is the most important privacy right protected by the Fourth Amendment to the U.S. Constitution. Students should address the question of whether the taking of a DNA sample is more invasive than fingerprinting or photographing the arrestee.

Indictment or Information An accused person must be formally charged with a crime before being brought to trial. This is usually done through an indictment issued by a grand jury or an information statement issued by a magistrate. Evidence of serious crimes, such as murder, is usually presented to a grand jury. If the grand jury determines that there is sufficient evidence to hold the accused for trial, it issues an indictment. For lesser crimes, such as burglary or shoplifting, the accused is brought before a magistrate. A magistrate who finds that there is enough evidence to hold the accused for trial issues an information statement.

Arraignment If an indictment or information is issued, the accused is brought before a court for an arraignment proceeding during which the accused is (1) informed of the charges, and (2) asked to enter a plea.

The accused may plead guilty or not guilty. A party may enter a plea of nolo contendere whereby the accused agrees to the imposition of a penalty but does not admit guilt. The government has the option of accepting a nolo contendere plea or requiring the defendant to plead guilty or not guilty.

Ethics: Plea Bargain Agreements in Criminal Cases Sometimes the accused and the government enter plea bargain negotiations prior to trial with the intent of avoiding a trial. If an agreement is reached, the government and the accused execute a plea bargain agreement that sets forth the terms of their agreement.

Criminal Trial  All jurors must unanimously agree before the accused is found guilty of the crime charged  If one juror has reasonable doubt about the guilt of the accused, the accused cannot be found guilty of the crime charged  If all of the jurors agree that the accused did not commit the crime, the accused is innocent of the crime charged After trial, the following rules apply:  If the defendant is found guilty, he or she may appeal  If the defendant is found not guilty, the government cannot appeal  If the jury cannot come to a unanimous decision about the defendant’s guilt one way or the other, the jury is considered a hung jury Common Crimes: Many common crimes are committed against persons and property.

Murder – The unlawful killing of another human being without justification—includes firstdegree murder, second-degree murder, voluntary manslaughter, and involuntary manslaughter.

Sometimes a murder is committed during the commission of another crime even though the perpetrator did not originally intend to commit murder. Most states hold the perpetrator liable for the crime of murder in addition to the other crime. This is called the felony murder rule. The intent to commit the murder is inferred from the intent to commit the other crime.

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Critical Legal Thinking: First-Degree Murder This case involved a domestic dispute in which Gregory O. Wilson lit his girlfriend, Melissa Spear, on fire with gasoline. Ms. Spear suffered third-degree burns over most of her body. Nine months after the incident, she died. The state of Ohio brought murder charges against Wilson.

The defendant argued he was not liable for murder because there was not sufficient causation between his horrific act and Ms. Spear’s eventual death. The jury nevertheless convicted Wilson, and he appealed. The court of appeals upheld the conviction, noting that if even if the victim does not die immediately or soon after the defendant’s wrongful act, the defendant is not relieved of the natural consequences of inflicting serious wounds on another person. State of Ohio v. Wilson, 2004 Ohio 2838, Web 2004 Ohio App. Lexis 2503 (Court of Appeals of Ohio, 2004) Robbery – The taking of personal property from another person by the use of force or fear.

Burglary – The taking of personal property from another’s home, office, or commercial or other type of building.

Larceny – The taking of another’s personal property other than from his or her person or building.

Theft – The taking of another’s personal property in jurisdictions that do not recognize a distinction between robbery, burglary, and larceny.

Receiving stolen property – A crime that involves (1) knowingly receiving stolen property, and (2) intending to deprive the rightful owner of that property.

Arson – The willful or malicious burning of a building.

Business and White-Collar Crimes White-collar crimes are often committed by businesspeople and usually involve cunning and deceit rather than physical force.

Forgery – The fraudulent making or alteration of a written document that affects the legal liability of another person.

Embezzlement – The fraudulent conversion of property by a person to whom that property was entrusted.

Bribery – A crime in which one person gives another person money, property, favors, or anything else of value for a favor in return. Often referred to as a payoff or kickback.

Extortion – A threat to expose something about another person unless that other person gives money or property. Often referred to as blackmail.

Criminal Fraud – A crime that involves obtaining title to property through deception or trickery.

This crime is commonly referred to as false pretenses or deceit.

Mail Fraud and Wire Fraud – Mail fraud involves use of the mail to defraud another person, while wire fraud involves the use of a communications wire (telephone, television, radio, etc.) to defraud another person.

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Ethics: Ponzi Scheme Defrauds Investors This case involved an eight-year Ponzi scheme that defrauded more than 5,000 investors, many of them elderly or living on modest incomes, of $215 million. A jury convicted the defendants Durham, Cochran, and Snow on various counts of conspiracy, securities, fraud, and wire fraud.

The U.S. district judge sentenced Durham to 50 years, Cochran to 25 years, and Snow to 10 years’ imprisonment and issued an order of restitution of $209 million. The U.S. Court of Appeals affirmed the convictions, commenting that “Ponzi schemes themselves generate no legitimate gains; they will inevitably collapse at some point, when the volume of new money from investor/victims is no longer sufficient to meet the demands and expectations of earlier investor/victims.” United States v. Durham, 766 F.3d 672, 2014 U.S. App. Lexis 17267 (United States Court of Appeals for the Seventh Circuit, 2014) Money Laundering – To “wash” money that was gained through illegal activities and thereby make the money appear as if it was earned legitimately.

Contemporary Environment: Racketeer Influenced and Corrupt Organizations Act (RICO) RICO makes it a federal crime to acquire or maintain an interest in, use income from, or conduct or participate in the affairs of an “enterprise” through a “pattern” of “racketeering activity.”

Criminal Conspiracy – When two or more persons enter into an agreement to commit a crime, it is considered a criminal conspiracy. An overt act is required, but not the actual commission of the crime.

Business Environment: Corporate Criminal Liability Corporations have generally been held to lack the mens rea to commit a crime; after all, they are not alive, and only act through their agents. The courts have held, though, that they are criminally liable for the actions of their agents, managers, and employees. They cannot be imprisoned, but they can be fined, lose a license, or be disbanded. The corporate directors, officers, and employees can be held individually liable for the crimes they commit personally.

Regulatory Crimes – Include violations of securities, antitrust, environmental, consumer, employment, credit, bankruptcy, intellectual property, and other statutes.

Cybercrimes – The government has had to apply existing laws to newer mediums and develop new laws to address digital crimes.

Information Technology: The Internet and Identity Theft In identity theft—or ID theft—one person steals information about another person to pose as that person and take the innocent person’s money or property or to purchase goods and services using the victim’s credit information.

Information Infrastructure Protection Act – Makes it a federal crime for anyone to access and acquire information intentionally from a protected computer without authorization.

Counterfeit Access Device and Computer Fraud and Abuse Act – Makes it a federal crime to access a computer knowingly to obtain (1) restricted federal government information, (2) financial records of financial institutions, or (3) consumer reports of consumer reporting agencies.

Federal Court Case Case 7.2 Computer Crime: United States v. Barrington

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Facts: Three Florida A&M University (FAMU) students, Marcus Barrington, Christopher Jacquette, and Lawrence Secrease, unlawfully accessed FAMU’s internet-based grading system.

The three used their unlawful access to change course grades for themselves and other students.

Barrington received approximately 30-35 grade changes, Jacquette about 43, and Secrease around 36. The group made over 650 unauthorized grade changes for at least 90 students. The three were indicted and charged with the federal crimes of conspiring to commit wire fraud using a protected computer, fraud using a protected computer, and identity theft. Jacquette and Secrease entered into a plea agreement and each was sentenced to 22 months in prison. Barrington went to trial and denied involvement in the scheme. Barrington was convicted and sentenced to 7 years in prison.

Barrington appealed.

Issue: Was Barrington guilty of the crimes charged and was the prison sentence appropriate?

Decision: The U.S. court of appeals affirmed Barrington’s conviction and prison sentence.

Reason: The court noted that there was an adequate evidentiary basis for the jury to conclude that Barrington committed the criminal acts alleged, and Barrington’s “arrogance and contempt for the law” justified the sentence imposed.

Ethics Questions: Arguably, Barrington should have entered into a plea deal before trial. The evidence was certainly in favor of the prosecution, and the prosecutor had access to two coconspirators that could testify against him. Jacquette had every right to testify against Barrington, and testifying against Barrington promoted justice. The 7-year prison sentence was justifiable, since computer fraud and identity theft are very serious crimes.

Information Technology: Electronic Communications Privacy Act The Electronic Communications Privacy Act (ECPA) makes it a crime to intercept an electronic communication at the point of transmission, while in transit, when stored by a router or server, or after receipt by the intended recipient. An electronic communication includes any transfer of signals, writings, images, sounds, data, or intelligence of any nature. The ECP makes it illegal to access email while in transmission or stored.

The ECPA provides that stored electronic communications may be accessed without violating the law by: 1. The party of entity providing the electronic communication service; or 2. Government and law enforcement entities that are investigating suspected illegal activity.

Fourth Amendment Protection From Unreasonable Search and Seizure The Fourth Amendment protects individuals and corporations from unreasonable search and seizure; that is, searches carried out without the benefit of search warrants issued by the court authorizing the police or federal agents to search a designated place for specific items, or warrantless searches carried out incident to arrest, where evidence is in plain view, or when it is likely that the evidence will be destroyed.

Exclusionary Rule The exclusionary rule permits evidence to be excluded from trial if it is obtained subsequent to an unreasonable search and seizure. However, the good faith exception to the exclusionary rule permits even this tainted evidence to be introduced, provided the officers conducting the search reasonably believed that they were acting pursuant to a lawful search warrant.

U.S. Supreme Court Case Case 7.3 Search of Cellphones: Riley v. California Facts: Two cases were combined for decision by the U.S. Supreme Court. Both involved a police search of cell phones without a warrant, with the evidence gathered being instrumental in the defendants’ convictions. Both defendants moved to suppress the evidence the police obtained from their cell phones, alleging that the information obtained from the cell phones were the fruits 63 .

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of an unconstitutional search in violation of the Fourth Amendment to the U.S. Constitution. In both cases, the courts denied the defendants’ requests. After appeals, the U.S. Supreme Court agreed to hear the combined cases.

Issue: Can the police, without a warrant, search digital information on a cell phone from an individual who has been arrested?

Decision: The U.S. Supreme Court held that police cannot, without a warrant, search digital information on a cell phone from an individual who has been arrested.

Reason: The court noted that cell phones differ in both a quantitative and qualitative sense from other objects that might be kept on an arrestee’s person, such as billfolds, address books, wallets, and purses. Today, many of the more than 90% of American adults who own a cell phone keep on their person a digital record of nearly every aspect of their lives. Cell phones for most Americans hold “the privacies of life.”

Ethics Questions: The U.S. Supreme Court decision represents strong support for an individual’s Fourth Amendment privacy rights. The decision does acknowledge the Supreme Court justices’ at least fundamental understanding of the “digital world.”

Searches of Business Premises As a general rule, the government does not have the right to search business premises without a search warrant.

Fifth Amendment Privilege Against Self-Incrimination The Fifth Amendment provides that no person can be compelled in any criminal case to give evidence against themselves. We speak of those asserting this privilege as “taking the Fifth.”

Only individuals are protected by this, not business entities, so business records are not protected.

Contemporary Environment: Miranda Rights The warning that is read to a criminal suspect who is in the custody of police or government agents before they are interrogated is called the Miranda rights. Those rights include the right to remain silent, that anything that you say can be used against you in court, that you have the right to have an attorney present when you are being questioned, and that if you cannot afford an attorney, one will be provided for you.

Attorney-Client and Other Privileges The Fifth Amendment protects all communications between a client and their attorney, preventing the attorney from being called as a witness against their own client. Other privileged parties are psychiatrist/psychologist–patient, priest/minister/rabbi–penitent, spousal privileges, and parent–child. About twenty states have enacted special accountant-client privileges.

Ethics: Immunity from Prosecution A governmental agency may agree not to use any evidence given by a person against them. At this point, the person loses the right to take the Fifth, and must deliver up all information as required.

Other Constitutional Protections: Fifth Amendment Protection Against Double Jeopardy The Double Jeopardy Clause of the Fifth Amendment protects persons from being tried twice for the same crime.

Sixth Amendment Right to a Public Jury Trial

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The Sixth Amendment guarantees that a criminal defendant has the right to a public jury trial.

This includes rights to (1) be tried by an impartial jury of the state or district in which the alleged crime was committed, (2) confront (cross-examine) the witnesses against the accused, (3) have the assistance of a lawyer, and (4) have a speedy trial.

Eighth Amendment Protection Against Cruel and Unusual Punishment The Eighth Amendment protects criminal defendants from cruel and unusual punishment. This prohibits the torture of criminals, but it does not prohibit capital punishment.

V. Key Terms and Concepts  Accountant-client privilege—An accountant cannot be called as a witness against a client in a court action in a state where these statutes are in effect.  Actus reus (criminal act, guilty act)—The actual performance of a criminal act.  Arraignment—A hearing during which the accused is brought before a court and is (1) informed of the charges against him or her, and (2) asked to enter a plea.  Arrest—Before the police can arrest a person for the commission of a crime, they usually must obtain an arrest warrant based on a showing of probable cause.  Arrest warrant—A document for a person’s detainment, based on a showing of probable cause that the person committed a crime.  Arson—The willful or malicious burning of a building.  Attorney-client privilege—A rule that says a client can tell his or her lawyer anything about the case without fear that the attorney will be called as a witness against the client.  Bail—If a criminal defendant posts a bail amount established by the court, he or she can be released from jail or prison pending trial.  Bail bond—A bail bond professional who posts bail for a criminal defendant.  Beyond a reasonable doubt—The accused must be found guilty beyond a reasonable doubt.  Blackmail—Extortion of private persons.  Booking—Booking is the administrative procedure for recording an arrest, fingerprinting the suspect, taking a photograph of the suspect (often called a “mug shot”), etc.  Bribery—A crime in which one person gives another person money, property, favors, or anything else of value for a favor in return. A bribe is often referred to as a payoff or kickback.  Burden of proof—The burden of proof in a criminal trial is on the government to prove that the accused is guilty of the crime charged.  Burglary—The taking of personal property from another’s home, office, or commercial or other type of building.  Capital murder—A murder for which the defendant could be executed.  Civil action—A lawsuit brought by a party to recover monetary damages or other remedies from a defendant.  Civil RICO—Persons injured by a RICO violation can bring a private civil RICO action against the violator to recover for injury to business or property.  Common crime—Many common crimes are committed against persons and property.  Corporate criminal liability—Modern courts impose corporate criminal liability. These courts have held that corporations are criminally liable for the acts of their directors, officers, and employees.  Counterfeit Access Device and Computer Fraud and Abuse Act (CFAA)—Makes it a federal crime to access a computer knowingly to obtain restricted federal government information, financial records of financial institutions, or consumer reports of consumer reporting agencies.

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Crime—A crime is a violation of a statute for which the government imposes a punishment.

Criminal conspiracy—A crime in which two or more persons enter into an agreement to commit a crime and an overt act is taken to further the crime.

Criminal fraud (false pretenses or deceit)—A crime that involves obtaining title to property through deception or trickery.

Criminal intent—Most crimes require criminal intent to be proven before the accused can be found guilty of the defined crime.

Criminal law—Federal, state, and local governments’ criminal laws are intended to afford this protection by providing an incentive for persons to act reasonably in society and imposing penalties on persons who violate them.

Criminal RICO—RICO makes it a federal crime to acquire or maintain an interest in, use income from, or conduct or participate in the affairs of an enterprise through a pattern of racketeering activity.

Cruel and unusual punishment—A clause of the Eighth Amendment that protects criminal defendants from torture or other abusive punishment.

Cybercrime—A crime that is committed using computers, e-mail, the Internet, or other electronic means.

Defendant—In a criminal lawsuit, the accused, which is usually an individual or a business, is the defendant.

Defense attorney—In a criminal lawsuit, the accused is represented by a defense attorney.

Double Jeopardy Clause—A clause of the Fifth Amendment that protects persons from being tried twice for the same crime.

Eighth Amendment—The Eighth Amendment to the U. S. Constitution protects criminal defendants from cruel and unusual punishment.

Electronic Communications Privacy Act (ECPA)—A federal statute that makes it a crime to intercept an electronic communication at the point of transmission, while in transit, when stored by a router or server, or after receipt by the intended recipient.

Embezzlement—The fraudulent conversion of property by a person to whom that property was entrusted.

Exclusionary rule—A rule that says evidence obtained from an unreasonable search and seizure can generally be prohibited from introduction at a trial or an administrative proceeding against the person searched.

Extortion—A threat to expose something about another person unless that other person gives money or property.

Extortion under color of official right—Extortion of public officials.

Felony—The most serious type of crime; inherently evil crime. Most crimes against persons and some business-related crimes are felonies.

Felony murder rule—Most states hold the perpetrator liable for the crime of murder in addition to the other crime. This is called the felony murder rule.

Fifth Amendment—The Fifth Amendment to the U.S. Constitution provides that no person “shall be compelled in any criminal case to be a witness against himself.”

First-degree murder—The intentional unlawful killing of a human being by another person with premeditation, malice aforethought, and willful act.

Forgery—The fraudulent making or alteration of a written document that affects the legal liability of another person.

Fourth Amendment—The Fourth Amendment to the U.S. Constitution protects persons and corporations from overzealous investigative activities by the government.

General intent crime—A crime that requires that the perpetrator either knew or should have known that his or her actions would lead to harmful results.

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

Grand jury—Evidence of serious crimes, such as murder, is usually presented to a grand jury.

Guilty—An accused may plead guilty or not guilty.

Hung jury—A jury that cannot come to a unanimous decision about the defendant’s guilt. In the case of a hung jury, the government may choose to retry the case.

Identity theft (ID theft)—One person steals information about another person to pose as that person and take the innocent person’s money or property or to purchase goods and services using the victim’s credit information.

Identity Theft and Assumption Deterrence Act—To address the growing problem of identity theft, Congress enacted the Identity Theft and Assumption Deterrence Act. Immunity from prosecution—The government’s agreement not to use against a person granted immunity any evidence given by that person.

Indictment—The charge of having committed a crime (usually a felony), based on the judgment of a grand jury.

Information—The charge of having committed a crime (usually a misdemeanor), based on the judgment of a judge (magistrate).

Information Infrastructure Protection Act (IIP Act)—Congress addressed computer-related crimes as distinct offenses. The IIP Act provides protection for any computer attached to the internet.

Intent crime—A crime that requires the defendant to be found guilty of committing a criminal act (actus reus) with criminal intent (mens rea).

Involuntary manslaughter—The crime of involuntary manslaughter is a nonintent crime.

Judgment proof—In many cases, a person injured by a criminal act will not sue the criminal to recover civil damages because the criminal is often judgment proof—that is, the criminal does not have the money to pay a civil judgment.

Kickback (payoff)—The crime of commercial bribery entails the payment of bribes to private persons and businesses. This type of bribe is often referred to as a kickback, or payoff.

Larceny—The taking of another’s personal property other than from his or her person or building.

Magistrate—For lesser crimes (e.g., burglary, shoplifting), the accused will be brought before a magistrate (judge).

Mail fraud—The use of mail to defraud another person.

Mala in se—Felonies include crimes that are mala in se—that is, inherently evil.

Mala prohibita—Misdemeanors are less serious than felonies. They are crimes mala prohibita; that is, they are not inherently evil but are prohibited by society.

Mens rea (criminal intent, evil intent)—The possession of the requisite state of mind to commit a prohibited act.

Miranda rights—Rights that a suspect must be informed of before being interrogated, so that the suspect will not unwittingly give up his or her Fifth Amendment right.

Misdemeanor—A crime that is less serious than a felony; not inherently evil but prohibited by society. Many crimes against property are misdemeanors.

Money laundering—In order to “wash” the money and make it look as though it was earned legitimately, many criminals purchase legitimate businesses and run the money through those businesses to “clean” it before they receive the money.

Money Laundering Control Act—A federal statute that makes it a crime to (1) knowingly engage in a money transaction through a financial institution involving property from an unlawful activity worth more than $10,000, and (2) knowingly engage in a financial transaction involving the proceeds of an unlawful activity.

Murder—The unlawful killing of a human being by another with malice aforethought—the element of mens rea (guilty mind).

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Nolo contendere—A party may enter a plea of nolo contendere whereby the accused agrees to the imposition of a penalty but does not admit guilt.

Nonintent crime—A crime that imposes criminal liability without a finding of mens rea (intent).

Not guilty—An accused may plead guilty or not guilty.

Parent-child privilege—A parent cannot be compelled to be a witness against a child, and vice-versa. This privilege is designed to keep the family together.

Penal code—A collection of criminal statutes.

Plaintiff—In a criminal lawsuit, the government (not a private party) is the plaintiff.

Plea—If an indictment or information is issued, the accused is brought before a court for an arraignment proceeding, during which the accused is (1) informed of the charges against him, and (2) asked to enter a plea.

Plea bargain—Negotiations between an accused and the government with the intent of reaching an agreement between the parties to avoid a trial.

Plea bargaining agreement—An agreement in which the accused admits to a lesser crime than charged. In return, the government agrees to impose a lesser sentence than might have been obtained had the case gone to trial.

Presumed innocent until proven guilty—A person charged with a crime in the United States is presumed innocent until proven guilty.

Priest/rabbi/minister/imam-penitent privilege—The accused may tell the truth in order to repent, be given help, and seek forgiveness for his deed.

Privilege against self-incrimination—The Fifth Amendment provision that a person may not be required to be a witness against himself or herself in a criminal case. This is called the privilege against self-incrimination.

Probable cause—Evidence of the substantial likelihood that a person either committed or is about to commit a crime.

Prosecutor (prosecuting attorney)—In a criminal lawsuit, the government is represented by a lawyer called the prosecutor or prosecuting attorney.

Psychiatrist/psychologist-patient privilege—The accused may tell the truth in order to seek help for his condition.

Public defender—In a criminal lawsuit, if the accused cannot afford a private defense lawyer, the government will provide one free of charge. This government defense attorney is often called a public defender.

Racketeer Influenced and Corrupt Organizations Act (RICO)—A federal act that provides for both criminal and civil penalties for racketeering.

Reasonable search and seizure—Reasonable search and seizure by the government is lawful.

Receiving stolen property—A crime that involves (1) knowingly receiving stolen property, and (2) intending to deprive the rightful owner of that property.

Regulatory crime—Violations of regulatory statutes that include securities, antitrust, environmental, consumer, employment, credit, bankruptcy, intellectual property, and other statutes.

Regulatory statutes—Statutes such as environmental laws, securities laws, and antitrust laws that provide for criminal violations and penalties.

Right to a public jury trial—The Sixth Amendment to the U.S. Constitution guarantees that a criminal defendant has the right to a public jury trial.

Robbery—The taking of personal property from another person by the use of fear or force.

Search warrant—A warrant issued by a court that authorizes the police to search a designated place for specified contraband, articles, items, or documents. A search warrant must be based on probable cause.

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Second-degree murder—The intentional, unlawful killing of a human being by another person that is not premeditated or planned in advance.

Self-incrimination—The Fifth Amendment to the U.S. Constitution states that no person shall be compelled in any criminal case to be a witness against him or herself.

Sixth Amendment—The Sixth Amendment to the U.S. Constitution guarantees that a criminal defendant has the right to a public jury trial.

Specific intent crime—A crime that requires that the perpetrator intended to achieve a specific result from his or her illegal act.

Speedy Trial Act—A federal statute that requires that a criminal defendant in a federal case be brought to trial within 70 days after indictment.

Spouse-spouse privilege—One spouse cannot be compelled to be a witness against another spouse. This privilege is designed to keep the family together.

Strict liability crime—A crime that imposes criminal liability for the commission of a prohibited act without requiring proof of intent, recklessness, or grossly negligent conduct.

Theft—If a person pick-pockets somebody’s wallet, it is not robbery because there has been no use of force or fear. This is a theft.

Unanimous decision—If the jury cannot come to a unanimous decision about the defendant’s guilt, the jury is considered a hung jury.

Unreasonable search and seizure—Protection granted by the Fourth Amendment for people to be free from unreasonable search and seizure by the government.

Violation—A crime that is neither a felony nor a misdemeanor that is usually punishable by a fine.

Voluntary manslaughter—The intentional, unlawful killing of a human being by another person that is not premeditated or planned in advance and that is committed under circumstances that would cause a person to become emotionally upset.

Warrantless arrest—An arrest that is made without obtaining an arrest warrant. The arrest must be based on probable cause and a showing that it was not feasible to obtain an arrest warrant.

Warrantless search—Warrantless searches are permitted only (1) incident to arrest, (2) where evidence is in “plain view,” or (3) where it is likely that evidence will be destroyed.

White-collar crime—A type of crime that is prone to being committed by businesspersons.

Wire fraud—The use of telephone or telegraph to defraud another person.

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Chapter 8 Intellectual Property and Information Technology

How does the Internet affect the law?

I. Teacher to Teacher Dialogue This chapter is of particular interest to business majors because so many of their areas of study revolve around how to gain a competitive advantage while trying to stay within the bounds of law and professional ethics. In the area of business torts, what is the difference between aggressive comparative advertising and the unfair trade practice of disparagement? Or in the area of intellectual property, how far can you take the fair use doctrine before you have crossed the line of copyright infringement?

With regard to protection provided for intellectual property, it might be helpful to use examples to illustrate the various rules of patents, copyrights, and trademarks. It might also be worthwhile to review the underlying public policies behind giving these protections in the first place. You can talk about the notion of these rights acting as a form of public/private partnership designed to award innovation, creativity, and uniqueness. Possibly talk about how these protections are, in effect, limited period monopolies that would otherwise go against the grain of our free competition laws. The entire scheme, of course, is to provide financial incentives by creating a legally protected property right.

In addition, try to show students how the protection of intellectual property rights must be integrated into the entire business cycle of new and emerging companies whose growth is tied to new technologies. The Internet is changing the way intellectual property laws are interpreted. In many ways, this is one of the most important legal horizons for business today, and that is why students find it so interesting. The best way for students to approach these areas is to recognize that each of these protections carries a benefit/burden dichotomy. The benefits of the statutory protection are accorded to those who know how to use the statute on a continuing basis.

II. Chapter Objectives 1. Define intellectual property and list the types of intellectual property.

2. Define trade secret and describe the misappropriation of a trade secret.

3. Describe how an invention can be patented and the penalties for patent infringement.

4. Describe the items that can be copyrighted and describe the penalties for copyright infringement.

5. Define trademark and service mark and describe the penalties for trademark infringement.

6. Define dilution and describe the forms of dilution of a trademark.

III. Key Question Checklist  Is the area of endeavor qualified for some particular form of legal protection; e.g., copyright, patent, trademark, etc.?  Which specific steps apply to protect the work?  What are the penalties for engaging in cyber infringement?

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IV. Chapter Outline Introduction to Intellectual Property and Cyberpiracy – The U.S. economy is based on the freedom of ownership of property. In additional to real estate and personal property, intellectual property rights have value to both individuals and businesses. Federal law provides protections to intellectual property rights.

Intellectual Property Intellectual property rights include:  Trade secrets  Patents  Copyrights  Trademarks Trade Secret  A product formula, pattern, design, compilation of data, customer list, or other business secret  Many states have adopted the Uniform Trade Secrets Act to give statutory protection to trade secrets  State unfair competition laws allow the owner of a trade secret to bring a lawsuit for misappropriation against anyone who steals a trade secret  To be actionable, the defendant must have obtained the trade secret through unlawful means  Plaintiffs can sue to recover profits or damages or to get an injunction  The owner of a trade secret is obliged to take all reasonable precautions to prevent those secrets from being discovered by others  If the owner fails to take precautions, the secret is no longer subject to protection under state unfair competition laws Reverse Engineering – A competitor can lawfully discover a trade secret by reverse engineering (i.e., taking apart and examining a rival’s product or re-creating a secret recipe). A competitor or other party who has reverse engineered a trade secret can use the trade secret but not the trademarked name used by the original creator of the trade secret.

Misappropriation of a Trade Secret – The owner of a trade secret can bring a civil lawsuit under state law against anyone who has misappropriated a trade secret through unlawful means, such as theft, bribery, or industrial espionage. Generally, a successful plaintiff in a misappropriation of a trade secret action can (1) recover the profits made by the offender from the use of the trade secret, (2) recover for damages, and (3) obtain an injunction prohibiting the offender from divulging or using the trade secret.

Information Technology: Defend Trade Secrets Act Enacted in 2016, the Defend Trade Secrets Act (DTSA) is a federal statute that allows an owner of a trade secret to bring a civil lawsuit in federal court against a defendant for the misappropriation of a trade secret.

Economic Espionage Act – Makes it a federal crime for any person to convert a trade secret to his or her benefit or for the benefit of others, knowing or intending that the act would cause injury to the owner of the trade secret.

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Ethics: Coca-Cola Employee Tries to Sell Trade Secrets to Pepsi-Cola This section discusses a Coca-Cola employee’s attempt to steal trade secrets of the company and sell them to PepsiCo. PepsiCo notified Coca-Cola officials and federal authorities, and the defendant was convicted by a federal jury.

Patent A patent is a grant by the federal government to the inventor of an invention for the exclusive right to use, sell, or license the invention for a limited amount of time. The Federal Patent Statute, enacted in 1952, establishes the requirements for obtaining a patent and protects patented inventions from infringement.

U.S. Court of Appeals for the Federal Circuit The U.S. Court of Appeals for the Federal Circuit is a special federal appeals court that hears appeals from the Patent Trial and Appeal Board of the U.S. Patent and Trademark Office (PTO) and U.S. district courts concerning patent issues.

Patent Application To obtain a patent, a patent application must be filed with the U.S. Patent and Trademark Office (PTO) in Washington, DC. The PTO provides for the online submission of patent applications and supporting documents through its EFS-Web system.

Patent Number If a patent is granted, the invention is assigned a patent number. If a patent application is filed but a patent has not yet been issued, the applicant usually places the words “patent pending” on the article.

Subject Matter That Can Be Patented Federal patent law recognizes categories of innovation that can be patented, including:  Machines (for example, a mechanical device with moving parts and/or circuitry)  Processes (for example, a new way to manufacture glue)  Articles of manufacture (for example, a new tool)  Compositions of matter (for example, a chemical pharmaceutical)  Improvements to existing machines, processes, or compositions of matter  Asexually reproduced plants (for example, a newly developed plant breed)  Living material invented by a person (for example, a genetically modified organism) Requirements for Obtaining a Patent To be patented, an invention must be (1) novel, (2) useful, and (3) nonobvious. An invention is novel if it is new and has not been invented and used in the past. An invention is useful if it has some practical purpose. If an invention is nonobvious, it qualifies for a patent; if it is obvious, then it does not qualify for a patent.

U.S. Supreme Court Case Case 8.1 Patent: Association for Molecular Pathology v. Myriad Genetics, Inc. Facts: Through extensive research, Myriad Genetics, Inc. (Myriad) discovered the precise location and sequence of two naturally-occurring segments of DNA. Mutations in these genes can dramatically increase a female’s risk of developing breast and ovarian cancer. For women who are tested and found to have the dangerous mutations of these DNA segments, medical treatment can reduce the risks of cancer developing. Myriad obtained a patent for its discovery from the U.S. Patent and Trademark Office. The Association for Molecular Pathology sued Myriad, seeking a declaration that Myriad’s patent was invalid. The U.S. district court held that Myriad’s 72 .

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claim was invalid because it covered a product of nature and was therefore unpatentable. The Federal Circuit of Appeals held that the isolated DNA was patent eligible. The U.S. Supreme Court granted review.

Issue: Is a naturally occurring segment of DNA patent eligible?

Decision: The U.S. Supreme Court held that a naturally occurring DNA segment is a product of nature and not patent eligible merely because it has been isolated. The U.S. Supreme Court reversed the decision of the Federal Circuit Court of Appeals.

Reason: Myriad did not create anything.

Ethics Questions: The U.S. Supreme Court’s decision might affect the amount of research that is conducted to find naturally occurring, disease-causing DNA sequences. In light of the decision, companies might not view the potential reward as being worth the risk of investment. Although it is debatable whether the government should compensate Myriad for its research costs associated with its discovery of the two DNA sequences, this case bolsters the argument for governmentfunded scientific research—more for the purpose of the “common good” than for profit.

Patent Period In 2011, Congress passed the Leahy-Smith America Invents Act (AIA). The act stipulates a “firstto-file” rule for determining the priority of a patent. This means that the first party to file a patent on an invention receives the patent even though some other party was the first to invent the invention.

Utility patents (i.e., patents that protect the functionality of items) are valid for 20 years. The patent terms begins to run from the date the patent application is filed. After the patent period runs out, the invention or design enters the public domain, meaning that anyone can produce and sell the invention without paying the prior patent holder.

Patent Infringement Patent infringement occurs when someone makes unauthorized use of another’s patent. In a suit for patent infringement, a successful plaintiff can recover: (1) Money damages equal to a reasonable royalty rate on the sale of the infringed articles: (2) Other damages caused by the infringement (for example, loss of customers); (3) An order requiring the destruction of the infringing article; and (4) An injunction preventing the infringer from such action in the future.

Design Patent A design patent is a patent that may be obtained for the ornamental nonfunctional design of an item. A design patent is valid for 14 years.

Copyright A copyright is a legal right that gives the author of qualifying subject matter, who meets other requirements established by copyright law, the exclusive right to publish, produce, sell, license, and distribute the work. The Copyright Revision Act of 1976 currently governs copyright law.

The act establishes the requirements for obtaining a copyright and protects copyrighted works from infringement.

Tangible Writing Only tangible writings—writings that can by physically seen—are subject to copyright registration and protection.

Registration of Copyrights To be protected under federal copyright law, a work must be the original work of the author. A copyright is automatically granted the moment a work is created and fixed in tangible form. The 73 .

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Berne Convention (an international treaty to which the United States is a signatory) eliminated the need for the symbol or word “copyright” in order for a work to be copyright-protected.

Copyright Period The Copyright Term Extension Act of 1998 extended copyright protection to the following: (1) Individuals are granted copyright protection for their lifetime plus 70 years.

(2) Copyrights owned by businesses are protected for the shorter of either: (a) 120 years from the year of creation (b) 95 years from the year of first publication Civil Copyright Law: Copyright Infringement Copyright infringement occurs when a party copies a substantial and material part of the plaintiff’s copyrighted work without permission. A plaintiff can bring a civil action against the alleged infringer and potentially recover: (1) The profit made by the defendant from the copyright infringement; (2) Damages suffered by the plaintiff; (3) An order requiring the impoundment and destruction of the infringing works; and (4) An injunction preventing the defendant from infringing in the future.

Federal Court Case Case 8.2 Copyright Infringement: Broadcast Music, Inc. v. McDade & Sons, Inc. Facts: Norton’s Country Corner (Norton’s) is a cowboy bar located in Queen Creek, Arizona.

The bar is owned by McDade & Sons, Inc., which is owned 100% by Nancy McDade. Certain copyright owners of music have authorized Broadway Music, Inc. (BMI) to license the use of their copyright songs, and BMI attends public performances of music to determine whether any copyrights it is authorized to license are being performed without a license. One night a BMI representative attended a live band performance at Norton’s and discovered that 13 copyrighted songs that BMI was authorized to license were played without a license. BMI sued McDade and Sons, Inc. and Nancy McDade in U.S. district court for trademark infringement. The defendants argued they had not committed trademark infringement and that trademark law did not apply to owners of small establishments.

Issue: Are the defendants liable for trademark infringement?

Decision: The U.S. district court held that the defendants had engaged in copyright infringement and awarded $39,000 in damages, attorney’s fees and costs to the plaintiffs, and issued a permanent injunction against the defendants’ infringement of copyrighted musical compositions licensed by Broadcast Music, Inc. Reason: The defendants were not licensed by BMI to perform the plaintiffs’ copyrighted musical compositions.

Ethics Questions: Copyright is a property right, and the copyright owner has the right to control its use and dissemination. Given the fact that it is a property right, it is difficult to argue that small-business owners of bars and other establishments should be free from copyright laws. As a loose analogy, that would be somewhat like arguing it would be okay for someone to steal your watch, as long as the perpetrator was a “small-time” criminal! It is likely that many restaurants, bars, and other establishments play copyright music without the copyright owner’s permission, so even though an individual violator’s act of misusing copyrighted material would arguably be de minimus, the collective misappropriation of copyrighted material could be quite monumental.

Fair Use Doctrine The fair use doctrine permits certain limited use of a copyright by someone other than the copyright holder without the permission of the copyright holder. The following uses are protected under this doctrine: 74 .

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(1) Quotation of the copyrighted work for review or criticism or in a scholarly or technical work; (2) Use in a parody or satire; (3) Brief quotation in a news report; (4) Reproduction by a teacher or student of a small part of the work to illustrate a lesson; (5) Incidental reproduction of a work in a newsreel or broadcast of an event being reported; and (6) Reproduction of a work in a legislative or judicial proceeding Contemporary Environment: Fair Use Doctrine Dodger Productions, Inc. produced a stage musical called Jersey Boys. The musical is a historical dramatization about the American rock ‘n’ roll singing group called the Four Seasons and contains hit songs of the group. The Ed Sullivan Show was a weekly television show that highlighted many singing groups. One night the Four Seasons appeared and sang on The Ed Sullivan Show. At the end of the first act of Jersey Boys, a 7-second clip is shown on a screen hanging over the middle of the stage of the Four Seasons television appearance on The Ed Sullivan Show.

SOFA Entertainment, Inc. (SOFA) owns copyrights to the Ed Sullivan Show, including the appearance of the Four Seasons. SOFA sued Dodger Productions for copyright infringement.

Dodger Productions asserted the defense of fair use. The U.S. court of appeals held that Dodger Productions’ use of the 7-second clip from The Ed Sullivan Show in the Jersey Boys musical was fair use of a copyrighted work and was not copyright infringement. The court stated, “The clip is 7 seconds long and only appears once in the play. Dodger’s use of the clip did not harm SOFA’s copyright in The Ed Sullivan Show. This case is a good example of why the ‘fair use’ doctrine exists.” SOFA Entertainment, Inc. v. Dodger Productions, Inc., 709 f.3d 1273, 2013 U.S. App. Lexis 4830 (United States Court of Appeals for the Ninth Circuit, 2013) Criminal Copyright Law: No Electronic Theft Act In 1997, Congress enacted the No Electronic Theft Act (NET Act), a federal statute that makes it a crime for a person to infringe willfully on a copyright.

Information Technology: Digital Millennium Copyright Act The Digital Millennium Copyright Act is a federal law that: (1) Prohibits unauthorized access to copyrighted digital works by circumventing the wrapper or encryption technology that protects the intellectual property; and (2) Prohibits the manufacture and distribution of technologies, products, or services primarily designed for the purpose of circumventing wrappers or encryption technology protecting digital works.

Trademark A mark is any trade name, symbol, word, logo, design, or device used to identify and distinguish goods of a manufacturer or seller or services of a provider from those of other manufacturers, seller, or providers. Trademarks reference the goods of a manufacturer or seller, while service marks reference the services of a provider.

In 1946, Congress enacted the Lanham (Trademark) Act to provide federal protection to trademarks, service marks, and other marks. This act (1) protects the owner’s investment and goodwill in a mark, and (2) prevents consumers from being confused about the origin of goods and services.

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 It can be renewed for an unlimited number of 10-year periods  The registrant is entitled to use the registered trademark symbol ® in connection with a registered trademark or service mark  An applicant can register a mark if it has been used in commerce  An applicant can register a mark six months prior to its proposed use in commerce  If the mark is not used within this period, the applicant loses the mark Types of Marks – The word mark collectively refers to trademarks, service marks, certification marks, and collective membership marks.

Trademark – A distinctive mark, symbol, name, word, motto, or device that identifies the goods of a particular business.  e.g., IBM, Coca-Cola Service Mark – Used to distinguish the services of the holder from those of its competitors.  e.g., United Airlines, Weight Watchers, Marriott Hotels Certification Mark – Used to certify that goods and services are of a certain quality or originate from particular geographical areas.  e.g., “Florida” oranges, “Napa Valley” wines Collective Membership Mark – Used by cooperatives, associations, and fraternal organizations.  e.g., Boy Scouts of America Certain marks cannot be registered. They include: (1) The flag or coat of arms of the United States, any state, municipality, or foreign nation; (2) Marks that are immoral or scandalous; (3) Geographical names standing alone; (4) Surnames standing alone; (5) Any mark that resembles a mark already registered with the federal PTO. Distinctiveness or Secondary Meaning To qualify for federal protection, a mark must: (1) Be distinctive – i.e., a brand name that is unique and fabricated (for example, Google); or (2) Have acquired a “secondary meaning” – i.e., when an ordinary term has become a brand name (for example, Nike’s “Just Do It” slogan) Trademark Infringement The owner of a mark can sue a third party for the unauthorized use of a mark. The owner must prove that: (1) The defendant infringed the plaintiff’s mark by using it in an unauthorized manner; and (2) Such use is likely to cause confusion, mistake, or deception of the public as to the origin of the goods or services.

A successful plaintiff in a trademark infringement case can recover: (1) The profits made by the infringer through the unauthorized use of the mark; (2) Damages caused to the plaintiff’s business and reputation; (3) An order requiring the defendant to destroy all goods containing the unauthorized mark; and (4) An injunction preventing the defendant from such infringement in the future.

Abandonment of a Mark For a holder to keep a trademark or service mark, the mark must be used in commerce. If a holder of a mark fails to use or continue to use a mark in commerce, the holder runs the risk of being found to have abandoned the mark. Nonuse in commerce for three consecutive years is evidence of abandonment of a mark.

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Information Technology: Google Inc. Abandoned “Android” Trademark Erich Specht founded Android Data Corporation (ADA) in 1998, from which he developed software and offered website hosting and design services. Specht registered the trademark “Android Data” with the U.S. Patent and Trademark Office in 2002. Despite the trademark’s approval, by the end of 2002, ADA stopped operations. Specht shut off its phone line and let the registration for the company’s URL (androiddata.com) lapse.

During the years that Specht struggled with this shrinking business, another technology start-up, Android Incorporated, developed the Android operating system for mobile phones. In 2005, Google purchased Android Incorporated and two years later released its new Android operating system for smartphones. In 2007, Google tried to register “Android” as a trademark, but the Patent and Trademark Office denied the application, citing the likelihood of confusion with Specht’s Android Date mark. Specht sued Google for trademark infringement. Google counterclaimed, alleging that Specht had abandoned the mark after 2002, forfeiting his ability to assert any rights to it. The U.S. district court held that Specht abandoned the mark in 2002, canceled Specht’s registration of the mark, and granted summary judgment to Google.

The U.S. court of appeals affirmed the decision that Specht had abandoned the Android Data trademark, permitting Google to obtain the Android trademark. The court stated, “A trademark is abandoned if its use in commerce has been discontinued with no intent to resume use. Once a mark is abandoned, it returns to the public domain, and may be appropriated anew. By adopting the mark first, Google became the senior user, entitled to assert rights to the Android mark against the world.” Specht v. Google, Inc., 747 F.3d 929, 2014 U.S. App. Lexis 6318 (United States Court of Appeals for the Seventh Circuit, 2014) Generic Names If a word, name, or slogan is too generic it cannot be registered as a trademark. If a word is not generic, it can be trademarked. A trademark that becomes a common term for a product line or type of service is called a generic name. Once a trademark becomes a generic name, the term loses its protection under federal trademark law.

Information Technology: “Google” Trademark is Not a Generic Name Chris Gillespie registered 763 domain names that included the word “Google.” Each of these domain names paired the word “google” with some other term identifying a specific brand, product, or person—for example, “googledisney.com” and “googlebarackobama.com.” Google, Inc. objected to these registrations and filed a complaint with the National Arbitration Forum (NAF), which has authority to decide domain name disputes. Google claimed that the domain names were confusingly similar to its GOOGLE trademark. The NAF agreed and transferred the domain names to Google.

Gillespie sued in U.S district court seeking cancellation of the GOOGLE trademark, alleging that the GOOGLE trademark had become generic. Gillespie alleged that the word “google” is primarily understood as a generic term universally used to describe the act of internet searching using all search engines.

The U.S. district court held that the trademark GOOGLE was not generic and granted summary judgment to Google. The U.S. court of appeals agreed. The court of appeals stated, “Over time the holder of a valid trademark may become a victim of genericide when the public appropriates a trademark and uses it as a generic name for particular types of goods or services irrespective of its source.” However, the court held that the trademark word GOOGLE had not reached this stage.

The court of appeals affirmed the grant of summary judgment to Google. Elliot v. Google, Inc., 860 F.3d 1151 (United States Court of Appeals for the Ninth Circuit, 2017).

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Dilution The Federal Trademark Dilution Act (FTDA) of 1995 protects famous marks from dilution. The act provides that owners of marks have a valuable property right in their marks that should not be diluted, blurred, tarnished, or eroded in any way by another. Dilution is broadly defined as the lessening of the capacity of a famous mark to identify and distinguish its holder’s goods and services, regardless of the presence or absence of competition between the owner of the mark and the other party. The two most common forms of dilution are: (1) Blurring—Occurs where a party uses another party’s famous mark to designate a product or service in another market so that the unique significance of the famous mark is weakened; and (2) Tarnishment—Occurs where a famous mark is linked to products of inferior quality or is portrayed in an unflattering, immoral, or reprehensible context likely to evoke negative beliefs about the mark’s owner.

Congress revised the FTDA when it enacted the Trademark Dilution Revision Act of 2006. The act provides that a dilution plaintiff does not need to show that it has suffered actual harm to prevail in its dilution lawsuit but instead only needs to show that there would be the likelihood of dilution.

The FTDA, as amended, has three fundamental requirements that the holder of the senior mark must prove: 1. The mark must be famous; 2. The use by the other party must be commercial; and 3. The use by the other party causes a likelihood of dilution of the distinctive quality of the mark.

Federal Court Case Case 8.3 Dilution of a Trademark: V Secret Catalogue, Inc. and Victoria’s Secret Stores, Inc. v.

Moseley Facts: Victoria’s Secret sued the Moseleys, alleging a violation of the Federal Trademark Dilution Act of 1995 since the Moseleys operated under business names “Victor’s Secret” and “Victor’s Little Secret.” The case eventually was decided by the U.S. Supreme Court in favor of the Moseleys, when the Court found that there was no showing of actual dilution by the junior marks, as required by the statute. Congress overturned the Supreme Court’s decision by enacting the Trademark Dilution Revision Act of 2006, which requires the easier showing of a likelihood of dilution by the senior mark. On remand, the U.S. District Court applied the new likelihood of confusion test, found a presumption of tarnishment of the Victoria’s Secret mark that the Moseleys failed to rebut, and held against the Moseleys. The Moseleys appealed to the U.S. Court of Appeals.

Issue: Is there tarnishment of the Victoria’s Secret senior mark by the Moseleys’ use of the junior marks Victor’s Secret and Victor’s Little Secret?

Decision: The U.S. Court of Appeals affirmed the U.S. District Court’s judgment in favor of Victoria’s Secret.

Reason: The Moseleys had two opportunities in the District Court to offer evidence that there was no real probability of tarnishment, but they failed to do so.

Ethics Questions: It is highly probable that the Moseleys were trading off the famous Victoria’s Secret name—the names “Victor’s Secret” and “Victor’s Little Secret” are too similar to “Victoria’s Secret” to conclude otherwise. The fact that the husband’s name is “Victor” should be irrelevant to the determination of whether there was mark infringement in this case. It is the combination of the names “Victor’s Secret” and “Victor’s Little Secret” with the sale of lingerie, among other things, that creates mark tarnishment.

Global Law: International Protection of Intellectual Property This section covers many international treaties that protect intellectual property rights, including the Berne Convention and the WIPO Copyright treaty (copyrights), the Paris Convention and the 78 .

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Patent Cooperation Treaty (patents), and the Paris Convention, the Madrid Agreement and Protocol and the Nice Agreement (trademarks). The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) protects patents, copyrights, trademarks, and other intellectual property rights internationally.

V. Key Terms and Concepts  ©—It is advisable to place the copyright notice © and the year of publication and the author’s name on many copyrighted works because it notifies the world that the work is protected by a copyright, identifies the owner of the copyright, and shows the year of its publication.  ®—A symbol that is used to designate marks that have been registered with the U.S. Patent and Trademark Office.  Abandonment of a mark—If a holder of a mark fails to use or continue to use a mark in commerce, the holder runs the risk of being found to have abandoned the mark. Nonuse in commerce for three consecutive years is evidence of abandonment of a mark.  Berne Convention—In 1989, the United States signed the Berne Convention, an international copyright treaty.  Blurring—Blurring occurs when a party uses another party’s famous mark to designate a product or service in another market so that the unique significance of the famous mark is weakened.  Certification mark—A mark that certifies that a seller of a product or service has met certain geographical location requirements, quality standards, material standards, or mode of manufacturing standards established by the owner of the mark.  Collective membership mark—A mark that indicates that a person has met the standards set by an organization and is a member of that organization.  Copyright—A legal right that gives the author of qualifying subject matter, and who meets other requirements established by copyright law, the exclusive right to publish, produce, sell, license, and distribute the work.  Copyright infringement—An infringement that occurs when a party copies a substantial and material part of a plaintiff’s copyrighted work without permission. A copyright holder may recover damages and other remedies against the infringer.  Copyright registration certificate—Copyright registration creates a public record of the copyrighted work. A copyright registration certificate is issued to the copyright holder.  Copyright Revision Act—A federal statute that (1) establishes the requirements for obtaining a copyright, and (2) protects copyrighted works from infringement.  Copyright Term Extension Act—Extended copyright protection for individuals and businesses. Individuals are granted copyright protection for their lifetime plus 70 years.

Copyrights owned by businesses are protected for the shorter of either 120 years from the year of creation, or 95 years from the year of first publication.  Defend Trade Secrets Act (DTSA)—The Defend Trade Secrets Act (DTSA) is a federal statute enacted in 2016 that allows the owner of a trade secret to bring a civil lawsuit in federal court against a defendant for the misappropriation of a trade secret.  Design patent—A patent that may be obtained for the ornamental nonfunctional design of an item.  Digital Millennium Copyright Act (DMCA)—A federal statute that prohibits unauthorized access to copyrighted digital works by circumventing encryption technology or the manufacture and distribution of technologies designed for the purpose of circumventing encryption protection of digital works.  Dilution—Congress enacted the Federal Trademark Dilution Act (FTDA) of 1995 to protect famous marks from dilution.  Distinctive—Being unique and fabricated.

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         

Economic Espionage Act (EEA)—A federal statute that makes it a crime for any person to convert a trade secret for his or her own or another’s benefit, knowing or intending to cause injury to the owners of the trade secret.

Encryption technology—Software and entertainment companies have developed “wrappers” and encryption technology to protect their copyrighted works from unauthorized access.

Fair use doctrine—A doctrine that permits certain limited use of a copyright by someone other than the copyright holder without the permission of the copyright holder.

Federal Patent Statute—A federal statute that establishes the requirements for obtaining a patent and protects patented inventions from infringement.

Federal Trademark Dilution Act (FTDA)—A federal statute that protects famous marks from dilution, erosion, blurring, or tarnishing.

First-to-file rule—The first party to file a patent on an invention receives the patent even though some other party was the first to invent the invention.

First-to-invent rule—The United States still follows the first-to-invent rule; the first person to invent an item or a process is given patent protection over a later inventor who was first to file a patent application.

Generic name—A term for a mark that has become a common term for a product line or type of service and therefore has lost its trademark protection.

Intellectual property—Patents, copyrights, trademarks, and trade secrets. Federal and state laws protect intellectual property rights from misappropriation and infringement.

Lanham (Trademark) Act (Lanham Act)—A federal statute that (1) establishes the requirements for obtaining a federal mark, and (2) protects marks from infringement.

Leahy-Smith America Invents Act (AIA)—Stipulates a “first-to-file” rule for determining the priority of a patent.

Mark—Any trade name, symbol, word, logo, design, or device used to identify and distinguish goods of a manufacturer or seller or services of a provider from those of other manufacturers, sellers, or providers.

Misappropriation of a trade secret—A successful plaintiff in a misappropriation of a trade secret action can (1) recover the profits made by the offender from the use of the trade secret, (2) recover for damages, and (3) obtain an injunction prohibiting the offender from divulging or using the trade secret.

No Electronic Theft Act (NET Act)—A federal statute that makes it a crime for a person to willfully infringe on a copyright.

Nonobvious—If an invention is nonobvious, it qualifies for a patent.

Novel—An invention is novel if it is new and has not been invented and used in the past.

Patent—A grant by the federal government upon the inventor of an invention for the exclusive right to use, sell, or license the invention for a limited amount of time.

Patent application—To obtain a patent, a patent application must be filed with the PTO in Washington, DC. Patent infringement—Unauthorized use of another’s patent. A patent holder may recover damages and other remedies against a patent infringer.

Patent number—If a patent is granted, the invention is assigned a patent number.

Patent pending—If a patent application is filed but a patent has not yet been issued, the applicant usually places the words patent pending on the article.

Patent Trial and Appeal Board (PTAB)—A section within the U.S. Patent and Trademark Office (PTO) that reviews adverse decisions by patent examiners, reviews reexaminations, conducts post-grant reviews, and conducts other patent challenge proceedings.

Prior art—Third parties may file a pre-issuance challenge to a pending patent application asserting that the sought-after patent is not patentable because it appeared in prior art. This 80 .

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                   

could be a reference, description, or event in the past that demonstrates that the invention in question is not new.

Provisional application—An application that an inventor may file with the U.S. Patent and Trademark Office (PTO) to obtain three months to prepare a final patent application.

Public domain—After a patent period expires, the invention or design associated with the prior patent enters the public domain, meaning that anyone can produce and sell the invention without paying the prior patent holder.

Reverse engineering—A competitor can lawfully discover a trade secret by performing reverse engineering (i.e., taking apart and examining a rival’s product or re-creating a secret recipe).

Secondary meaning—A brand name that has evolved from an ordinary term.

Service mark—A mark that distinguishes the services of the holder from those of its competitors.

SM—A symbol that designates an owner’s legal claim to an unregistered mark that is associated with a service.

Tangible writings—Only tangible writings—writings that can be physically seen—are subject to copyright registration and protection.

Tarnishment—Tarnishment occurs where a famous mark is linked to products of inferior quality or is portrayed in an unflattering, immoral, or reprehensible context likely to evoke negative beliefs about the mark’s owner.

TM—A symbol that designates an owner’s legal claim to an unregistered mark that is associated with a product.

Trade secret—A product formula, pattern, design, compilation of data, customer list, or other business secret.

Trademark—A distinctive mark, symbol, name, word, motto, or device that identifies the goods of a particular business.

Trademark Dilution Revision Act—Congress revised the Federal Trademark Dilution Act (FTDA) when it enacted the Trademark Dilution Revision Act of 2006.

Trademark Electronic Application System (TEAS)—The U.S. Patent and Trademark Office (PTO) provides for the paper filing of the application or for the electronic filing of the application through its Trademark Electronic Application System.

Trademark infringement—Unauthorized use of another’s mark. The holder may recover damages and other remedies from the infringer.

Uniform Trade Secrets Act—Many states have adopted the Uniform Trade Secrets Act to give statutory protection to trade secrets.

U.S. Copyright Office—Published and unpublished works may be registered with the U.S. Copyright Office in Washington, DC. U.S. Court of Appeals for the Federal Circuit—A special federal appeals court that hears appeals from the Board of Patent Appeals and Interferences and federal court concerning patent issues.

U.S. Patent and Trademark Office—Applications for patents must be filed with the U.S. Patent and Trademark Office (PTO) in Washington, DC. Useful—An invention is useful if it has some practical purpose.

Utility patent—A patent that protects the functionality of an invention.

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Chapter 9 Formation and Requirements of Contracts When do we have a contract?

I. Teacher to Teacher Dialogue A good way to open the overview of contract law is by identifying two main teaching objectives from this chapter. The first objective is to introduce the notion of apparent versus hidden “parties” to a contract. By apparent, of course, we are talking about the actual participants or signatories to the contract. These are the persons or entities whose rights and obligations we are about to examine and ascertain. By “hidden” parties, stress the point that a contract is not, in the final analysis, all that private. What elevates a mere agreement between two or more private parties into a legally recognized contract is the willingness of the public, through its courts, to enter the fray and enforce the contract rights and duties. Thus, the first objective is to interject the notion of public policy participation and support of the contracting process.

The second objective is to introduce students to some of the working vocabulary of contract law. As is the case with all specialized forms of endeavors, contract law has a language all its own, and a basic knowledge of some of the key terms used in contracts is essential. The key contract terms used tend to be dichotomous, and you can use that dichotomy as a learning tool.

Take for example, the number of parties to a contract. At least two parties are required in all contracts. One of those two parties has to initiate the contract formation process. The person starting the mutual assent process with a promise is the offeror, and the other person is the offeree. Next, look at the dichotomy of the promises being used: is it a promise for a promise (bilateral) or is it a promise for an act (unilateral)? Have these promises been expressly made or can they somehow be implied from the circumstances? Does the form that this agreement is taking require certain formalities (such as a negotiable instrument), or can it be done in any manner chosen by the parties (informal) as long as the elements of the contract are met?

Once the parties have formed an agreement, are the performance obligations already fully met (executed), or are there still performance obligations remaining from one or more of the parties (executory)? In addition, you may have to examine issues of enforceability. If all the elements of contract formation are present, the agreement is considered a valid contract. If one or more of the essential elements is missing, the agreement is not really a contract and may be legally void. There are also certain situations where a contract is created but will not be enforced.

If a legal defense exists, such as failure to meet the statute of frauds writing requirement, the contract may be unenforceable. Sometimes, certain persons are given a legally recognized power to avoid an existing contract. Such a contract is voidable, and examples of this sort of situation can be found in cases involving young people with limited mental capacity.

II. Chapter Objectives 1. Define contract and list the elements necessary to form a valid contract.

2. Describe and distinguish among valid, void, voidable, and unenforceable contracts.

3. Define agreement and describe offer and acceptance.

4. Define consideration and describe the requirements of consideration.

5. Describe capacity to contract.

6. Describe lawful contracts and identify illegal contracts.

7. Define unconscionable contract and determine when such contracts are unenforceable.

8. Describe e-commerce and e-contracts.

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III. Key Question Checklist  What body of contract law will control the formation, rights, duties, and remedies of this agreement?  Are the four elements of a contract in place?  How is this contract defined? Formal or informal? Executed or executory?  Are there any defenses that make the contract unenforceable?

IV. Chapter Outline Introduction to Formation and Requirement of Contracts  Contracts are the basis of many daily activities  They provide the means for individuals and businesses to sell and otherwise transfer property, services, and other rights  Contracts are voluntarily entered into by parties  If one party fails to perform as promised, the other party can use the court system to enforce the contract  If done over the internet, we refer to this as e-commerce Definition of a Contract A contract is an agreement that is enforceable by a court of law or equity.

Parties to a Contract Every contract involves at least two parties:  Offeror – The party who makes an offer to enter into a contract  Offeree – The party to whom an offer to enter into a contract is made

Elements of a Contract For a contract to be enforceable, there must be: 1. An agreement between the parties (This requires an offer by the offeror and an acceptance of the offer by the offeree). There must be mutual assent by the parties.

2. Consideration – The promise must be supported by a bargained for consideration that is legally sufficient. Gift promises and moral obligations are not considered supported by valid consideration.

3. Contractual capacity – The parties to a contract must have contractual capacity. Certain parties, such as persons adjudged to be insane, do not have contractual capacity.

4. A lawful object – The object of the contract must be lawful. Contracts that have illegal objects or contracts that are against public policy are void.

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Defenses to the Enforcement of a Contract Two defenses may be raised to the enforcement of contracts: (1) Genuineness of assent—The consent of the parties to create a contract must be genuine. If the consent is obtained by duress, undue influence, or fraud, there is no real consent.

(2) Writing and form—The law requires that certain contracts be in writing or in a certain form.

Failure of such a contract to be in writing or to be in proper form may be raised against the enforcement of the contract.

Federal Court Case Case 9.1 Contract: Facebook, Inc. v. Winklevoss Facts: The Winklevosses alleged that Facebook and Mark Zuckerberg had misled them into believing that Facebook shares were worth $36 per share at the time of settlement, when in fact an internal Facebook document valued the stock at $8.88 per share for tax code purposes. The Winklevosses sought to rescind the settlement agreement. The U.S. District Court enforced the settlement agreement. The Winklevosses appealed.

Issue: Is the settlement agreement enforceable?

Decision: The U.S. Court of Appeals upheld the U.S. District Court’s enforcement of the settlement agreement.

Reason: At some point, litigation must come to an end. According to the court, that point had been reached.

Ethics Questions: Courts are inclined to enforce settlement agreements. After all, a settlement agreement is a contract. A case disposed by way of a settlement agreement is one less case the court will have to litigate. Even though fraud could be a bar to the enforceability of a contract, including a settlement agreement, the court noted that the Winklevosses were sophisticated parties well-represented by attorneys and therefore less likely to be the victims of the circumstances of fraud alleged in the case. The Winklevosses could have demanded an independent evaluation of the value of Facebook stock before they entered into the settlement agreement with Facebook. They entered the settlement agreement voluntarily and willingly.

Classifications of Contracts There are several types of contracts. Each differs somewhat in formation, enforcement, performance, and discharge.

Bilateral and Unilateral Contracts A bilateral contract is a contract entered into by way of exchange of promises of the parties. It is a promise for a promise. A unilateral contract is a contract in which the offeror’s offer can be accepted only by the performance of an act by the offeree. It is a promise for an act.

Formal and Informal Contracts Formal contracts require a special form or method of creation. Examples include negotiable instruments, letters of credit, and recognizances. Informal contracts, also known as simple contracts, do not qualify as formal contracts. No special form or method is required for their creation. Examples include leases, sales contracts, and service contracts.

Valid, Void, Voidable, and Unenforceable Contracts Valid Contract  Contract that meets all of the essential elements to establish a contract  Enforceable by at least one of the parties Void Contract  A contract that has no legal effect  Neither party is obligated to perform 84 .

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 Neither party can enforce the contract Voidable Contract  A contract in which one or both parties have the option to void their contractual obligations  If a contract is voided, both parties are released from their contractual obligations Unenforceable Contract  A contract where the essential elements to create a valid contract are not met  However, there is some legal defense to the enforcement of the contract Executory and Executed Contracts An executory contract has not been fully performed by one or both parties, while an executed contract is a completed contract that has been fully performed by both parties.

Express Contracts This is an agreement that is expressed in written or oral words. Most personal and business contracts are express contracts.

State Court Case Case 9.2 Express Contract: McKee v. Isle of Capri Casinos, Inc. Facts: Pauline McKee was attending a family reunion at the Isle Casino Hotel in Waterloo. One evening she and several members of her family gambled at the casino. McKee was playing a penny slot machine called “Miss Kitty.” A person wins at the Miss Kitty game by lining up different combinations of symbols from left to right on the slot machine screen. The game includes a button entitled “Touch Game Rules” in the lower left corner of the screen. Tapping this button displays the rules of the game and a chart describing potential winning combinations of symbols. The rules do not mention any additional bonus, jackpot, or prize available to a person playing the game. The rules state “MALFUNCTION VOIDS ALL PAYS AND PLAYS,” and a sign on the front of the machine reiterates this warning. McKee did not read the rules before she played the slot machine.

While playing the game, McKee won $1.85 based on how the symbols had lined up on the slot machine screen. However, at the same time a message appeared on the screen stating “Bonus Award $41797550.16.” The casino paid McKee $1.85 but refused to pay the alleged bonus, claiming it was an error and not part of the game. McKee sued the casino in district court to recover $41,797,550.16. The casino introduced evidence that the appearance of the bonus on the screen was an error in the game’s computer system. The casino moved for summary judgment.

The district court held that the rules of the Miss Kitty game were an express contract between McKee and the casino. The court granted summary judgment in the casino, and McKee appealed.

Issue: Was there a contract between the parties that provided for the payment of a bonus when playing the Miss Kitty slot machine?

Decision: The Supreme Court of Iowa affirmed the district court’s grant of summary judgment in favor of the casino.

Reasoning: Gambling contracts are governed by traditional contract principles. The Supreme Court of Iowa agreed with the district court that the Miss Kitty rules of the game are the relevant contract here, and they form an express contract. It is undisputed that the rules of the Miss Kitty game did not provide for any kind of bonus.

Ethics Questions: This case appears to involve a straightforward application of contract law, thus justifying the district court’s grant of summary judgment and the Iowa Supreme Court’s affirmation of the lower court ruling. The rules of the game formed an express contract between Ms. McKee and the casino, and the contract did not provide for any kind of bonus.

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Implied-in-Fact Contract  A contract where agreement between parties has been inferred from their conduct  The following elements must be established to create an implied-in-fact contract: (1) The plaintiff provided property or services to the defendant; (2) The plaintiff expected to be paid by the defendant for the property or services and did not provide the property or services gratuitously; and (3) The defendant was given an opportunity to reject the property or services provided by the plaintiff but failed to do so.

Contemporary Environment: Implied-in-Law Contract (Quasi Contract)  Allows a court to award monetary damages to a plaintiff for providing work or services to a defendant even though no actual contract existed between the parties  Intended to prevent unjust enrichment and unjust detriment Agreement An agreement is the manifestation by two or more persons of the substance of a contract. It requires an offer and an acceptance. The offeror is the person who makes an offer, while the offeree is the person to whom an offer has been made.

Requirements of an Offer According to Section 24 of the Restatement (Second) of Contracts, an offer is “(t)he manifestation of willingness to enter into a bargain, so made as to justify another person in understanding that his assent to that bargain is invited and will conclude it.”

For an offer to be effective: 1. The offeror must objectively intend to be bound by the offer; 2. The terms of the offer must be definite or reasonably certain; and 3. The offer must be communicated to the offeree.

Generally, an offer (and contract) must contain the following terms: 1. Identification of the parties; 2. Identification of the subject matter and quantity; 3. The consideration to be paid; and 4. The time of performance.

Objective Intent The intent to enter into a contract is determined using the objective theory of contracts.  The objective theory of contracts addresses whether a reasonable person viewing the circumstances would conclude that the parties intended to be legally bound  Offers that are made in jest, anger, or undue excitement do not include the necessary objective intent Federal Court Case Case 9.3 Objective Theory of Contract: Kolodziej v. Mason Facts: Attorney James Mason represented the criminal defendant Nelson Serrano, who stood accused of murdering his former business partner and the son and daughter and son-in-law of another business partner. During the defendant’s capital murder trial, Mason participated in an interview with NBC News in which he focused on the seeming implausibility of the prosecution’s theory of the case. Serrano claimed he had an alibi and therefore could not have committed the murders. Mason argued that it was impossible for his client to have committed the murders in accordance with the prosecution’s timeline. During the NBC News interview, Mason stated, “I challenge anybody to show me, and guess what? Did they bring in any evidence to say that somebody made that (travel) route, did so? If they can do it, I’ll challenge ‘em. I’ll pay them a 86 .

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million dollars if they can do it.” NBC televised Mason’s interview, including Mason’s milliondollar challenge.

Dustin Kolodziej, a law student, saw the interview and decided to take up Mason’s million-dollar challenge. He recorded himself retracing Serrano’s alleged travel route within the prosecution’s timeline, and sent defense attorney Mason a copy of the recording of his journey and demanded $1 million. Mason refused to pay, and Kolodziej sued Mason in U.S. district court for breach of contract to recover $1 million. The district court held that Mason’s offer was made in jest and therefore no contract existed between Mason and Lolodziej. Kolodziej appealed.

Issue: Was Mason’s million-dollar challenge made on television a legitimate legal offer?

Decision: The U.S. court of appeals affirmed the district court’s decision in favor of Mason.

Reasoning: The court used an objective test to determine whether the contract was enforceable.

Using this test, the court concluded that no reasonable person would have concluded that Mason’s statements constituted an invitation to contract. The exaggerated amount of “a million dollars” was mere hyperbole.

Ethics Questions: The court’s reasoning is arguably sound. The objective test of reasonableness does not focus on what the individual plaintiff thought, so even if Kolodziej sincerely believed that Mason’s million-dollar challenge represented an actual offer and an invitation to contract, no contract would be formed if a reasonable third-party would disagree with such a conclusion. As the court concluded, in applying the reasonable person standard, the exaggerated amount of “a million dollars” was mere hyperbole.

Auctions In an auction, the seller offers goods for sale through an auctioneer. There are two types of auctions: (1) Auction with reserve – Unless expressly stated otherwise, an auction is an auction with reserve. i.e., the seller retains the right to refuse the highest bid and withdraw the goods from auction; and (2) Auction without reserve – An auction in which the seller expressly gives up his or her own right to withdraw the goods from sale and must accept the highest bid.

Termination of an Offer by Acts of the Parties An offer may be terminated by certain acts of the parties. These include: (1) Revocation of the offer by the offeror  Withdrawal of an offer by the offeror terminates the offer  An offeror can revoke an offer at any time prior to its acceptance by the offeree  Effective upon direct or indirect receipt unless an option with consideration (2) Rejection of the offer by the offeree  Express words or conduct by the offeree that rejects an offer  Rejection terminates the offer  Effective upon receipt (3) Counteroffer by the offeree  A response by an offeree that contains terms and conditions different from or in addition to those of the offer  A counteroffer terminates an offer (4) Lapse of time  An offer expires at the lapse of time of an offer  An offer may state that it is effective only until a certain date  Unless otherwise stated, the time period begins to run when the offer is actually received by the offeree and terminates when the stated time period expires  If no time is stated in an offer, the offer terminates after a “reasonable time,” dictated by the circumstances 87 .

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Termination of an Offer by Operation of Law An offer is terminated by operation of law if, prior to the acceptance of the offer, one of the following occurs: (1) The subject matter of the offer is destroyed through no fault of either party; (2) Either the offeror or the offeree dies or becomes incompetent; or (3) The object of the offer is made illegal by law.

Business Environment: Option Contract An offeree can prevent the offeror from revoking his or her offer by paying the offeror compensation to keep the offer open for an agreed-upon period of time. This is called an option contract.

Acceptance An acceptance is the manifestation of assent by the offeree to the terms of the offer in a manner invited or required by the offer as measured by the objective theory of contracts.  Only the offeree can legally accept an offer and create a contract  A unilateral contract can be accepted only by the offeree’s performance of the required act  A bilateral contract can be accepted by an offeree who promises to perform (or, where permitted, by performance of) the requested act  The offeree’s acceptance must be unequivocal Mirror Image Rule A rule stating that for an acceptance to exist, the offeree must accept the terms as stated in the offer  To meet this rule, the offeree must accept the terms of the offer without modification  Any attempt to accept the offer on different terms constitutes a counteroffer, which rejects the offeror’s offer Acceptance-Upon-Dispatch Rule  A rule that states that an acceptance is effective when it is dispatched, even if it is lost in transmission  Also called the mailbox rule  If an offeree first dispatches a rejection and then sends an acceptance, the mailbox rule does not apply to the acceptance Consideration Consideration, a necessary element for the existence of a contract, is something of legal value that is given in exchange for a promise. Common types of consideration include:  A tangible payment (for example, money or property); or  The performance of an act (for example, providing legal services) Under the modern law of contracts, a contract is considered supported by legal value if: 1. The promisee suffers a legal detriment; or 2. The promisor receives a legal benefit A contract must arise from a “bargained-for exchange.” A bargained-for exchange is an exchange that parties engage in that leads to an enforceable contract.

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State Court Case Case 9.4 Consideration: Ferguson v. Carnes Facts: Thomas Ferguson and Theresa Carnes were brother and sister and the only living children of a wealthy mother. The mother frequently threatened to disinherit both siblings. Ferguson and Carnes entered an oral agreement to afford each other assurance against disinheritance. The oral agreement provided if one of them were disinherited, they would divide evenly between them whatever property either received from their mother’s estate. The mother died with a will that named Carnes as her sold beneficiary and disinherited Ferguson. When Carnes refused to divide her inheritance with Ferguson, he sued his sister for breach of contract. Carnes alleged that the oral promise was unenforceable because it lacked consideration. The circuit court held that there was no consideration and granted Carnes summary judgement. Ferguson appealed.

Issue: Was the oral promise supported by consideration?

Decision: The court of appeal held that the oral agreement did not lack consideration, reversed the decision of the circuit court, and remanded the case for further proceedings.

Reason: A promise, no matter how slight, can constitute sufficient consideration so long as a party agrees to do something that they are not bound to do.

Ethics Questions: The oral agreement between Ferguson and Carnes did not lack consideration.

Essentially, the terms of the oral agreement delineated mutual promises. The consideration lies in the fact that each gave up the possibility of inheriting more than the other in return for insuring that neither would be disinherited in whole or part. The reasoning of the District Court of Appeal of Florida in this case appears sound.

Gift Promise A gift or gratuitous promise is an unenforceable promise because it lacks consideration.

Contracts that Lack Consideration Types of Consideration Illegal consideration Illusory promise Preexisting duty

Past consideration

Description of Promise Promise to refrain from doing an illegal act.

Promise where one or both parties can choose not to perform their obligation.

Promise based on the preexisting duty of the promise to perform. The promise is enforceable if (1) the parties rescind the contract and enter into a new contract, or (2) there are unforeseen difficulties.

Promise based on the past performance of the promise.

Capacity to Contract The law presumes that the parties to a contract have the requisite contractual capacity to enter into the contract. The following persons do not have this capacity:  Minors  Mentally incompetent persons  Intoxicated persons The common law of contracts and many state statutes protect persons who lack contractual capacity from having contracts forced on them. The person asserting incapacity bears the burden of proof.

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Infancy Doctrine  Minors do not always have the maturity, experience, or sophistication needed to enter into contracts with adults.  Most states have enacted statutes that specify the age of majority.  The most prevalent age of majority is 18 years of age for both males and females.  Any age below the statutory age of majority is called the period of minority.  The infancy doctrine allows minors to disaffirm (or cancel) most contracts they have entered into with adults.  The infancy doctrine is based on public policy reasoning that minors should be protected from the unscrupulous behavior of adults.  Disaffirmance is the act of a minor to rescind a contract under the infancy doctrine.

Disaffirmance may be done orally, in writing, or by the minor’s conduct.  If the minor has transferred consideration to the competent party before disaffirming the contract, that party must place the minor in status quo.  A minor is obligated only to return the goods or property he or she has received from the adult in the condition it is in at the time of disaffirmance.  Most states provide that the minor must put the adult in status quo upon disaffirmance of the contract if the minor’s intentional or grossly negligent conduct caused the loss of value to the adult’s property.  Minors who misrepresent their age must place the adult in status quo if they disaffirm the contract. A minor who has misrepresented his or her age when entering into a contract owes the duties of restoration and restitution when disaffirming it.  Minors are obligated to pay for the necessaries of life they contract for. Examples of necessaries include food, shelter, clothing, and medical services.

Mentally Incompetent Persons  The law protects people suffering from substantial mental incapacity from enforcement of contracts against them .  To be relieved of his or her duties under a contract, the law requires a person to have been legally insane at the time of entering into the contract.  Legal insanity is a state of contractual incapacity as determined by law.

The law has developed two standards concerning contracts of mentally incompetent persons: (1) Adjudged insane  A person who has been adjudged insane by a proper court or administrative agency  A contract entered into by such a person is void  Neither party can enforce the contract (2) Insane, but not adjudged insane  A person who is insane but has not been adjudged insane by a court or administrative agency  A contract entered into by such a person is generally voidable  The competent party cannot void the contract Intoxicated Persons  A person who is under contractual incapacity because of the ingestion of alcohol or drugs to the point of incompetence  Most states provide that contracts entered into by such intoxicated persons are voidable by that person  The contract is not voidable by the other party if that party had contractual capacity

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Legality One requirement to have an enforceable contract is that the object of the contract must be lawful.

Lawful contracts include contracts for the sale of goods, services, real property, and intangible rights; the lease of goods; property leases; and licenses.

Illegal Contacts Contracts with an illegal object are void and therefore unenforceable.There are two key categories of illegality: (1) Contracts contrary to law – Federal and state legislatures have enacted statutes that prohibit certain types of conduct. Contracts to perform an activity that is prohibited by statute are illegal contracts. Examples include gambling contracts, contracts that provide for usurious rates of interest, and contracts that violate licensing statutes.

(2) Contracts contrary to public policy – These contracts that have a negative impact on society or that interfere with the public’s safety and welfare. Such contracts are void. Examples include immoral contracts, contracts in restraint of trade, and exculpatory clauses.

Exculpatory Clause An exculpatory clause, also called a release of liability clause, is a contractual provision that relieves one or both of the parties to a contract from tort liability.

State Court Case Case 9.5 Exculpatory Agreement: DeCormier v. Harley-Davidson Motor Company Group, Inc. Facts: Cynthia DeCormier participated in the Rider’s Edge New Riders Course, and instructional course for new motorcycle riders sponsored by Harley-Davidson Motor Company Group, Inc. and conducted by St. Louis Motorcycle, Inc. d/b/a/ Gateway Harley-Davidson (Gateway). Before participating in the course, DeCormier signed a “Release and Waiver” that discharged HarleyDavidson and Gateway from liability, including negligence, arising out of or in connection with her participation in the program. While performing an exercise of the course, DeCormier’s motorcycle slipped and landed on her leg, causing her serious injuries. DeCormier sued HarleyDavidson and Gateway to recover damages for her injuries, alleging that the course was slippery and wet and that the instructors should not have directed her to perform motorcycle exercises at the time of her accident. Harley-Davidson and Gateway filed a motion for summary judgment, alleging that the exculpatory clause signed by DeCormier before participating in the course released them from liability. The circuit court granted summary judgment in favor of HarleyDavidson and Gateway. DeCormier appealed the decision.

Issue: Is the exculpatory clause signed by plaintiff DeCormier enforceable?

Decision: The Supreme Court of Missouri affirmed the circuit court’s decision enforcing the exculpatory clause.

Reason: While exculpatory agreements will be strictly construed, the court will enforce exculpatory agreements to protect a party from liability for their own negligence. Therefore, Harley-Davidson and Gateway were entitled to judgment on their affirmative defense of release.

Ethics Questions: In terms of prospective negligence liability, this case illustrates the strategic advantage of requiring an exculpatory agreement before a prospective plaintiff enters into a potentially harmful activity that involves the defendant’s oversight.

Unconscionable Contracts  Some lawful contracts are so oppressive or manifestly unfair that they are unjust  To prevent the enforcement of such contracts, the courts have developed the equitable doctrine of unconscionability  A contract found to be unconscionable under this doctrine is called an unconscionable contract 91 .

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 The following elements must be shown to prove that a contract or clause is unconscionable: o The parties possessed severely unequal bargaining power; o The dominant party unreasonably used its unequal bargaining power; and o The adhering party had no reasonable alternative.  Judicial remedies for unconscionability include: o Refusing to enforce the contract; o Refusing to enforce the unconscionable clause but enforcing the remainder of the contract; or o Limiting the applicability of any unconscionable clause so as to avoid any unconscionable result.

Critical Legal Thinking: Interest Rates of Over 1,000% Per Year on Consumer Loans is Unconscionable B&B Investment Group, Inc. marketed high-cost signature loans of $50 to $300 from offices located in New Mexico. B&B target the working poor, most of whom were less educated and financially unsophisticated individuals who were usually under or near the poverty line. Most borrowers did not have a banking account, or if they did, it was to receive government assistance deposits. The loans were for one year on which B&B charged annual percentage interest rates ranging from 1,147 to 1,500 percent. B&B employees were instructed to describe loan coasts as $1.00 or $1.50 per day, which was itself usually only half of what the loan cost daily, and to never disclose the annual percentage rate (APR).

If borrowers failed to make required loan payments, B&B would have their wages garnished so that their employers were required to make the loan payments out of the borrower’s paycheck.

Based on the terms of the loans, borrowers were liable for B&B’s costs on collecting the debt, including attorney fees. Nonpayment of loans destroyed the credit ratings of borrowers who missed loan payments.

The Attorney General for the State of New Mexico sued B&B for unconscionable trade practices.

The Supreme Court of New Mexico held that the small-principal, high-interest-rate signature loans made by B&B were unconscionable. The court stated, “We conclude that the interest rates in this case are substantively unconscionable. We hold it is grossly unreasonable and against public policy to offer installment loans at 1,147 to 1,500 percent interest.”

The Supreme Court of New Mexico ordered B&B to refund all money collected on the loans that exceeded 15 percent of the loan principal, to refund any fees and penalties it collected from borrowers, and issued an injunction against B&B’s engaging in unfair practices in the future.

State of New Mexico v. B&B Investment Group, Inc., 329 P.3d 658, 2014 N.M. Lexis 230 (Supreme Court of New Mexico, 2014) E-Commerce The sale and lease of goods and services and other property and the licensing of software over the internet or by other electronic means. Much of the new cyberspace economy is based on electronic contracts (e-contracts) and electronic licenses (e-licenses).

Digital Law: Electronic Contracts and Licenses This section discusses the Uniform Computer Information Transactions Act (UCITA), a law that establishes uniform legal rules for the formation and enforcement of electronic contracts and licenses.

V. Key Terms and Concepts  Acceptance—An agreement requires an offer by the offeror and an acceptance of the offer by the offeree.

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                             

Acceptance-upon dispatch rule (dispatch rule or mailbox rule) —A rule which states that an acceptance is effective when it is dispatched, even if it is lost in transmission.

Actual contract—An actual contract may be either express or implied-in-fact.

Adjudged insane—Declared legally insane by a proper court or administrative agency.

Age of majority—The most prevalent age of majority is 18 years of age for both males and females.

Agreement—To have an enforceable contract, there must be an agreement between the parties.

Auction—In an auction, the seller offers goods for sale through an auctioneer.

Auction with reserve—An auction in which the seller retains the right to refuse the highest bid and withdraw the goods from sale.

Auction without reserve—An auction in which the seller expressly gives up his or her right to withdraw the goods from sale and must accept the highest bid.

Bargained-for exchange—An exchange that parties engage in that leads to an enforceable contract.

Bilateral contract—A contract entered into by way of exchange of promises of the parties; a “promise for a promise.”

Consideration—A promise must be supported by a bargained-for consideration that is legally sufficient.

Contract—A contract is an agreement that is enforceable by a court of law or equity.

Contract contrary to law—Contracts to perform activities that are prohibited by law.

Examples include gambling contracts, contracts that provide for usurious rates of interest, and contracts that violate licensing statutes.

Contract contrary to public policy—A contract that has a negative impact on society or that interferes with the public’s safety and welfare.

Contractual capacity—The parties to a contract must have contractual capacity for the contract to be enforceable against them.

Counteroffer—A response by an offeree that contains terms and conditions different from or in addition to those of the offer.

Disaffirm—The right that minors hold to cancel most contracts with adults.

Electronic commerce (e-commerce)—The sale and lease of goods and services and other property and the licensing of software over the internet or by other electronic means.

Electronic contract (e-contract)—A contract that is formed electronically.

Electronic license (e-license)—Electronic licensing is usually of computer and software information.

Exculpatory clause (release of liability clause)—A contractual provision that relieves one (or both) of the parties to a contract from tort liability for ordinary negligence.

Executed contract—A contract in which the essential elements to create a valid contract are met but there is some legal defense to the enforcement of the contract.

Executory contract—A contract that has not been fully performed by either or both sides.

Express contract—An agreement that is expressed in written or oral words.

Form—The law requires that certain contracts be in writing or in a certain form.

Formal contract—A contract that requires a special form or method of creation.

Genuineness of assent—The consent of the parties to create a contract must be genuine.

Gift promise (gratuitous promise)—A promise that is unenforceable because it lacks consideration.

Illegal consideration—A promise to refrain from doing an illegal act. Such a promise does not support a contract.

Illegal contract—A contract that has an illegal object.

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Illusory promise (illusory contract)—A contract into which both parties enter but one or both of the parties can choose not to perform their contractual obligations.

Implied-in-fact contract—A contract in which agreement between parties has been inferred from their conduct.

Implied-in-law contract (quasi-contract)—An equitable doctrine whereby a court may award monetary damages to a plaintiff for providing work or services to a defendant even though no actual contract existed. The doctrine is intended to prevent unjust enrichment and unjust detriment.

Infancy doctrine—A doctrine that allows minors to disaffirm (cancel) most contracts they have entered into with adults.

Informal contract (simple contract)—A contract that is not formal. Valid informal contracts are fully enforceable and may be sued upon if breached.

Insane but not adjudged insane—Being insane but not having been adjudged insane by a court or an administrative agency.

Intoxicated person—A person who is under contractual incapacity because of ingestion of alcohol or drugs to the point of incompetence.

Lapse of time—A stated time period after which an offer terminates.

Lawful contract—Contracts that are enforceable. Examples include contracts for the sale of goods, services, real property, and intangible rights.

Lawful object—The object of a contract must be lawful. Most contracts have a lawful object.

Legal value—Support for a contract when either (1) the promisee suffers a legal detriment, or (2) the promisor receives a legal benefit.

Legally enforceable contract—A contract in which if one party fails to perform as promised, the other party can use the court system to enforce the contract and recover damages or another remedy.

Letter of credit—A letter of credit is an agreement by the issuer of the letter to pay a sum of money upon the receipt of an invoice and other documents.

Minor—A person who has not reached the age of majority.

Mirror image rule—A rule which states that for an acceptance to exist, the offeree must accept the terms as stated in the offer.

Necessaries of life—Items such as food, clothing, shelter, and medical services. Minors are obligated to pay for the necessaries of life for which they contract.

Negotiable instrument—Negotiable instruments, which include checks, drafts, notes, and certificates of deposit, are special forms of contracts recognized by the Uniform Commercial Code (UCC).

Objective theory of contracts—A theory that says the intent to contract is judged by the reasonable person standard and not by the subjective intent of the parties.

Offer—An agreement requires an offer by the offeror and an acceptance of the offer by the offeree.

Offeree—The party to whom an offer to enter into a contract is made.

Offeror—The party who makes an offer to enter into a contract.

Option contract—A contract that is created when an offeree pays an offeror compensation to keep an offer open for an agreed-on period of time. An option contract prevents the offeror from revoking his or her offer during the option period.

Past consideration—A prior act or performance. Past consideration does not support a new contract.

Period of minority—Any age below the statutory age of majority.

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Preexisting duty—Something a person is already under an obligation to do. A promise lacks consideration if a person promises to perform a preexisting duty.

Recognizance—In a recognizance, a party acknowledges in court that he or she will pay a specified sum of money if a certain event occurs.

Rejection of an offer—Express words or conduct by the offeree to reject an offer.

Rejection terminates the offer.

Restatement (Second) of Contracts—The Restatement, which is currently in its second edition, is cited in this book as the Restatement (Second) of Contracts.

Revocation of an offer—Withdrawal of an offer by the offeror that terminates the offer.

Unconscionable contract—A contract that courts refuse to enforce in part or at all because it is so oppressive or manifestly unfair as to be unjust.

Unenforceable contract—A contract in which the essential elements to create a valid contract are met but there is some legal defense to the enforcement of the contract.

Unequivocal acceptance—An offeree’s acceptance must be certain. For an acceptance to exist, the offeree must unmistakably accept the terms as stated in the offer.

Unified Contract Law (UCL)—A statute of China that establishes contract law that provides for the formation of contracts and the enforcement of contracts and sets forth remedies for the breach of contracts.

Uniform Computer Information Transactions Act (UCITA)—A model act that establishes uniform legal rules for the formation and enforcement of electronic contracts and licenses.

Unilateral contract—A contract in which the offeror’s offer can be accepted only by the performance of an act by the offeree; a “promise for an act.”

Valid contract—A contract that meets all the essential elements to establish a contract; a contract that is enforceable by at least one of the parties.

Void contract—A contract that has no legal effect; a nullity.

Voidable contract—A contract in which one or both parties have the option to void their contractual obligations. If a contract is voided, both parties are released from their contractual obligations.

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Chapter 10 Performance and Breach of Contracts

How can you fix what went wrong?

I. Teacher to Teacher Dialogue Genuineness of Assent The first set of defenses to the enforcement of contracts in this chapter revolves around the issue of free will. Where free will is compromised, mutual assent is also compromised, and the agreement may not stand as a contract. What makes this area of law difficult is that courts and juries are asked to exercise 20/20 hindsight when looking back on what the parties were thinking as they were embarking on the road to contract formation. The subjectivity of measuring intent has always been a troublesome puzzle to unravel, but without it, the objective facts placed before a court may not show the reality of consent. Because of the potential harshness of a bad contract, courts want to be very sure that the assent element of contracts is just that—a free and real consent to the agreement.

At one end of the spectrum is an innocent mistake that can be either unilateral or bilateral. With a contract mistake, one or both of the parties is acting under an erroneous belief about the subject matter of the contract. Normally, if only one of the parties is mistaken (a unilateral mistake), there will be no grounds for recission unless that mistake is coupled with some sort of bad faith or abuse on the part of the nonmistaken party. When the mistake is mutual (a bilateral mistake), either party may seek recission if the mistake is considered material (so important that no real meeting of the minds ever occurred).

The next issue is found in the area of misrepresentation or concealment. A problem occurs when a person is actively seeking to misrepresent. Here we can see that freedom of assent is even further compromised than in mistake alone. Now the element of scienter (guilty mind) enters the picture, and the justification for rescission is greatly increased. If the misrepresentation is material, known to be so by the maker, made with the intent to deceive, and is justifiably relied upon by an innocent and injured party, then the elements of fraud are in place. With a finding of fraud, the injured party may seek rescission and/or civil damages. In addition, the state may choose to prosecute the wrongdoer under the penal code. Contract fraud, unfortunately, not only sits at the other end of the spectrum but can also be found at the “top of the charts” on the most popular white collar criminal list. As with so many areas of criminal behavior, the consumer pays the ultimate cost of these crimes through passed on costs for insurance, credit, and any number of other services undermined by these kinds of activities.

Another highly sensitive area of mutual assent is found in the realm of undue influence.

Undue influence involves taking away a person’s free will through any manner of physical, emotional, or psychological manipulation. It can happen in any relationship, and where it is alleged, the person claiming to be the victim of undue influence has the burden of proof in showing the alleged duress. One important exception to this general rule involves persons who act in a fiduciary role. A person in a fiduciary role is entrusted with acting for the benefit of another. Most professionals in law, accounting, the healing arts, and business find themselves in fiduciary roles to one degree or another. As for the fiduciary, the burden of proof is now reversed.

In dealing with their respective clients, patients, or beneficiaries, a contract is presumed to be

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under undue influence, and the burden of proof is on the fiduciary to show that the transaction is at “arm’s length” (i.e., is it fairly arrived at).

Writing Requirement As a practical matter, most contracts of any importance should be in writing. Most students already intuitively know this. The more important concern is to recognize how, when, and where the writing should be used and when exceptions should be made to the general rule. A three-step logic in the classroom might be helpful: 1. First, be sure to recognize which categories of contracts are covered by the Statute of Frauds, including the major exceptions, such as partial performance or orders for specially made goods under the UCC. 2. Second, have students learn how to use the parol evidence rule. Explain the “whys and wherefores” of the rule from both the theoretical as well as the practical point of view.

3. Finally, because the bottom line is to make sure that equity is done, explain both the public policy and practical necessity of having exceptions to the parol evidence rule.

The second set of defenses to the enforcement of contracts revolves around writing requirements associated with certain contracts. The genesis of the writing requirement for certain contracts is found in two roots: one historical and one practical. The historical root goes back to early English common law as developed under William the Conqueror and his successors. Status in that society was almost entirely measured by how much land one owned or had control over.

Being lord of the manor meant privilege, power, and rank. Thus, contracts involving the transfer of land ownership were of utmost importance because of the bearing they had on social status.

Highly ritualized written processes of titled transfers to land evidenced these important contracts.

The original title to the land was often traceable to a knights’s fief or fee for services provided to the sovereign. From this phrase, the highest recognized ownership in land today is still called fee simple absolute.

The second root of the writing requirement is found on a more mundane level, having less to do with knights in shining armor and more with practicality. A writing is considered the best and most neutral evidence of the parties’ intent at the time the agreement was entered into.

The writing does not lose its memory; it does not take sides. Thus, when English lawmakers wrote the Statute of Frauds, they decided the statute would serve them with the best of both worlds—impose a writing requirement on the most important contracts to act as the best evidence in a court of law.

The English version of the Statute of Frauds has been carried over to our legal system virtually intact for over three hundred years. All U.S. states have adopted their own versions of the statute, and they are virtually uniform in that they require contracts involving interests in land, consideration of marriage, one year plus, third party guarantees, and others to be in writing. The most significant addition to this list came with the adoption of the Uniform Commercial Code.

Under the provisions of the UCC, contracts for the sale of goods for more than $500 need to be in writing. Thus, the first question which needs to be answered is: Does the statute cover this contract or not?

Once you have decided the contract is covered, what are the effects of having failed to use a writing? Several possibilities may occur at this juncture. The parties may proceed to voluntarily perform the contract. But if one or both decide to assert the statute, its teeth are found in it being used as a defense to enforcement; i.e., if the party against whom contract enforcement is sought has not signed it, it may not be enforced against him or her. There are equity-based exceptions to this general rule based on partial performance and promissory estoppel. Once the contract is finally reduced to writing, the next element of the Statute of Frauds takes hold: the parol evidence rule and the exceptions to it. The exclusion face of the rule states that the writing is intended to express the final intent of the parties. All prior or contemporaneous statements must 97 .

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ultimately have been reflected in writing and will remain barred from the interpretation of the instrument. This provision is designed to prevent a rewrite of the document after the fact with new evidence to prevent fraud.

The converse is found in the exceptions to the parol evidence rule. Long ago, an anonymous legal scholar said: “The Statute of Frauds should not be used to perpetuate frauds.”

The exceptions to the parol evidence rule are designed to let in additional information not shown on the original writing in certain limited circumstances. These special circumstances are grounded in public policy and simple practical necessity. Public policy provides an overriding basis in cases involving fraud, misrepresentation, deceit, bad faith, power to avoid based on age or mental capacity, duress, undue influence, and mistake. All these elements are considered in the best interest of public policy and will be allowed into evidence, notwithstanding the statute, if the facts warrant it.

The second area of exception to the parol evidence rule is explaining ambiguities. If the contract, as written, contains ambiguous language, parol evidence is allowable to clear the ambiguity as long as it is consistent with the original terms. The nature of the evidence allowable under this rule can range from oral statements made by the parties on up to entire standards of usage and trade used by a particular industry. This exception is particularly important in contracts covered by the UCC. While it is relatively easy to talk about intended beneficiaries, talking about assignments and the like represents “the wall” to many students. Over and over again, student feedback identifies the materials on after-formation introduction of third parties as the most difficult concept to grasp. This difficulty makes it especially important to have a good game plan going into the class session. Not to have one leaves you open, as an instructor, to an often open-ended and obtuse discussion of the minutiae of assignment as opposed to presenting the big picture.

Due to the difficulty of this topic, it might be wise to discuss intended beneficiaries first.

In this part of the presentation, use of examples really helps the students. Moving on to afterformation third party involvement and a review of performance obligations might work next.

In this section, you can first give an overview of why third parties get involved, such as credit or commodity trading transactions. Then use a diagram on the board to illustrate some of the key aspects of assignment and novation. Maybe remind students of notice duties between the old and new parties to the contract. All in all, the more examples you use to illustrate these points, the better.

Third parties can become involved in a contract ab initio (from its inception) or after the fact. Contracts with third party involvement from the beginning are generically labeled intended beneficiary contracts.

These contracts are broken down into two subcategories: donee and creditor. The donee beneficiary contract is probably the one most students will be familiar with and most likely to be a participant in. Insurance contracts are good examples of these. The insured child becomes a third party intended (donee) contract beneficiary. And if his rights have vested under the contract, the contract cannot be altered, canceled, or rescinded without his consent. Other examples of third party donee beneficiaries can be found in trusts and contracts to make a will. The second category of intended third party beneficiaries is found in the law of creditors’ rights. When there is a preexisting debtor/creditor relationship, this relationship may act as the basis for a second contract where the named creditor beneficiary may be protected as an intended beneficiary. For example, suppose A borrows money from B to buy a car, and the car is used as collateral for the loan. B can now be named as a loss-payee (a person named in the policy to be paid in case of loss) up to the amount owed, even though B has not paid for or been a signatory to the insurance policy between A and his or her insurance company.

Incidental beneficiaries is not really a category of intended beneficiaries at all. The law is very straightforward on this point: if you do not qualify as an intended beneficiary based on donee or creditor grounds, you are classified as an incidental beneficiary and will not have any 98 .

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legally recognized standing to sue for protection under the contract. There is one minor exception to this rule in certain government contracts. Ordinarily, a taxpayer who objects to these contracts is classified as an incidental beneficiary, with no standing to sue, unless he or she can show that he belongs to a class for whose primary and immediate benefit the government contract was made.

Another category of third party involvement in contracts is the introduction of a third party after the contract was already formed. This party becomes involved by way of assignment or novation. In assignment, one of the original parties transfers rights or duties to a new third party participant. Compare this with a novation, derived from the Latin nova, meaning new. In a novation, the original contract with A and B is ended when a new contract is entered into between one of the original parties and a new party, C. The most common example is found in the assumption of mortgage obligations. In these forms of after-formation involvement of third parties, the law of assignment is far more important. Public policy in the law of contracts favors the transferability of contract rights and duties. Consider the world of finance, commodities, and the like. All of these commercially critical practices are facilitated by the transfer of contract rights from one person or business entity to another.

The second objective of this chapter is to introduce students to the concept of performance obligations and discharge from contracts. The rules of performance and breach of contract are rooted in common sense. Most contracts are completed legally when the parties have lived up to the reciprocal obligations set forth in their contract. Conversely, a breach is found when a failure of performance is not somehow excused by law. We are expected to live up to our performance obligations and no more. If those obligations are not met, breach of contract is the result.

The evaluation process of contract performance issues is best broken down into time sequence subparts: precontract, during the contract, and postcontract. In precontract issues, what are the covenants entered into before performance is to be initiated? Were there any conditions that may affect the rights and duties of the parties to contract? Conditions are certain events that have a triggering effect on the obligations of the contract. The timing of conditions can be superimposed upon the contract. A precondition, or condition precedent, calls for the event to take place before the contract goes into effect. For example: “I will buy this car if my mechanic signs off on the engine inspection.” A concurrent condition calls for two or more events to coincide in time. Consider an escrow where a third party is used as a holder of property and is instructed to act vis-à-vis that property only upon satisfaction of mutually dependent acts of third parties. This is a common form of property transfer used in the sale of real estate. The escrow holds the deed to the property from the seller until the buyer has delivered the purchase price in a form acceptable to both parties. A condition subsequent is found where performance may be excused by a certain event after the contract was entered into. For example, a parolee is allowed to stay out of prison as long as the conditions of the parole release are met.

There are certain circumstances that will act to excuse nonperformance. These circumstances are also based in common sense. Can it really be reasonable to expect personal service contracts to be enforced after death or disability? Or does it make sense to accept performance after destruction of a unique subject matter of the contract? A third form of excuse is found in subsequent illegality. If a contract was legal at the time it was formed but subsequent events have made its enforcement illegal, courts will no longer enforce its performance covenants based upon the new illegality.

In addition to excused nonperformance, there are a number of possible circumstances that may result in a discharge from any further contractual performance. These fall into two main categories: discharge by acts of the parties or by operation of law. Discharges by acts of the parties are voluntary postcontract formation events such as mutual recission, reformation, accord and satisfaction, a substituted contract, or novation. In all these scenarios, the parties have, in effect, reentered the bargaining and created a new deal.

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In an operation of law discharge, something has happened where the court steps in and declares that this contract performance obligation can no longer be enforced. Examples of such legal impediments to enforcement would include the running of a statute of limitation or bankruptcy. In both cases, any further performance under the contract has been legally ended. If, however, the contract duty has not been discharged, excused, or performed, and the absolute duty to perform has been breached, one must examine what remedies are available to the nonbreaching party.

How, when, and where the end comes to a contract is what this chapter is about. Putting a timeline on the steps of performance really helps students identify not only when the duty obligations are met, but also when a breach has taken place. Seeing how the conditions affect the ultimate rights of the parties also helps students determine what remedies should be used in case of a breach.

As noted in the prior chapter, we are expected to live up to our performance obligations.

If these obligations are not met, a breach of contract is often the legal result. There are a number of possible circumstances that may result in a discharge from any further performance. These fall into two main categories: discharge by acts of the parties or by operation of law. Discharge by acts of the parties in voluntary post-contract formation might occur in many ways, such as mutual rescission, reformation, accord and satisfaction, and substituted contract, or novation. In all of these scenarios, the parties have, in effect, reentered the bargaining and created a new deal.

In addition, contract obligations may have been met and breached with less than full performance. In substantial performance, 100 percent of the performance was not involved. If the breach was not material or intentional, the non-breaching party may sue for damages but not rescission. For example, if a $100,000 house has the wrong doorknob in it, and replacement will cost $100, the original contract can still be enforced less the price of the current doorknob.

Compare this with a house with no doors. The failure to provide doors may be construed as only partial performance because of lack of security. The non-breaching party may then sue for rescission or recover damages.

Another objective of this chapter is to introduce students to remedies in contract after a breach has taken place. An overview of the remedies available to the non-breaching party in contract can be compared to the various directions posted on a map when your car has broken down. Because your trip has been brought to an abrupt halt, you must decide which options make the most sense to you. Do you try to go back where you started? Can the car be fixed where you are, or do you need a tow to your original destination? By analogy, contracts can be also brought back (rescission), fixed (damages or reformation), or taken forward to their original destination (specific performance). The majority of remedies provided by the courts for contract breach fall into the category of a repair by way of monetary damages. In this repair process, there is an attempt to provide the innocent party with a financial replacement for the benefits he or she had under the original contract.

Think of monetary damages as an ascending staircase, starting at the bottom with token or nominal damages and going all the way up to punitive damages. Nominal damages are applicable where there is little real economic consequence arising from the breach. In a nominal damage award, the winner wins in principle but not in significant monetary terms.

The next step is found in compensatory or actual damages. These damages seek to restore the benefit of the bargain by providing a monetary substitute for what was lost due to the breach.

For example, if Mario had a deal with Zoomo Motors to buy a new car for $20,000 and had to buy a comparable model from Zamay Motors for $30,000 due to Zoomo’s breach, the actual measure of compensatory damages would be $10,000. If Mario had a resale contract for the car to A.J. for $40,000 and Zoomo knew of this second contract, Zoomo may also be liable for an additional $10,000 in consequential damages to Mario. In addition, had Zoomo’s breach been related to a bad faith tort within the contract setting, the court might also grant punitive damages.

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Punitive damages are a form of court-imposed civil punishment. Normally, punitive damages are not granted for contract breach alone, but if the bad faith involved shocks the conscience of the court, tort damages may be applicable. One other damages-related remedy lies in the area of liquidation or agreed upon damages set by the parties. A court will examine these damages to make sure that they are not a disguised penalty.

The other two paths available to the nonbreaching party are going backwards or going forward with the contract. In going backwards, a court is asked to return the parties to their precontract position by way of rescission or restitution (i.e., to undo the contract). A common example of rescission is found in return of deposit clauses in purchase contracts or in consumer protection statutes which provide for a three-day cooling off period after a contract is signed.

These statutes generally allow for a unilateral right of rescission within the three-day period by the buyer.

Another category of remedies involves going forward with the original terms of the agreement. These remedies are classified as equitable remedies because the breach cannot be adequately compensated by normal economic damage measures. The underlying theory is that the contract must somehow be enforced as a matter of equity and fair play rather than substituted by money alone. Equitable remedies are often found in modern day versions of specific performance, quasi-contract, and injunctive relief.

The last category of remedies is in regards to contract-related torts. Where the contract is related to situations involving intentional interference with contract relations or breach of an implied covenant of good faith and fair dealing, a court may grant punitive damages.

II. Chapter Objectives 1. Describe genuineness of assent and how it is affected by mistake, fraud, and duress.

2. List and describe the contracts that must be in writing under the Statute of Frauds.

3. Describe third-party rights in contracts.

4. Describe and distinguish between covenants and conditions in contracts.

5. Identify when performance of a contract is discharged.

6. Describe the performance and breach of contractual duties.

7. List and describe the monetary damages that can be awarded when there is a breach of contract.

8. Describe the equitable remedies of specific performance, reformation, and injunction.

9. Identify when contract disputes are to be resolved using arbitration.

III. Key Question Checklist  Assuming no conditions are in effect, are there any excuses to enforcing this contract?  Have the parties changed their performance obligations?  Is there an operation of law change to performance obligations?  Has a breach of contract taken place?  Is there a stipulation in the contract addressing how a breach may be resolved?  If liquidated damages do not apply, what possible law or monetary measures may be applicable?  Do any equitable remedies apply?

IV. Chapter Outline Introduction to Performance and Breach of Contracts A contract may not be enforced even if all the required elements of a legal contract are met.

This can happen when the party against whom the enforcement is sought raises certain defenses against its enforcement.

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Genuineness of Assent  Voluntary assent by the parties is necessary to create an enforceable contract  One of the primary defenses to the enforcement of a contract is that the assent of one or both of the parties to the contract was not genuine or real  Genuineness of assent may be missing because a party entered into a contract based on (1) mistake, (2) fraudulent misrepresentation, (3) duress, or (4) undue influence Unilateral Mistake  Occurs when only one party is mistaken about a material fact regarding the subject matter of the contract  In most cases, the mistaken party will not be permitted to rescind the contract  The contract will be enforced on its terms Mutual Mistake of a Material Fact  A mistake made by both parties concerning a material fact that is important to the subject matter of the contract  If there has been a mutual mistake of a material fact, the contract may be rescinded on the grounds that no contract has been formed because there has been no “meeting of the minds” between the parties Mutual Mistake of Value  A mistake that occurs if both parties know the object of the contract but are mistaken as to its value  The contract remains enforceable by either party because the identity of the subject matter of the contract is not at issue Fraud – When a person intentionally makes an assertion that is not in accord with the facts.  Occurs when one person consciously decides to induce another person to rely and act on a misrepresentation  Also known as intentional misrepresentation or fraudulent misrepresentation  The innocent party may (1) rescind the contract and obtain restitution, or (2) enforce the contract and sue for damages  To prove fraud, the following elements must be established: o The wrongdoer made a false representation of material fact; o The wrongdoer intended to deceive the innocent party; o The innocent party justifiably relied on the misrepresentation; and o The innocent party was injured Federal Court Case Case 10.1 Fraud in the Inducement: Portugues-Santana v. Rekomdiv International, Inc. Facts: Victor Portugues-Santana (Portugues) wanted to open a Victoria’s Secret franchise in Puerto Rico. Richard Domingo, a business broker, told Portugues that obtaining a Victoria’s Secret franchise was a “done deal” if he hired Domingo’s firm, Rekomdiv International, Inc. (Rekomdiv), and hired former United States Senator Birch Bayh’s law firm, Venable, LLP, to assist him. Portugues relied on Domingo’s representations and entered into retainer agreements with Rekomdiv and Venable. Portugues paid $225,000 to Rekomdiv and $400,000 to Venable.

Several months later, someone from Venable e-mailed Portugues and told him a Victoria’s Secret franchise was not available because Victoria’s Secret did not use a franchise system, owning and operating its own stores instead. Portugues sued Domingo, Rekomdiv, Bayh, and Venable for breach of contract and dolo (Spanish for “fraud.”) Venable and Bayh settled with Portugues for

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an undisclosed amount. At trial, the jury found in favor of Portugues in his lawsuit against Domingo and Rekomdiv, awarding him $625,000. The decision was appealed.

Issue: Are Domingo and Rekomdiv liable to Portugues for dolo?

Decision: The U.S. court of appeals affirmed the U.S. district court’s finding of fraud and the award of $625,000 in favor of the plaintiff.

Reason: Domingo and Rekomdiv committed fraud. Portugues received nothing in return for the $225,000 he paid Domingo and Rekomdiv.

Ethics Questions: Dolo is fraud. Domingo did not act ethically in this case. He and his company took $225,000 from Portugues to obtain a Victoria’s Secret franchise when Victoria’s Secret did not even offer franchising. Defendants settle lawsuits in order to avoid the prospect of an even higher jury verdict at trial, as well as to avoid the media publicity surrounding a high-profile case.

This lawsuit involved a former U.S. senator, so the case would have likely received a great deal of media attention had it gone to trial.

Duress  Occurs when one party threatens to do some wrongful act unless the other party enters into a contract  If a party to a contract has been forced into making the contract, there is no contractual assent  A contract entered into under duress cannot be enforced Undue Influence  Occurs when one person (the dominant party) takes advantage of another person’s mental, emotional, or physical weakness and unduly persuades that person (the servient party) to enter into a contract  The persuasion by the wrongdoer must overcome the free will of the innocent party  A contract that is entered into because of undue influence is voidable by the innocent party Statute of Frauds  State statute that requires certain types of contracts to be in writing  Is intended to ensure that the terms of important contracts are not forgotten, misunderstood, or fabricated Contracts Involving Interests in Real Property  Under the Statute of Frauds, any contract that transfers an ownership in real property (land, buildings, trees, soil, minerals, timber, plants, crops, fixtures, and things permanently affixed to the land or buildings) must be in writing to be enforceable  The Statute of Frauds writing requirement also applies to mortgages, leases for a term over one year, and express easements  The doctrine of part performance allows a court to order an oral contract for the sale of land or transfer of another’s interest in real estate to be specifically performed if it has been partially performed and performance is necessary to avoid injustice Agents’ Contracts  Many state Statutes of Frauds require that agents’ contracts to sell real property covered by the Statute of Frauds be in writing to be enforceable  This requirement is known as the “equal dignity rule”

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One-Year Rule  An executory contract that cannot be performed by its own terms within one year of its formation must be in writing  Intended to prevent disputes about contract terms that might otherwise occur toward the end of a long-term contract  Includes modifications and runs from date of contract Guaranty Contract  Occurs when one person agrees to answer for the debts or duties of another person  In a guaranty situation, there are at least three parties and two contracts.  The first contract, which is known as the original contract or primary contract, is between the debtor and the creditor  The second contract, called the guaranty contract, is between the person who agrees to pay the debt if the primary debtor does not (i.e., the guarantor) and the original creditor UCC Contract for the Sale or Lease of Goods  Section 2-201(1) of the Uniform Commercial Code (UCC) is the basic Statute of Frauds provision for sales contracts  UCC Section 2-201(1) states that contracts for the sale of goods priced at $500 or more must be in writing to be enforceable  Section 2A-201(1) of the Uniform Commercial Code (UCC) is the Statute of Frauds provision that applies to the lease of goods  UCC Section 2A-201(1) states that lease contracts requiring payments of $1,000 or more must be in writing Required Signature  The Statute of Frauds and the UCC require a written contract to be signed by the party against whom enforcement is sought  The signature of the person who is enforcing the contract is not necessary  The signature may appear anywhere on the writing  The signature may be affixed by an authorized agent Parol Evidence Rule  Parol evidence – Any oral or written words that are outside of the four corners of a written contract  Parol evidence rule – Provides that if a written contract is a complete integration, any prior contemporaneous oral or written statements are inadmissible as evidence to alter or contradict the terms of the written contract  The parties to a written contract may include a clause stipulating that the contract is a complete integration and the exclusive expression of their agreement and that parol evidence may not be introduced to explain, alter, contradict, or add to the terms of the contract. This type of clause, called a merger clause or an integration clause, expressly reiterates the parol evidence rule Federal Court Case Case 10.2 Parol Evidence Rule: In the Matter of Pilgrim’s Pride Corporation Facts: Pilgrim’s Pride Corporation (PPC) operated a chicken processing plant in Clinton, Arkansas. PPC contracted with more than 100 chicken growers to supply the plant with poultry.

The growers received chicks and feed from PPC, then raised the chicks to maturity and sold them to PPC at a price based on weight. Each grower signed the same boilerplate contract provided by PPC. The contract specified that it was “to continue on a flock to flock basis.” The contract stated 104 .

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that either party could terminate the contract without cause between flocks, which lasted between 4 to 9 weeks, and that PPC could end the agreement at any time for “cause or economic necessity.” The contract included a merger clause representing that the contract “supersedes, voids, and nullifies” all prior agreement and oral statements, and a clause preventing oral modification of the contract.

Citing economic factors caused by an increase in the cost of chicken feed and a drop in the price of chicken, PPC idled the Clinton plant and terminated its contracts with the chicken growers.

The growers sued PPC, contending that PPC officials had made oral representations that the company would maintain a long-term relationship with them and that PPC assured them that PPC “was here for the long haul.” The U.S. district court held that the written contracts barred the growers’ claims against PPC based on alleged oral promises, and the growers appealed.

Issue: Do the contracts signed by the growers bar their claims of oral promises by PPC? Decision: The U.S. court of appeals affirmed the district court’s ruling in favor of PPC. Reasoning: The court reasoned that the contracts between PPC and the growers barred the growers’ claims because the contracts and the claims cover the same subject matter. The plain language of the contracts specified that the agreements between PPC and the growers were to “continue on a flock to flock basis”—a time period spanning between four and nine weeks.

Ethics Questions: The intent of the parol evidence rule is to lend stability, predictability, and integrity to written contracts. Contracting parties must realize that if a contract-related dispute should develop, a court will most likely rely on the plain language of their contract in order to determine rights and liabilities.

Third Party Rights  Third parties generally do not acquire any rights under other people’s contracts  Two exceptions are: (1) assignees to whom rights are subsequently transferred; and (2) intended third-party beneficiaries to whom the contracting parties intended to give rights under the contract at the time of contracting Assignment  An assignment is the transfer of contractual rights by an obligee to another party  The assignor is an obligee who transfers a right  The assignee is a party to whom a right has been transferred Intended Beneficiary An intended beneficiary is a third party who is not in privity of contract but who has rights under the contract and can enforce the contract against the promisor.

Covenants and Conditions In contracts, parties make certain promises to each other. These promises may be classified as covenants or conditions.

Covenant  An unconditional promise to perform  Nonperformance of a covenant is a breach of contract that gives the other party the right to sue  The majority of provisions in contracts are covenants Conditions of Performance A conditional (qualified) promise is not as definite as a covenant. The promisor’s duty to perform arises only if the condition occurs. A conditional promise becomes a covenant if the condition is met.

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Types of Conditions include: (1) Condition precedent—an event must occur or not occur before an obligation exists; and (2) Condition subsequent—an event or non-event excuses the duty to perform.

Discharge of Performance A party’s duty to perform under a contract may be discharged by mutual agreement of the parties or by impossibility of performance.

Discharge by Agreement  Mutual rescission: Requires parties to enter into a second agreement that expressly terminates the first one.  Novation: Substitutes a third party for one of the original contracting parties. The new substituted party is obligated to perform a contract. All three parties must agree to the substitution. The exiting party is relieved of liability on the contract.  Accord and satisfaction: The agreement whereby the parties agree to accept something different in satisfaction of the original contract is called an accord. The performance of an accord is called a satisfaction.

Discharge by Impossibility of Performance  Under certain circumstances, the nonperformance of contractual duties is excused—that is, discharged—because of impossibility of performance  The parties may agree in a contract that certain events will excuse nonperformance of the contract. These clauses are called force majeure clauses Force Majeure Clause – A clause in a contract in which the parties specify certain events that will excuse nonperformance.

Breach of Contract – Occurs if one or both of the parties fail to perform their duties as specified in the contract.

Types of Performance Complete Performance Substantial Performance (Minor Breach) Inferior Performance (Material Breach)

Legal Consequence The contract is discharged.

The non-breaching party may recover damages caused by the breach.

The non-breaching party may either: (1) Rescind the contract and recover restitution, or (2) Affirm the contract and recover damages

Monetary Damages  A non-breaching party may recover monetary damages from a breaching party  Such damages are available regardless of whether the breach was minor or material  Types of monetary damages include: o Compensatory Damages—an award of money intended to compensate a nonbreaching party for loss of the bargain o Consequential Damages—foreseeable damages that arise from circumstances outside a contract o Liquidated Damages—damages that parties to a contract agree in advance should be paid if the contract is breached 106 .

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Federal Court Case Case 10.3 Liquidated Damages: Burke v. 401 N. Wabash Venture, LLC Facts: 401 N. Wabash Venture, LLC is the developer of a hotel and condominium building in Chicago. Michael Burke, a citizen of Ireland, signed a contract with the developer to buy a condominium unit and two parking spaces for $2,282,130 when the building was completed.

Burke paid a deposit of $456,426—20 percent of the purchase price—as required by the purchase agreement. The purchase agreement contained a liquidated damage clause that permitted the developer to retain the deposit money if Burke did not complete the purchase of the unit.

When it came time to close the purchase, Burke refused to pay the rest of the contract price and asked the developer to refund his deposit. The developer refused to refund Burke the deposit, which it kept as liquidated damages, and resold the unit at a price higher than in the purchase agreement. Burke sued the developer in U.S. district court, alleging that the liquidated damage provision was a penalty and therefore unenforceable. The developer moved to dismiss Burke’s lawsuit. The U.S. district court held that the liquidated damage clause was enforceable and dismissed Burke’s lawsuit. Burke appealed.

Issue: Was the liquidated damage clause an unenforceable penalty?

Decision: The U.S. court of appeals affirmed the district court’s decision that enforced the liquidated damage agreement permitting the developer to retain the plaintiff’s deposit.

Reason: The court rejected the plaintiff’s argument that the liquidated damage clause was a penalty because the developer sold the unit for more than the price in the plaintiff’s purchase agreement, reasoning that under the terms of the agreement, it was irrelevant to the liquidated damage issue whether the unit was later resold. The court also noted that under state (Illinois) law, the 20 percent figure was not so high as to be unenforceable on public policy grounds.

Ethics Questions: A liquidated damage clause is enforceable so long as it is reasonable, and a court will base its conclusion regarding reasonableness on the facts and circumstances of the particular case.

Mitigation of Damages  A non-breaching party is under a legal duty to avoid or reduce damages caused by a breach of contract  The extent of mitigation depends on the type of contract involved Equitable Remedies An equitable remedy is available if there has been a breach of contract that cannot be adequately compensated through a legal remedy or to prevent unjust enrichment.

Types of Equitable Remedy Specific Performance

Reformation

Injunction

Description Court orders the breaching party to perform the acts promised in the contract. The subject matter of the contract must be unique.

Court rewrites a contract to express the parties’ true intentions. Usually used to correct clerical errors.

Court order that prohibits a party from doing a certain act. Available in contract actions only in limited circumstances.

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State Court Case Case 10.4 Specific Performance: Alba v. Kaufmann Facts: The buyers agreed to purchase a house from the sellers. Prior to closing, the sellers sent the buyers an e-mail indicating that they had experienced a “change of heart” and no longer wished to go forward with the sale. When the sellers refused to consummate the transaction, the buyers sued for specific performance and summary judgment. The supreme court of New York denied the motion. The buyers appealed.

Issue: Is an order of specific performance of the real estate contract warranted in this case?

Decision: The appellate court, as a matter of law, granted the Albas’ motion for summary judgment and ordered Kaufmann specifically to perform the real estate contract.

Reason: Volitional unwillingness, as distinguished from good faith inability, to meet contractual obligations does not justify cancellation of a contract.

Ethics Questions: It was not ethical for the sellers to attempt to “back out of” the contract. A deal is a deal. It was certainly not unethical for the buyers to seek specific performance in this case. As the court noted, an order of specific performance is quite common in a contract for the sale of real estate, since each parcel of real estate is unique.

Arbitration of Contract Disputes Arbitration is a non-judicial, private resolution of a contract dispute. Most arbitration agreements stipulate binding arbitration, meaning the arbitrator’s decision cannot be appealed to the courts.

The Federal Arbitration Act promotes the arbitration of contract disputes whether the dispute involves federal or state law. The U.S. Supreme Court has upheld the Federal Arbitration Act’s national policy favoring arbitration and the enforcement of arbitration agreements.

Federal Court Case Case 10.5 Arbitration of a Contract Dispute: Mance v. Mercedes-Benz USA Facts: The buyer agreed to purchase a new Mercedes-Benz automobile from the seller. The buyer signed a retail installment contract that included a binding arbitration clause. The arbitration clause was highlighted by bold, capitalized text. The buyer experienced problems with the automobile, and sued the seller in U.S. district court for breach of express and implied warranties.

The seller moved for an order compelling the buyer to arbitrate.

Issue: Is the arbitration clause enforceable?

Decision: The U.S. district court held that that arbitration clause was enforceable and granted Mercedes-Benz’s motion to compel arbitration.

Reason: The arbitration provision was conspicuous and not oppressive.

Ethics Questions: Freedom of contract principles apply in this case. The buyer was not obligated to agree to a binding arbitration clause in the contract, but he did so. The buyer may or may not have known about the existence and enforceability of the arbitration clause, depending on whether he reviewed and understood the agreement, but contracting parties are obligated to read contract provisions. The law will not protect those who have eyes and will not see. If a contracting party does not understand a contract provision, he or she has the responsibility to ask for an explanation before finalizing the agreement.

V. Key Terms and Concepts  Accord and satisfaction—The agreement whereby the parties agree to accept something different in satisfaction of the original contract.  Agents’ contract—A rule stating that agents’ contracts to sell property covered by the Statute of Frauds must be in writing to be enforceable. This requirement is often referred to as the “equal dignity” rule.  Arbitration—A non-judicial, private resolution of a contract dispute.

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Arbitration agreement—Arbitration occurs if the parties have entered into an agreement to resolve their dispute(s), either as part of their contract or as a separate agreement.

Many consumer and business contracts contain arbitration clauses.

Assignee—A party to whom a right has been transferred.

Assignment of rights (assignment)—The transfer of contractual rights by an obligee to another party.

Assignor—An obligee who transfers a right.

Binding arbitration—The arbitrator’s decision cannot be appealed to the courts. Most arbitration agreements stipulate binding arbitration.

Breach of contract—If a contracting party fails to perform an absolute duty owed under a contract.

Compensatory damages—Damages that are generally equal to the difference between the value of the goods as warranted and the actual value of the goods accepted at the time and place of acceptance.

Complete integration—A written contract that is a complete and final statement of the parties’ agreement. A completely integrated contract is viewed as the best evidence of the terms of the parties’ agreement.

Complete performance (strict performance)—Occurs when a party to a contract renders performance exactly as required by the contract; discharges that party’s obligations under the contract.

Condition—A qualification of a promise that becomes a covenant if it is met.

Condition precedent—A condition that requires the occurrence of an event before a party is obligated to perform a duty under a contract.

Condition subsequent—A condition whose occurrence or nonoccurrence of a specific event automatically excuses the performance of an existing contractual duty to perform.

Conditional promise (qualified promise)—The promisor’s duty to perform or not perform arises only if the condition does or does not occur. A conditional promise is not as definite as a covenant, but a conditional promise becomes a covenant if the condition is met.

Consequential damages (special damages or foreseeable damages)—Foreseeable damages that arise from circumstances outside the contract. In order to be liable for these damages, the breaching party must know or have reason to know that the breach will cause special damages to the other party.

Covenant—An unconditional promise to perform.

Discharge by agreement—The parties to a contract may mutually agree to discharge their contractual duties under a contract. The different methods for discharging a contract by mutual agreement include mutual rescission, novation, and accord and satisfaction.

Dominant party—In the case of undue influence, the party that takes advantage of another person’s mental, emotional, or physical weakness and unduly persuades that person to enter into a contract.

Duress—A situation in which a party threatens to do a wrongful act unless another party enters into a contract.

Economic injury—A plaintiff’s financial loss resulting from the wrongful actions of the defendant.

Equal dignity rule—A rule which says that agents’ contracts to sell property covered by the Statute of Frauds must be in writing to be enforceable.

Equitable remedies—A remedy that is available if there has been a breach of contract that cannot be adequately compensated through a legal remedy or to prevent unjust enrichment.

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Executed contract—A fully performed contract.

Executory contract—A contract that has not yet been fully performed. A contract situation in which one or more contracting parties still have a remaining obligation.

Federal Arbitration Act—A federal statute which promotes the arbitration of contract disputes whether the dispute involves federal or state law.

Force majeure clause—A clause in a contract in which the parties specify certain events that will excuse nonperformance.

Genuineness of assent—The requirement that a party’s assent to a contract be genuine.

Guarantor—A person who agrees to pay a debt if the primary debtor does not.

Guaranty contract—A promise in which one person agrees to answer for the debts or duties of another person. It is a contract between the guarantor and the original creditor.

Impossibility of performance (objective impossibility)—Nonperformance that is excused if a contract becomes impossible to perform. It must be objective, not subjective, impossibility.

Incidental beneficiary—A party who is unintentionally benefited by other people’s contracts.

Inferior performance—Occurs when a party fails to perform express or implied contractual obligations that impair or destroy the essence of the contract.

Injunction—A court order that prohibits a person from doing a certain act.

Intended third-party beneficiary—A third party who is not in privity of contract but who has rights under the contract and can enforce the contract against the promisor.

Intent to deceive—The person who made the misrepresentation either had knowledge that the misrepresentation was false or made the misrepresentation without sufficient knowledge of the truth.

Intentional misrepresentation (fraudulent misrepresentation or fraud)—An event that occurs when one person consciously decides to induce another person to rely and act on a misrepresentation.

Lease contract—A legal document outlining the terms under which one party agrees to rent property from another party. A lease guarantees the lessee (the renter) use of an asset and guarantees the lessor (the property owner) periodic payments from the lessee for a specified term.

Liquidated damages—Damages that will be paid upon a breach of contract that are established in advance.

Liquidated damages clause—Damages that parties to a contract agree in advance should be paid if the contract is breached.

Material breach—A breach that occurs when a party renders inferior performance of his or her contractual duties.

Material fact—A fact that is important to the subject matter of a contract.

Merger clause (integration clause)—A clause in a contract which stipulates that it is a complete integration and the exclusive expression of the parties’ agreement.

Minor breach—A breach that occurs when a party renders substantial performance of his or her contractual duties.

Misrepresentation of a material fact—May occur by words (oral or written) or by the conduct of the wrongdoer. The misrepresentation was a significant factor in inducing the innocent party to enter into the contract.

Mitigation of damages—A non-breaching party’s legal duty to avoid or reduce damages caused by a breach of contract.

Monetary damages (dollar damages)—An award of money.

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Mutual mistake of a material fact—A mistake made by both parties concerning a material fact that is important to the subject matter of a contract.

Mutual mistake of value—A mistake that occurs if both parties know the object of the contract but are mistaken as to its value.

Mutual rescission—The cancellation of a wholly or partially executory contract through the consent of both contracting parties. Mutual rescission requires both parties to enter into a second agreement that expressly terminates the first one.

Novation agreement (novation)—Substitutes a third party for one of the original contracting parties. The new substituted party is obligated to perform the contract. All three parties must agree to the substitution. In a novation, the exiting party is relieved of liability on the contract.

Obligee—A party who is owed a right under a contract is called the obligee.

Obligor—A party who owes a duty of performance pursuant to a contract.

One-year rule—A rule which states that an executory contract that cannot be performed by its own terms within one year of its formation must be in writing.

Original contract (primary contract)—In a guaranty arrangement, the contract between the debtor and the creditor. (In contrast, the guaranty contract is between the guarantor and the creditor).

Parol evidence—Any oral or written words outside the four corners of a written contract.

Parol evidence rule—A rule that says if a written contract is a complete and final statement of the parties’ agreement, any prior or contemporaneous oral or written statements that alter, contradict, or are in addition to the terms of the written contract are inadmissible.

Part performance—This doctrine allows the court to order an oral contract to be specifically performed if performance is necessary to avoid injustice.

Penalty—A liquidated damages clause is considered a penalty if actual damages are clearly determinable in advance or if the liquidated damages are excessive or unconscionable.

Real property—Land itself, as well as buildings, trees, soil, minerals, timber, plants, crops, fixtures, and other things permanently affixed to the land or buildings.

Reformation—An equitable doctrine that permits the court to rewrite a contract to express the parties’ true intentions.

Reliance on a misrepresentation—In a fraud case, the innocent party who justifiably depended and acted on the wrongdoer’s misrepresentation.

Rescind—An act that cancels a contract.

Rescission—An action to rescind (undo) the contract. Rescission is available if there has been a material breach of contract, fraud, duress, undue influence, or mistake.

Sales contract—In the context of Article 2 of the Uniform Commercial Code (UCC), a contract for the sale of goods. A contract for the sale of goods involves the transfer of title, from the buyer to the seller, of items that are tangible, physical, and moveable (e.g., furniture, automobiles, etc.) for consideration (value).

Scienter—Knowledge that a representation is false or that it was made without sufficient knowledge of the truth.

Section 2-201(1) of the Uniform Commercial Code (UCC)—A section of the Uniform Commercial Code (UCC) which states that sales contracts for the sale of goods costing $500 or more must be in writing.

Section 2A-201(1) of the UCC—A section of the Uniform Commercial Code (UCC), which states that lease contracts involving payments of $1,000 or more must be in writing.

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Servient party—In the case of undue influence, the party that the dominant party persuades is referred to as the servient party.

Specific performance—A remedy that orders the breaching party to perform the acts promised in the contract.

Statute of Frauds—A state statute that requires certain types of contracts to be in writing.

Subsequent assignee (subassignee)—The party to which the assignee assigns.

Substantial performance—Performance by a contracting party that deviates only slightly from complete performance.

Tender of performance (tender)—An unconditional and absolute offer by a contracting party to perform his or her obligations under a contract.

UCC Statute of Frauds—A rule that requires certain types of agreements (e.g., a contract for the sale of goods priced at $500 or more) to be in writing in order to be enforceable.

Undue influence—A situation in which one person takes advantage of another person’s mental, emotional, or physical weakness and unduly persuades that person to enter into a contract.

Unilateral mistake—A mistake in which only one party is mistaken about a material fact regarding the subject matter of a contract.

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Chapter 11 Digital Law and E-Commerce How does technology affect the law?

I. Teacher to Teacher Dialogue Every generation has the good fortune, and sometimes misfortune, of being witness to events that become the landmarks by which future generations will measure history. These landmarks can take place as social upheavals such as civil rights movements, horrible conflagrations such as wars, or social-economic migrations such as our nation’s conversion from an agrarian to an industrial society. A key hallmark of all such events is that the road of history has taken a sharp turn from which there is little possibility of turning back.

One such major turn that we are now facing is the advent of the internet. Future generations will look upon our time as a road landmarked by the information age. This turn in the road is coupled and driven by incredible technological advancements symbolized by the internet.

Originally intended only for a select group of military and academic uses, it has virtually exploded onto every continent and every country to facilitate a level of communication not previously imagined. It has made planet Earth “smaller” than ever through unprecedented connectivity, while simultaneously creating an uncharted frontier for all who travel down this exciting path.

As teachers of law and ethics, it is our job to make our fair contribution to the evolution of this new cyberspace highway. We must first help our students appreciate that this path has been built and protected by a legal and regulatory environment that is founded on an underlying principle of social order and ethical decision-making. We must help our students understand and appreciate the roles that both government and business play in attaining the social goods that can come from these new technologies. We must also help students recognize the legal issues and risks that will confront them as they travel down this road. And most of all, we must do our part to help them develop both the critical thinking skills and the ethical sensitivity to see that both great benefit and harm can come from the information age.

How then do we start to teach the laws of e-commerce and the internet? It has taken the greatest technological minds of our generation to build this highway. It will take visionary thinking to help steer that technology towards the goals common to all law studies: which is to not only explain what it is but how it can be used as a socially responsible tool for the betterment of both our nation and the larger global community. Our challenge is to interpolate the lessons learned through virtually thousands of years of legal evolution governing every manner of human conduct into the virtual world of the internet. We are concerned with all aspects of privacy and intellectual property rights. The internet is impacting governmental regulation, employment law, consumer protection, business formation, and agency laws. We must take the lessons of history learned in those key areas of business law and remember that they are rooted in an orderly legal system. How, when, and where do we, as a society, allocate the respective rights and duties of its members? That allocation of rights and duties continues every day in new ways on the internet.

Precedent has extraordinary value in charting the new methods of business conducted over the internet. Consider, for example, the corollaries found between the long-standing Uniform Commercial Code (UCC), the newer Uniform Electronic Transactions Act (UETA), and the Uniform Computer Information Transactions Act (UCITA). The UCC has long provided us with useful tools to foster and protect commerce. These new proposals, while surely seen as imperfect by many, are evolutionary efforts to do the same for e-commerce. They seek to expand the 113 .

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economic wellbeing of our nation while still seeking to protect the legitimate concerns of individual rights of privacy and the like. We may be involved in transactions measured by milliseconds through cyberspace, but they are still contracts, and as such, need to be bound by all the rules of good conscience first evolved in the common law and then transferred to the UCC. For example, on the privacy front, we may be looking at unprecedented accumulations of personal information through the use of “cookies” and the like. However, the basic rules of rights of privacy should not be abrogated simply because it is technologically possible. Technology used in a harmful manner can only magnify the original problem. Good legal environments must steer new technologies along the well-precedented path of good faith and good conscience.

In the end, the art of teaching the law of e-commerce and the internet is basically the same as it has been since the beginnings of law. We must balance the good that can come from the information age with the lessons learned through centuries of the development of an orderly society. It is not easy to do this, and it takes a certain leap of faith to teach law in an area where our students are very often more technologically “savvy” than we are. As an old proverb says: “The act of faith is jumping off a cliff with the knowledge that you will be ok.” So it is in the interpolation of the law and the world of electronic commerce. We have to jump because we have no choice; that is where this road is taking us. But we must have faith in the law’s ability to help us land safely.

II. Chapter Objectives 1. Describe the internet.

2. Explain how email contracts and text contracts are formed.

3. Describe electronic commerce and web contracts.

4. Describe electronic licensing of software and informational rights.

5. Define domain name and describe how domain names are registered and protected.

III. Key Question Checklist  How is an internet domain name obtained and protected?  Is a license or licensing agreement involved?  What statutes and uniform laws govern e-commerce and the internet?  What laws have been put into place relative to a person’s signing of electronic contracts?

IV. Chapter Outline Introduction to Digital Law and E-Commerce E-commerce is the use of the internet to sell goods and services. It has exploded over the last decade and brought about the creation of a number of new laws. Internet websites and domain names have become standard in business today.

The Internet The internet is a collection of millions of computers that provide a network of electronic connections between the computers.

Web The standard for information exchange on the web is HTTP. Documents on the web are formatted using common coding languages. Web pages are stored on servers operated by ISPs and are viewed through browsers. Each website has a unique address online.

Email and Text Contracts Using email, individuals around the world can instantaneously communicate in electronic writing with one another. Contracts completed by using email, referred to as electronic mail contracts or 114 .

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email contracts, are enforceable as long as they meet the requirements necessary to form a traditional contract. This includes agreement, consideration, capacity, and lawful object.

Information Technology: Email Acceptance Creates an Enforceable Contract Carol Riselli contacted Clean Properties, Inc. and requested that it clean up a substantial release of oil that had occurred on property owned by Riselli in Belmont, Massachusetts, on an emergency basis. Clean properties offered to do this environmental cleanup pursuant to the terms and conditions in a proposed written contract that it sent to Riselli which identified the contract as Project 0941, Order 1. The proposed contract included the provision for a mechanic’s lien on the property in favor of Clean Properties that made the property collateral in case Clean Properties was not paid for its services. Riselli immediately responded to the email, which stated “I agree with the terms of the contract identified as Project #0941, Order 1. Please start work right away.”

The email concludes with a signature block that states “Thank you, Carol J. Riselli.”

Clean Properties provided services to clean up the oil but was not paid for its services. Clean Properties attempted to perfect its mechanic’s lien on the property so that it could bring proceedings to have the property sold and have the sum it was owed paid from the proceeds of the sale. Riselli alleged that there was no written contract between the parties because her acceptance and signature ware not in writing but were made electronically by email.

The superior court held that Riselli’s email acceptance of Clean Properties’ written offer created an enforceable contract. The court stated, “It is clear that a contract is formed when someone accepts a written offer by email, and that such a written contract is enforceable. Riselli’s email expressed her acceptance of the written contract terms offered by Clean Properties.” The court ruled that Clean Properties could perfect its remedy afforded by the mechanic’s lien. Clean Properties, Inc. v. Riselli, 2014 Mass. Super. Lexis 106 (Commonwealth of Massachusetts Superior Court, 2014) Information Technology: Regulation of Email Spam The CAN-SPAM Act prohibits spammers from falsifying headers in email messages, prohibits deceptive subject lines, requires that recipients be given an opportunity to opt out, and requires that sexually oriented emails be labeled as this. It does not stop spam, but it does make it easier to identify it.

Internet Service Provider (ISP) Internet service providers (ISPs) provide email accounts to users, internet access, and storage on the internet. ISPs offer a variety of access devices and services to connect users to the internet.

The Communications Decency Act is a federal statute stating that internet service providers are not liable for the content transmitted over their networks by email users and websites.

E-Commerce and Web Contracts The internet and electronic contracts, also called e-contracts, have increased as a means of conducting personal and commercial business. Assuming the elements to establish a traditional contract are present, a web contract is valid and enforceable.

State Court Case Case 11.1 Web Contract: Hubbert v. Dell Corporation Facts: Plaintiffs Dewayne Hubbert, Elden Craft, Chris Grout, and Rhonda Byington purchased computers from Dell Corporation online through Dell’s website by completing online order forms on five pages on Dell’s website. They filed a lawsuit against Dell, alleging that Dell misrepresented the speed of the microprocessors included in the computers they purchased. Dell made a demand for arbitration, asserting that the plaintiffs were bound by the arbitration agreement that was contained in the Terms and Conditions of Sale. The plaintiffs countered that 115 .

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the arbitration clause was not part of their web contract because the Terms and Conditions of Sale were not conspicuously displayed as part of their web contract. The trial court sided with the plaintiffs, finding that the arbitration clause was unenforceable because the terms and conditions of sale were not adequately communicated to the plaintiffs. Dell appealed.

Issue: Were the Terms and Conditions of Sale adequately communicated to the plaintiffs?

Decision: The appellate court reversed the decision of the trial court.

Reason: Because the “Terms and Conditions of Sale” were a part of the online contract, they were bound by the “Terms and Conditions of Sale,” including the arbitration clause.

Ethics Questions: It was not a valid argument by the plaintiffs to claim that the Terms and Conditions of Sale were not included in their web contract with Dell. Many individuals will readily admit that they do not take the time to read the terms and conditions of sale when purchasing goods over the Internet, even though such contractual provisions are legally binding.

Information Technology: E-SIGN Act: Statute of Frauds and Electronic Contracts The federal Electronic Signature in Global and National Commerce Act (E-SIGN Act) is designed to place the world of electronic commerce on par with the world of paper contracts in the United States. The E-SIGN Act recognizes that electronic contracts meet the writing requirement of the statute of frauds.

Information Technology: E-SIGN Act: E-Signatures and Electronic Contracts The E-SIGN Act recognizes electronic signatures, giving them the same force and effect as pensigned ones.

Counteroffers Ineffectual Against an Electronic Agent Most web pages use electronic ordering systems that do not have the ability to evaluate and accept or make counteroffers. Most state laws recognize this limitation and provide that an econtract is formed if an individual takes action that causes the electronic agent to cause performance or promise benefits to the individual. Thus, counteroffers are not effective against electronic agents.

E-Licensing of Software and Information Rights Much of the new cyberspace economy is based on electronic contracts and the licensing of computer software and information. E-commerce created problems for forming contracts over the internet, enforcing e-commerce contracts, and providing consumer protection.

License – A license is a contract authorizing access to, use of, or some other form of limited rights to intellectual property and information. The parties to a license are the licensor, the party that owns the intellectual property or information rights, and the licensee, the party granted the limited rights.

E-License – The owner of the program or application is the electronic licensor, or e-licensor, and the owner of the computer or digital device to whom the license is granted is the electronic licensee, or e-licensee.

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Licensing Agreement – Usually, the parties enter into a written agreement that tends to be quite detailed. This is primarily because of the nature of the subject matter and the limited uses granted in the intellectual property or informational rights. Breach of contract by one party to a licensing agreement gives the nonbreaching party certain rights, including the right to recover damages or other remedies.

Domain Names Most businesses conduct e-commerce by using websites on the internet. Each website is identified by a unique internet domain name. The Internet Corporation for Assigned Names and Numbers (ICANN) is a private nonprofit organization that oversees the registration and regulation of domain names.

Registration of Domain Names – Domain names can be registered. The first step in registering a domain name is to determine whether any other party already owns the name. InterNIC (www.internic.net) maintains a database that contains the domain names that have been registered.

Domain Name Extensions – The most common top-level domains are .com, .net, .org, .info, .biz, .us, .mobi, .bz, .name, .museum, .coop, .aero, .pro, and .edu.

Information Technology: Specific Top-Level Domain Names Companies can have their own company name TLDs (top-level domain names), such as .google and .nike. In addition, companies can obtain TLDs for specific products, such as .iphone or .prius.

Such TLDs help companies with the branding of their company names and products. TLDs can also be registered for industries and professions, such as .accountants, .attorneys, .pharmacy, and .realtor.

Some of the new domain names are .actor, .bar, .career, .dating, .vacation, and .website.

Cities and other government agencies can register their names, such as .nyc (New York City) and .paris (Paris, France). Even persons sharing a cultural identity can have their own TLD, such as .kurd (for Kurds living in Iraq and elsewhere) or .ven (Venetian community, Italy).

TLDs can be registered in languages other than English, including French and Spanish.

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Country Domain Names – Countries have specific extensions assigned to the country. Many countries make these domain name extensions available for private purchase for commercial use.

Examples include .ca (Canada), .mx (Mexico), and .us (United States).

Information Technology: Sale of Domain Names Domain names can be very valuable. Like other property, domain names can be purchased and sold. Some domain names that have been sold, and the sale price, include: (1) Clothes.com—$4.9 million; (2) Medicare.com—$4.8 million; and (3) Slots.com—$5.5 million.

Cybersquatting on Domain Names – Sometimes a party will register a domain name of another party’s trademarked name or famous person’s name. This is called cybersquatting. Most cybersquatters do not distribute goods or services; instead, they merely “sit on” the internet domain names.

Information Technology: Anticybersquatting Consumer Protection Act In 1999, the U.S. Congress enacted the Anticybersquatting Consumer Protection Act (ACPA).

The act was specifically aimed at cybersquatters who register internet domain names of famous companies and people and hold them hostage by demanding ransom payments from the famous company or person. The ACPA prohibits cybersquatting itself if it is done in bad faith.

National Arbitration Forum Case 11.2 Domain Name: New York Yankees Partnership d/b/a The New York Yankees Baseball Club Facts: Moniker Online Services, Inc. (Moniker), registered the domain name <nyyankees.com>.

Moniker operates a commercial website under this domain name where it offers links to thirdparty commercial websites that sell tickets to Yankee baseball games and sell merchandise bearing the NEW YORK YANKEES trademark without the Yankees’ permission. The Yankees filed a complaint with the National Arbitration Forum alleging that Moniker had registered the domain in bad faith in violation of the Internet Corporation for Assigned Names and Numbers (ICANN) Uniform Domain Dispute Resolution Policy and were seeking to obtain the domain name from Moniker.

Issue: Did Moniker violate the ICANN’s Uniform Domain Dispute Resolution Policy (Policy)?

Decision: Yes. Reason: Complaint has sufficiently demonstrated that Moniker’s <nyyankees.com> domain name is confusingly similar to the complainant’s NEW YORK YANKEES mark. Moniker uses the <nyyankees.com> domain name to operate a website providing links to third-party commercial websites offering tickets to professional sporting events of the Yankees and merchandise bearing the Yankees’ NEWYORK YANKEES trademark.

Ethics Questions: Moniker did not act ethically in obtaining and using the <nyyankees.com> domain name and website. Moniker attempted to exploit the New York Yankees trademark for commercial gain without the permission of the trademark holder. The element of bad faith was demonstrated in this case. Moniker knew or should have known that the domain name it sought was confusingly similar to the New York Yankees’ trademark.

Global Law: Internet in Foreign Countries This case study notes that no international law governs the internet. Although U.S. law makes certain internet activities illegal, U.S. law does not apply to sources located outside of the United States. Some countries control or censure the use of the internet by its citizens.

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V. Key Terms and Concepts  .aero—This extension is exclusively reserved for the aviation community.  .biz—This extension is used for small-business websites.  .bz—This extension is commonly used by small businesses.  .com—This extension represents the word “commercial” and is the most widely used extension in the world.  .coop—This extension represents the word “cooperative” and may be used by cooperative associations around the world.  .edu—This extension is for educational institutions.  .info—This extension signifies a resource website. It is an unrestricted global name that may be used by businesses, individuals, and organizations.  .mobi—This extension is reserved for websites that are viewable on mobile devices.  .museum—This extension enables museums, museum associations, and museum professionals to register websites.  .name—This extension is for individuals, who can use it to register personalized domain names.  .net—This extension represents the word “network,” and it is most commonly used by ISPs, web-hosting companies, and other businesses that are directly involved in the infrastructure of the internet.  .org—This extension represents the word “organization” and is used primarily by nonprofit groups and trade associations.  .pro—This extension is available to professionals such as doctors, lawyers, and consultants.  .us—This extension is for U.S. websites. Many businesses choose this extension.  Anticybersquatting Consumer Protection Act (ACPA)—The act was specifically aimed at cybersquatters who register internet domain names of famous companies and people and hold them hostage by demanding ransom payments from the famous company or person.  Communications Decency Act—A federal statute that provides that internet service providers (ISPs) are not liable for the content transmitted over their networks by email users and websites.  Controlling the Assault of Non-Solicited Pornography and Marketing Act (CAN-SPAM Act)—Prohibits spammers from using falsified headers in email messages and prohibits deceptive subject lines that mislead a recipient about the contents or subject matter of the message.  Cybersquatting—Sometimes a party will register a domain name of another party’s trademarked name or famous person’s name. This is called cybersquatting.  Domain name—A unique name that identifies an individual’s or company’s website.  Electronic agent—Any computer system that has been established by a seller to accept orders.  Electronic commerce (e-commerce)—The sale of goods and services by computer over the internet.  Electronic license (e-license)—A contract whereby the owner of software or a digital application grants limited rights to the owner of a computer or digital device to use the software or digital application for a limited period and under specified conditions.  Electronic licensee (e-licensee)—The owner of the computer or digital device to whom the license is granted is the electronic licensee, or e-licensee.  Electronic licensor (e-licensor)—The owner of the program or application is the electronic licensor, or e-licensor.  Electronic mail (email)—Electronic written communication between individuals using computers connected to the internet.

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              

   

Electronic mail contract (email contract)—A contract that is entered into by the parties by use of email.

Electronic signature (e-signature)—The Electronic Signatures in Global and National Commerce Act (E-SIGN Act) recognizes an electronic signature, or e-signature. The act gives an e-signature the same force and effect as a pen-inscribed signature on paper.

Electronic Signatures in Global and National Commerce Act (E-SIGN Act)—This act is designed to place the world of electronic commerce on a par with the world of paper contracts in the United States.

Exclusive license—A license that grants the licensee exclusive rights to use informational rights for a specified duration.

Internet—A collection of millions of computers that provide a network of electronic connections between computers.

Internet Corporation for Assigned Names and Numbers (ICANN)— The organization that oversees the registration and regulation of domain names.

Internet service provider (ISP)—Websites and web pages are stored on servers throughout the world, which are operated by internet service providers (ISPs).

License—Grants a person the right to enter another’s property for a specified and usually short period of time.

Licensee—The party who is granted limited rights in or access to intellectual property or informational rights owned by the licensor.

Licensing agreement—Detailed and comprehensive written agreement between the licensor and licensee that sets forth the express terms of their agreement.

Licensor—The owner of intellectual property or informational rights who transfers rights in the property or information to the license.

Spam—Spam is unsolicited commercial advertising.

Text contracts—Contracts entered into by parties by use of text messaging.

Text messaging (texting)—Along with electronic mail (email), one of the most widely used applications for communication over the internet.

Top-level domain names (TLDs)—Prior to 2011, there were 22 top-level domain names (TLDs). The most used was .com, as well as .net, .org, .biz, and others. The new rules permit companies to have their own company name TLD suffixes, such as .canon, .google, .cocacola, and such.

Uniform Computer Information Transactions Act (UCITA)—A model act that provides uniform and comprehensive rules for contracts involving computer information transactions and software and information licenses.

Web—An electronic connection of millions of computers and electronic devices that support a standard set of rules for the exchange of information.

Web contract—A contract that is entered into by purchasing, leasing, or licensing goods, services, software, or other intellectual property from websites operated by sellers, lessors, and licensors.

Website—Large and small businesses sell goods and services over the internet through websites and registered domain names.

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Chapter 12 Sales Contracts, Leases, and Warranties What is a good?

I. Teacher to Teacher Dialogue Students for a number of reasons sometimes meet the introduction of materials on the Uniform Commercial Code (UCC) with a degree of resistance. First, it appears to be more technically complicated than the common law of contracts or torts. Second, it seems to be somewhat repetitive in that it sounds like "Contracts Verse Two." Because of these predispositions to the UCC, it might be worth it to stress the importance of the law as being a facilitator, rather than an impediment, to the flow of commerce and to discuss the concept of “merchant” from a business sense.

This might include examples of the need for holding merchants to a high standard of imputed knowledge about the usage and trade or norms within their respective areas of commerce.

Possibly remind students that the UCC is designed for the “fast track” of commerce by providing for maximum flexibility vis-à-vis formation, modification, and termination of commercial contracts. Also, it might be helpful to remind them of the simple truth that the essential ingredients of common law notions of fair play, good faith, and the like are carried over into the UCC by way of the doctrine of conscionability.

Of importance to an understanding of the UCC is to examine the Code as a specialized body of contract law, appearing to have eclipsed the common law of contracts, maintaining the portions of the common law it needs. The UCC is intended to cover a number of areas of contracts formerly resolved by common law, but the basic elements for both are the same. What is vastly different is the implementation of how those elements are arrived at in the light of commercial realities.

Early on, the Law Merchant of England set up special rules for commercial contracts with the realization that the law should be written to foster and encourage commerce rather than encumber it. The early faire courts were established by and for merchants. They were designed to have law reflect the needs of commerce. Some of the principles that evolved included: 1. Holding merchants to a higher standard.

2. Providing for uniformity of interpretation for commercial contracts.

3. Providing for more flexibility in the formation, modification, and termination of commercial contracts.

4. Retaining the common law essential ingredients of equity, fair play, good faith, and conscionability in commercial dealings.

The UCC is the descendent of the Law Merchant. Its predecessor, the 1906 Uniform Sales Act, was ultimately adopted by thirty-seven states. It was, in turn, eclipsed by the UCC beginning in 1952. The authors believed that the law should reflect the realities of commerce that are working rather than impose unnecessary obstacles or impediments to business. The UCC has been adopted, at least in part, in all fifty states. It continues to be one of the single most important legislative enactments in American legal history. It is updated and revised in order to keep up with the changing realities of the marketplace.

The rules of UCC contract performance, remedies, and the like constitute a set not only of standards of commercial behavior, but also of fallback expectations imposed on the parties if they fail to anticipate the issue in the initial contract. The same holds true in the law of wills. If the

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decedent did not act on how his or her estate is to be disposed of, the state decides for him or her by way of an intestate statute. The second lesson to be learned is an implied message that one has much more control over one's rights in UCC commercial contracts than one thinks. It is just that the law is not necessarily coined to protect the legally lazy. These performance obligations will be imposed on those who are. A third point is that all contract obligations under the UCC come under the umbrella of good faith and conscionability. This includes not only the performance obligations listed in this chapter's materials, but also any contractual modifications entered into by the parties.

One major issue that must be faced is the possibility that goods are damaged or claimed before they arrive. Who then bears the risk of loss and/or has the titled passed? Does any of this affect either parties’ obligations? This is the focus of this chapter. Other performance issues are addressed later in the text. The problem here is one of timing. If the answer is built into the contract, use it. Otherwise we must look to default rules. But make sure to enforce the concept of common sense because it does work here.

In UCC sales contracts, the seller makes the opening performance gesture. The seller’s duties are twofold: he or she must tender delivery of goods, and those goods must conform perfectly to the terms of the contract. If these obligations have been met, the duty shifts to the buyers to live up to their end of the deal. The basic duties of a buyer are found in the inspection process, acceptance of the delivery, and payment for the goods. Where both parties have lived up to their respective obligations, the normal performance obligations of the UCC have been satisfied.

Sometimes, extraordinary situations arise which may modify or excuse these basic performance duties. These sections of the code attempt to anticipate and answer problematic situations that arise in the fast paced world of business. The interesting and innovative aspect of many of these modifications of basic performance duties is that the UCC seeks to provide anticipatory sorts of changes, i.e., changes which seek to mitigate the problems rather than waiting too long and letting too much damage occur. Take, for example, the doctrines of anticipatory repudiation and adequate assurance. In both cases, the UCC says if one of the parties is seeing himself sink into commercial quicksand, he should not have to wait until he is neck deep before he can yell for legal help. These provisions are designed to allow performance modifications that will lessen the ultimate harm done by the breaching party.

The second set of UCC performance obligations reviewed in this chapter center around lease contracts entered into under Article 2A. One of the most interesting recent trends in the nation is the explosive growth of personal property leasing by both business entities and individuals. Prior to this trend, leases were considered to be the domain of real property law. The advent of highly leveraged buyouts and sophisticated techniques has made the use of debt rather than equity a way of life for many. In that light, it is really no surprise to see widespread leasing replace ownership in many areas of commerce. For example, a very high percentage of autos are leased rather than owned. Article 2A is the UCC’s attempt to keep up with this economic reality. Article 2A is designed to reflect existing leasing practices while clarifying the respective rights and duties of the parties to the transaction. The basic rules of common law contracts, as amended by the UCC, are carried over into Article 2A. The writing requirements have been tailored to fit the lease transaction, and the exceptions to the writing requirement are virtually the same as found in Article 2 of the code, as are the performance obligations and remedies.

Finally, the UCC allows for excuse from performance in a limited set of circumstances.

These circumstances are impossibility and commercial impracticability. In both cases, the circumstances need to have been unforeseeable and to enforce performance now would be inequitable in light of the changed situation. One must keep in mind, however, that these doctrines are not intended to be used as a back door to get out from under binding contract obligations. The burden of proof on the person claiming excuse is a heavy one.

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possibilities of common law tort remedies as well as the whole gambit of products liability law.

We probably should constantly try to remind students of the wide and varied menu of remedies they have to work with.

The UCC rules of warranty are a statutory set of buyer protections. There are five common denominators applicable to all warranties. First, determine whether any sort of warranty may be in existence either by acts of the parties or by imposition of law. Examine the scope and nature of the promises or assurances made under the alleged warranty. Second, decide if there has been any nonconformance with the terms of the warranty in the time frame covered by the transaction. This time frame may be limited to just the initial sale, or the period of performance may have been extended by way of post-sale promises. Third, if there has been a breach of warranty by reason of nonconformity to the promises made, has this breach caused an injury of any sort? Fourth, ascertain the measure of the alleged injury. Finally, are there any defenses, contractual or otherwise, applicable in this case? Remember also, warranties represent only one path to dealing with the problem. Other avenues may include tort law, consumer protection statutes, and equitable remedies.

II. Chapter Objectives 1. Describe the Uniform Commercial Code (UCC).

2. Define sales contracts governed by Article 2 of the UCC. 3. Define lease contracts governed by Article 2A of the UCC. 4. Describe the formation of sales and lease contracts.

5. Describe how Revised Article 2 (Sales) and Article 2A (Leases) permit electronic contracting.

6. Identify the party who bears the risk of loss of goods that are damaged or lost.

7. Identify the party who bears the risk of loss when goods are sold by nonowners to third parties.

8. List and describe remedies available to sellers, lessors, buyers, and lessees when there has been a breach of a sales or lease contract.

9. Describe warranties that apply to the sales and lease of goods.

10. Describe express warranties and distinguish them from statements of opinion.

11. List and describe implied warranties that may arise in the sale and lease of goods.

12. Identify warranty disclaimers and determine when they are lawful.

III. Key Question Checklist  Is this contract covered by one or more of the provisions of Article 2 or 2A of the UCC?  What is the status of the parties entering into this agreement?  Are the proper elements of formation of a contract in place?  What UCC rules of interpretation would you use in this case?  Are there any allowable contract modifications?  When does title pass in sales contracts?  When does the responsibility for loss of goods transfer from buyer to seller?  Does this contract come under the purview of the UCC?  Was an explicit agreement entered into by the parties regarding warranties?  What type(s) of warranties may be imposed by the UCC? IV. Chapter Outline Introduction to Sales Contracts, Leases, and Warranties – Most tangible items are considered goods. From early times, merchants developed their own set of rules and customs that controlled contracts and disputes. In England, these evolved into the Law Merchant courts that were eventually absorbed into the common law. Because of the intricacies of dealing with commercial 123 .

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contracts, the U.S. passed the Uniform Sales Act in the early 1900s. As we continued to industrialize, the Act become outdated, and the National Conference of Commissioners on Uniform State Laws promulgated the Uniform Commercial Code, which covers most aspects of commercial transactions.

Uniform Commercial Code (UCC) – The Uniform Commercial Code (UCC) is a model act divided into articles, with each article establishing uniform rules for a facet of commerce. It is continually being revised to reflect changes in modern commercial practices.

Article 2 (Sales) – Every state (except Louisiana, which has adopted only parts of the UCC) has enacted the UCC or the majority of the UCC as a commercial statute.

Landmark Law: Uniform Commercial Code (UCC) The UCC is a model act drafted by the American Law Institute and the National Conference of Commissioners on Uniform State Laws. This model act contains uniform rules that govern commercial transactions. The articles of the UCC are as follows: Article 1: General Provisions Article 2: Sales Article 2A: Leases Article 3: Negotiable Instruments Article 4: Bank Deposits Article 4A: Funds Transfers Article 5: Letters of Credit Article 6: Bulk Transfers and Bulk Sales Article 7: Warehouse Receipts, Bills of Lading, and Other Documents of Title Article 8: Investment Securities Article 9: Secured Transactions What Is a Sale? – A sale is when title of goods passes from a seller to a buyer for a price.

What Are Goods? – Goods are tangible, moveable items. Article 2 establishes that money, stocks, bonds, patents, and real estate are not tangible goods.

Goods Versus Services – Services are not covered by Article 2, unless it is a mixed sale and the goods make up a predominant part of the sale.

Article 2A (Leases) – Article 2A directly addresses personal property leases.

Definition of Lease – A lease is the transfer of the right to possession and use of the goods for a set period for consideration. The lessor transfers possession of the goods to a lessee.

Formation of Sales and Lease Contracts – A sales and lease contract requires an offer and acceptance, the same as any other contract.

Open Terms – The UCC allows that contracts will not fail for indefiniteness if the parties intended to make a contract and there is a reasonable basis for giving an appropriate remedy. The courts will apply the gap-filling rule to cover price terms, payment terms, delivery terms, time terms, and assortment terms that have been left open. Examples of open terms include: (1) Open Price Term – This implies a reasonable price is implied at the time of delivery.

(2) Open Payment Term – If the contract is silent, payment is due at the time and place that the goods are received.

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(3) Open Delivery Term – If the contract is silent, delivery is at the seller’s place of business. If there is no place of business, then it is at the seller’s residence.

(4) Open Time Term – If no time for performance is set in the contract, then performance must be within a reasonable time.

(5) Open Assortment Term – Buyer must make a selection in good faith and within the limits of commercial reasonableness.

Business Environment: UCC Firm Offer Rule The UCC states that a merchant that offers to sell, lease, or buy goods and gives a separate assurance that the offer will be held open for a stated time period or for a reasonable time, cannot revoke the offer. A merchant is also prevented from revoking an options contract. All other offers may be revoked at any time prior to its acceptance.

Acceptance – Under both common law and the UCC, a contract is created when it is sent to the offeror, not when it is received, provided it has been accepted in the manner and medium indicated, or if none is indicated, in a reasonable method and mode. The UCC permits acceptance by any manner or method.

Business Environment: UCC Permits Additional Terms The UCC allows additional terms or modified terms in an acceptance unless the acceptance is expressly conditional on assent to those terms. If one or both parties are nonmerchants, the modifications are considered proposed additions to the contract.

Business Environment: UCC “Battle of the Forms” There is no contract if the additional terms so materially alter the terms of the original offer that the parties cannot agree on the contract.

UCC Statute of Frauds – All contracts for the sale of goods costing $500 or more and lease contracts of $1000 or more must be in writing.

Business Environment: UCC Written Confirmation Rule UCC 2-201(2) stipulates that the confirmation is sufficient when the party to whom it is sent has reason to know its contents.

Identification of Goods – Identification can be made at any time and in any manner agreed upon by the parties. If the goods are not identified in the contract, the UCC establishes when identification occurs. Existing goods are identified when the goods are identified in the contract.

If they are part of a larger group, they are identified when designated or separated out. Future goods are identified when the young are conceived or crops planted.

Passage of Title – The title to goods passes in any method agreed to by the parties. Absent an agreement to the contrary, title passes when delivery is completed. In a shipment contract, the seller must ship the goods to the buyer via a common carrier and the seller is required to make proper shipping arrangements and deliver the goods into the carrier’s hands. Title passes to the buyer at the time and place of shipment. In a destination contract, the seller must deliver the goods either to the buyer’s place of business or to another destination specified in the sales contract. Title passes to the buyer when the seller tenders delivery of the goods at the specified destination.

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lease transactions. Definitions of terms associated with electronic commerce, and their implications, include: (1) Electronic—relating to technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities.

(2) Electronic agent—a computer program or an electronic or other automated means used independently to initiate an action or respond to electronic records or performances in whole or in part, without review or action by an individual.

(3) Electronic record (e-record)—a record created, generated, sent, communicated, received, or stored by electronic means.

(4) Electronic signature (e-signature)—the signature of a person that appears on an electronic record and is recognized as a lawful signature.

Risk of Loss – Although common law places the risk of loss on the party who had the title, the UCC allows the parties to agree on who will bear the risk. In a shipment contract, the risk of loss passes to the buyer when the seller delivers the conforming goods to the carrier; the buyer bears the risk of loss of the goods during transportation. In a destination contract the seller bears the risk of loss of the goods during their transportation; the risk of loss does not pass until the goods are tendered to the buyer at the specified destination.

Business Environment: Commonly Used Shipping Terms This section covers commonly used shipping terms. FOB (free on board) point of shipment requires that the seller arrange for the shipment of goods and be responsible for them until they are received at the common carrier. FAS (free alongside ship) requires that the seller bear the responsibility for the goods until they are delivered alongside a vessel or at a dock. CIF is cost, insurance, and freight, while C&F is cost and freight. FOB (free on board) place of destination requires the seller to bear the expense and risk of loss until the goods are tendered to the buyer at the place of destination. Ex-ship (from the carrying vessel) requires the seller to bear the expense and risk until the goods are unloaded. A no-arrival, no-sale contract requires the seller to bear the expense and risk of loss during transportation. If the goods do not reach the buyer, the seller is under no obligation to replace the shipment.

Sales of Goods by Nonowners – Sometimes people sell goods even though they do not hold valid title to them. The UCC anticipated many of the problems this situation could cause and established rules concerning the title, if any, that could be transferred to purchasers.

Stolen Goods – If a buyer has purchased goods from a thief, the real owner can reclaim the goods from the purchaser or lessee. This is called void title.

Fraudulently Obtained Goods – The seller has voidable title if the goods are obtained by fraud.

However, the buyer can transfer good title to a good faith purchaser for value.

Entrustment Rule – If an owner entrusts possession of goods to a merchant, the merchant can transfer the goods to a buyer in the ordinary course of business.

Remedies for Breach of Sales and Lease Contracts – Goods that are accepted must be paid for.

Buyers often purchase goods on credit extended by the seller. Unless the parties agree to other terms, the credit period begins to run from the time the goods are shipped. A lessee must pay lease payments in accordance with the lease contract.

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Seller’s and Lessor’s Remedies – Various remedies are available to sellers and lessors if a buyer or lessee breaches a sales or lease contract. The remedies available depend on whether the goods are in the possession of the seller or lessor, a carrier or bailee, or the buyer or lessee.

Goods in the possession of the seller or lessor:  Withhold delivery of the goods  Demand payment in cash if the buyer is insolvent  Resell or release the goods and recover the difference between the contract or lease price and the resale or release price  Sue for breach of contract and recover as damages either of the following:  The difference between the market price and the contract price  Lost profits  Cancel the contract Goods in the possession of a carrier or bailee:  Stop goods in transit  Carload, truckload, planeload, or larger shipment if the buyer is solvent  Any size shipment if the buyer is insolvent Goods in the possession of the buyer or lessee:  Sue to recover the purchase price or rent  Reclaim the goods  The seller delivers goods in cash sale, and the buyer’s check is dishonored  The seller delivers goods in a credit sale, and the goods are received by an insolvent buyer Buyer’s and Lessee’s Remedies – The UCC provides a variety of remedies to a buyer or lessee upon the seller’s or lessor’s breach of a sales or lease contract, depending on the following scenarios: Seller or lessor refuses to deliver the goods or delivers nonconforming goods that the buyer or lessee does not want:  Reject nonconforming goods  Revoke acceptance of nonconforming goods  Cover  Sue for breach of contract and recover damages  Cancel the contract Seller or lessor tenders nonconforming goods and the buyer or lessee accepts them:  Sue for ordinary damages  Deduct damages from the unpaid purchase or rent price Seller or lessor refuses to deliver the goods and the buyer or lessee wants them:  Sue for specific performance  Replevy the goods  Recover the goods from an insolvent seller or lessor Agreements Affecting Remedies – The UCC permits parties to a sales or lease contract to establish in advance in their contract the damages that will be paid upon a breach of the contract.

Such preestablished damages, called liquidated damages, substitute for actual damages.

Warranties – Warranties are the buyer’s or lessee’s assurance that the goods meet certain standards. Article 2 of the UCC establishes certain warranties that apply to the sale of goods.

Express Warranty – An express warranty is created when a seller or lessor states orally, in writing, or through inferences that the goods meet a certain standard of quality, performance, or 127 .

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condition. No formal words are necessary to create an express warranty. Puffing and commendation of goods do not create an express warranty, nor does as an affirmation of the value of the goods.

Implied Warranty – Implied warranties are not expressly stated in the sales or lease contract but are instead implied by law. The most common forms of implied warranties are (1) the implied warranty of merchantability, (2) the implied warranty of fitness for human consumption, and (3) the implied warranty of fitness for a particular purpose.

Implied Warranty of Merchantability – If the seller is a merchant normally dealing in the goods sold, there is an implied warranty of merchantability that the goods are fit for the purpose sold, that they are adequately contained, packaged, and labeled, and that they are of an even kind and quality. This warranty also means that the goods conform to all promises on their container, that their quality would pass without objection in the trade, and if they are fungible goods, that they are of at least average quality for the type of goods that they are.

Federal Court Case Case 12.1 Implied Warranty of Merchantability: Osorio v. One World Technologies, Inc. Facts: Osorio worked for a hardwood floor contractor. One day, he cut his left hand severely while using his employer’s table saw. Osorio sued the table saw manufacturer, Ryobi Technologies, Inc. (Ryobi) for breach of the implied warranty of merchantability. At trial, Osorio introduced an expert witness who testified that the technology existed to stop the saw when it comes into contact with flesh. Ryobi had not incorporated such technology into its saw. The jury found in favor of Osorio due to breach of the implied warranty of merchantability. Ryobi appealed.

Issue: Did Ryobi breach the implied warranty of merchantability?

Decision: The U.S. court of appeals affirmed the U.S. district court’s finding that Ryobi breached the implied warranty of merchantability.

Reason: Manufacturers must design products so that they are fit for the ordinary purposes for which such goods are used.

Ethics Questions: The use of such technology is usually a function of the cost of incorporating the technology into the product versus potential product liability for design defect. In terms of consumer impact, incorporation of such technology would likely serve to increase product price, but would also reduce the likelihood of severe injury to consumers.

Federal Court Case Case 12.2 Implied Warranty of Merchantability: Geshke v. Crocs, Inc. Facts: Crocs, Inc. makes odd-looking shoes called CROCS, a type of soft-soled resin clog that are known for their comfort. Nancy Geshke’s 9-year-old daughter N.K. wore a pair of CROCS when she and her mother and father visited Boston. The family boarded a descending escalator operated by the Massachusetts Bay Transportation Authority (MBTA). N.K.’s CROCS-shod right foot became entrapped in the side of the moving escalator. While N.K. screamed, an MBTA worker unsuccessfully attempted to activate the escalator’s emergency brake. A bystander rushed to the rescue, freeing N.K.’s foot before she reached the bottom plate. N.K. suffered injuries from the accident. Nancy Geshke, as mother and guardian of N.K., a minor, sued Crocs, Inc. for damages, alleging that it violated the implied warranty of merchantability by designing CROCS that present a heightened risk of danger to wearers using escalators, and that the manufacturer failed to warn of the risk. The U.S. district court found that the plaintiff’s allegations were unsupported and entered summary judgment in favor of Crocs, Inc. Geshke appealed.

Issue: Did Crocs, Inc. breach the implied warranty of merchantability of the safety of its CROCS footwear and fail to warn of such danger?

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Decision: The U.S. court of appeals affirmed the district court’s grant of summary judgment in favor of Crocs, Inc. Reason: According to the U.S. court of appeals, the plaintiff failed to introduce probative evidence that the defendant’s product was particularly dangerous on escalators; therefore, Crocs, Inc. owed no duty to warn.

Ethics Questions: Admittedly, a sympathetic plaintiff (a minor child) was involved in this case.

However, product liability law does not compel a product manufacturer to be an absolute insurer of the consumer’s safety, nor does it require a duty to warn of danger in all circumstances. As the U.S. court of appeals indicated in its decision, the evidence in this case did not establish that the defendant’s product was defective, nor did it indicate that the defendant’s product was especially dangerous on escalators.

Implied Warranty of Fitness for Human Consumption – This is an implied warranty that food and drink served by purveyors of food and drink (for example, restaurants and grocery stores) are safe for human consumption. The majority of states have adopted the “consumer expectation test” to determine the merchantability of food products. Under this test, the court asks what a consumer would expect to find or not find in food or drink that is consumed.

Implied Warranty of Fitness for a Particular Purpose – The UCC contains an implied warranty of fitness at the time of contracting if the seller knows the particular purpose that the buyer will be using the goods for, the seller makes a statement that the goods will serve that purpose, and the buyer relies on the statement.

Warranty Disclaimers – Express warranties can be limited by disclaimers, if the warranty and disclaimer can be construed together. Implied warranties of quality can be disclaimed by use of “as is,” “with all faults,” etc. Implied warranties of merchantability must be specifically disclaimed, while implied warranties of fitness can be generally disclaimed. Written disclaimers must be clearly noticeable by a reasonable person; i.e., they must be conspicuous.

State Court Case Case 12.3 Warranty Disclaimer: Roberts v. Lanigan Auto Sales Facts: Evan Roberts purchased a used vehicle from Lanigan Auto Sales. The sales contract contained a clause stating that the vehicle was “sold as is.” Subsequently, Roberts obtained a report that stated that the vehicle had previously been involved in an accident and suffered damage to the undercarriage of the vehicle. Roberts sued Lanigan for damages, alleging that Lanigan breached express and implied warranties by not disclosing the vehicle’s prior damage and accident history. Lanigan maintained it had never represented the quality of the vehicle and filed a motion to dismiss Robert’s action. The trial court dismissed Robert’s action on the basis that the sales contract contained the express term that the vehicle was “sold as is.” Roberts appealed.

Issue: Did the “sold as is” language of the sales contract bar Robert’s action?

Decision: The court of appeals affirmed the trial court’s decision that the “sold as is” language in the sales contract prevented Roberts from recovering damages from Lanigan Auto Sales. The Supreme Court of Kentucky affirmed the decision.

Reasoning: According to the Court of Appeals of Kentucky, a valid “as is” agreement prevents a buyer from holding a seller liable if the thing sold turns out to be worth less that the price paid.

Ethics Questions: Arguably, used car sales is one of the most important segments of the consumer economy that merits government regulation, since the bargaining relationship between seller and buyer is unequal (i.e., the seller is better-trained in the “art of the deal.”) Even so, the “as is” disclaimer is one of the most important tools used car sellers can use to avoid liability for an automobile that is discovered to be defective post-purchase. Without a duty to volunteer 129 .

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information of the type described in this case, it is incumbent upon buyers to ask specific questions to the seller before purchase (for example, “Has this car ever been involved in an accident?”), demand answers, and hold sellers responsible for fraud if they give factually inaccurate answers. This case also illustrates the importance of a prospective buyer getting an independent inspection of the used automobile prior to purchase.

Landmark Law: Magnuson-Moss Warranty Act This Act allows for full and limited warranties of consumer products. To qualify for a full warranty, the seller must guarantee free repair or replacement during a certain time period. In a limited warranty, the warrantor limits the scope of a full warranty. These warranties must be conspicuously displayed. There is no requirement that an express warranty be created, but if one is, it must be disclosed if it is a full or limited warranty.

Global Law: United Nations Convention on Contracts for the International Sale of Goods (CISG) The CISG is a model act for international sales contracts. The CISG provides legal rules that govern the formation, performance, and enforcement of international sales contracts entered into between international businesses. The CISG applies to contracts for the international sale of goods. The buyer and seller must have their places of business in different countries.

V. Key Terms and Concepts  Additional terms—In certain circumstances, the Uniform Commercial Code (UCC) permits an acceptance of a sales contract to contain additional terms and still to act as an acceptance rather than a counteroffer.  Article 2 (Sales)—An article of the UCC that governs contracts for the sale of goods.  Article 2A (Leases)—An article of the UCC that governs leases of goods.  “As is” disclaimer—Expressions such as “as is,” with all faults, or other language that makes it clear to the buyer that there are no implied warranties and disclaims all implied warranties.  Battle of the forms—A UCC rule that states that if both parties are merchants, then additional terms contained in the acceptance become part of the sales contract unless (1) the offer expressly limits the acceptance to the terms of the offer, (2) the additional terms materially alter the original contract, or (3) the offeror notifies the offeree that he or she objects to the additional terms within a reasonable time after receiving the offeree’s modified acceptance.  Buyer in the ordinary course of business—A person who, in good faith and without knowledge that the sale violates the ownership or security interests of a third party, buys the goods in the ordinary course of business from a person in the business of selling goods of that kind. A buyer in the ordinary course of business takes the goods free of any third-party security interest in the goods.  Caveat emptor—The doctrine of caveat emptor—“let the buyer beware”—governed the law of sales and leases for centuries.  C.&F. (cost and freight)—It is a pricing term that means that the price includes the cost of the goods and the cost of freight.  C.I.F. (cost, insurance, and freight)—It is a pricing term that means that the price includes the cost of the goods, the costs of insurance, and the costs of freight.  Conspicuous disclaimer—A disclaimer that is noticeable to a reasonable person.  Consumer expectation test—Used in a majority of states to determine the merchantability of food products. Under this test, the court asks what a consumer would expect to find or not find in food or drink that is consumed.

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Consumer products—Products that are sold to individuals for personal consumption.

Counteroffer—The inclusion of additional terms in the acceptance is considered a counteroffer rather than an acceptance.

Destination contract—A contract that requires the seller to deliver the goods either to the buyer’s place of business or to another destination specified in the sales contract.

Disclaimer of the implied warranty of fitness for a particular purpose—A statement that negates the implied warranty of fitness for a particular purpose (e.g., use of the term “as is”).

Disclaimer of the implied warranty of merchantability—A statement that negates the implied warranty of merchantability (e.g., use of the term “as is”).

Electronic—Relating to technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities.

Electronic agent—A computer program or an electronic or other automated means used independently to initiate an action or respond to electronic records or performances in whole or in part, without review or action by an individual.

Electronic lease contract (e-lease contract)—Revised Article 2A (Leases) establishes the rules for electronic lease contracts.

Electronic record (e-record)—A record that is created, generated, sent, communicated, received, or stored by electronic means.

Electronic sales contract (e-sales contract)—Revised Article 2 (Sales) establishes the rules for electronic sales contracts (e-sales contracts).

Electronic signature (e-signature)—An electronic signature is attributable to a person if it was the act of the person or the person’s electronic agent.

Entrustment rule—The real owner cannot reclaim the goods from a buyer in the ordinary course of business.

Ex-ship (from the carrying vessel)—Requires the seller to bear the expense and risk of loss until the goods are unloaded from the ship at its port of destination.

Express warranty—A warranty that is created when a seller or lessor makes an affirmation that the goods he or she is selling or leasing meet certain standards of quality, description, performance, or condition.

F.A.S. (free alongside ship) port of shipment—Requires the seller to deliver and tender the goods alongside the named vessel or on the dock designated and provided by the buyer.

F.A.S. (vessel) port of shipment—See F.A.S. (free alongside ship) port of shipment.

Firm offer rule—A UCC rule that says that a merchant who (1) makes an offer to buy, sell, or lease goods, and (2) assures the other party in a separate writing that the offer will be held open cannot revoke the offer for the time stated or, if no time is stated, for a reasonable time.

F.O.B. (free on board) point of shipment—Requires the seller to arrange to ship the goods and put the goods in the carrier’s possession.

F.O.B. (free on board) place of destination—Requires the seller to bear the expense and risk of loss until the goods are tendered to the buyer at the place of destination.

Full warranty— For a warranty to qualify as a full warranty, the warrantor must guarantee that a defective product will be repaired or replaced free during the warranty period.

Gap-filling rule—A rule that says an open term can be “read into” a contract.

Good faith purchaser for value—A person to whom good title can be transferred from a person with voidable title. The real owner cannot reclaim goods from a good faith purchaser for value.

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Good faith subsequent lessee—A person to whom a lease interest can be transferred from a person with voidable title. The real owner cannot claim the goods from the subsequent lease until the lease expires.

Goods—Tangible things that are movable at the time of their identification to the contract.

Identification of goods—Distinguishing the goods named in the contract from the seller’s or lessor’s other goods.

Implied by law—Not expressed, but still recognized by operation of law. For example, implied warranties (the implied warranty of merchantability, the implied warranty of fitness for human consumption, and the implied warranty of fitness for a particular purpose) are not expressly stated in a sales or lease contract, but are instead implied by law.

Implied warranties—Warranties that are not expressly stated in a sales or lease contract, but are instead implied by law. Examples include the implied warranty of merchantability, the implied warranty of fitness for human consumption, and the implied warranty of fitness for a particular purpose.

Implied warranty of fitness for a particular purpose—A warranty that arises when a seller or lessor warrants that the goods will meet the buyer’s or lessee’s expressed needs.

Implied warranty of fitness for human consumption—A warranty that applies to food or drink consumed on or off the premises of restaurants, grocery stores, fast food outlets, and vending machines.

Implied warranty of merchantability—Unless properly disclosed, a warranty that is implied that sold or leased goods are fit for the ordinary purpose for which they are sold or leased; and other assurances.

Lease—A transfer of the right to the possession and use of the real property for a set term in return for certain consideration; the rental agreement between a landlord and a tenant.

Lease contract—In a lease contract, the lessor is the person who transfers the right of possession and use of goods under the lease.

Lessee—The person who acquires the right to possession and use of goods under a lease.

Lessor—The person who transfers the right of possession and use of goods under the lease.

Limited warranty—In a limited warranty, the warrantor limits the scope of the warranty in some way.

Liquidated damages—Damages that will be paid upon a breach of contract that are established in advance.

Magnuson-Moss Warranty Act—A federal statute that regulates written warranties on consumer products.

Mirror image rule—Under common law’s mirror image rule, an offeree’s acceptance must be on the same terms as the offer.

Mixed sale—A sale that involves the provision of a service and a good in the same transaction.

No-arrival, no-sale contract—Requires the seller to bear the expense and risk of loss of the goods during transportation.

Open price term—If a sales contract does not contain a specific price (open price term), a “reasonable price” is implied at the time of delivery.

Open terms—Certain open terms are permitted to be “read into” a sales or lease contract.

This rule is commonly referred to as the gap-filling rule.

Ordinary lease—In the case of an ordinary lease, if the lessor is a merchant, the risk of loss passes to the lessee on the receipt of the goods.

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Proposed additions—If one or both parties to a sales contract are nonmerchants, any additional terms are considered proposed additions to the contract.

Risk of loss—Under the common law of contracts, the risk of loss of goods is placed on the party who holds title to the goods.

Sale—The passing of title from a seller to a buyer for a price.

Sales contract—All states have held that Uniform Commercial Code (UCC) Article 2 applies to sales contracts for the sale of goods.

Shipment contract—A contract that requires the seller to ship the goods to the buyer via a common carrier.

Shipping terms—Many sales contracts contain shipping terms that have different legal meanings and consequences.

Statement of opinion (puffing)—A commendation of goods, made by a seller or lessor, that does not create an express warranty.

Title—Legal, tangible evidence of ownership of goods.

UCC Statute of Frauds—A state statute that requires certain types of contracts to be in writing.

Uniform Commercial Code (UCC)—Comprehensive statutory scheme that includes laws that cover most aspects of commercial transactions.

United Nations Convention on Contracts for the International Sale of Goods (CISG)— Provides legal rules that govern the formation, performance, and enforcement of international sales contracts entered into between international businesses. A model act for international sales contracts.

Void leasehold interest—A situation in which a thief acquires no title to goods he or she steals.

Void title—A thief acquires no title to the goods he or she steals.

Voidable leasehold interest—A title that a purchaser has on goods obtained by (1) fraud, (2) a check that is later dishonored, or (3) impersonation of another person.

Voidable title—Title that a purchaser has if the goods were obtained by (1) fraud, (2) a check that is later dishonored, or (3) impersonating another person.

Warranty—A buyer’s or lessee’s assurance that the goods meet certain standards.

Warranty disclaimer—Statements that negate express and implied warranties.

Written confirmation rule—A rule that provides that if both parties to an oral sales or lease contract are merchants, the Statute of Frauds writing requirement can be satisfied if (1) one of the parties to an oral agreement sends a written confirmation of the sale or lease within a reasonable time after contracting, and (2) the other merchant does not give written notice of an objection to the contract within ten days after receiving the confirmation.

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Chapter 13 Credit, Secured Transactions, and Bankruptcy What is a bankruptcy?

I. Teacher to Teacher Dialogue Credit One of the difficulties in teaching these materials is trying to steer students clear of a certain statutory myopia. They read these materials and often come to the conclusion that Article 9 and mortgages must be the main ways credit is extended in our economic system. Obviously, this view is far from true. Secured credit on sales of personal goods and real estate represent important pieces of a much bigger puzzle. Consider the entire realm of personal credit, corporate bonds, credit cards, letters of credit, and on and on. The list is virtually endless. Thus, it is incumbent upon us, as instructors, to put this material in perspective at the outset by reminding students of this larger universe.

In addition to creating a sense of relative proportion, this universal perspective allows us to impart another important point—that few credit problems are isolated. Most people who find themselves in credit difficulties feel like they are being compacted by a four-sided vice. When things go wrong, all sorts of collection actions are likely to occur from both secured and unsecured creditors. Raising awareness at this point helps prepare students for the materials that follow on both bankruptcy and other related areas such as real property.

Secured Transactions The study of secured transactions allows teachers to focus on two sides of the same coin. One involves the rights, duties, and obligations of the debtor and creditor. The statutory materials covered in Article 9 of the UCC are extensive, and there is a lot of latitude on how to present them.

The second side of the coin involves trying to ascertain rights, duties, and obligations after someone (usually the debtor) has had a problem. So much of the law of credit really concerns the establishment of an order of priorities between competing creditors.

Article 9 of the UCC is a particularly good example of the interaction between the old and new. The original sources of the law of secured transactions involving personal property can be found in a combination of common law contracts, real property law, debtor and creditor law, and the law of liens. The UCC has sought to interpolate the best elements of all these areas into a cogent and organized structured system of facilitating secured credit transactions for the sale of personal property.

This system is premised on the legal realism that merchants doing business with each other are expected to live up to a higher standard of both behavior and knowledge of the law. In addition, that same realism attempts to protect the innocent third parties’ good faith reliance on the legitimacy of the marketplace whenever possible. These ends are mainly sought through the use of the recording principles long established in real property law transactions. These rules are designed to give creditors notice not only of the debtor’s obligation, but even more important, to give notice to other creditors that this security-based transaction has taken place.

Several practical factors make the law of secured transactions in personal property particularly troublesome. First, compared to real estate, personal property is portable. Being more moveable, the role of making sure that the security interest attaches and stays with the goods is of critical importance. Second, in a society based on credit, there is a strong likelihood that most 134 .

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large personal goods, such as automobiles and the like, may have more than one creditor looking to that good as security. This reliance on that good may come from either the original acquisition of the good or from subsequent transactions after the good is acquired. The ordering of priorities between multiple creditors having claims to the same goods becomes a critical issue.

Finally, just as there are likely to be multiple creditors, so are there likely to be multiple users. The vertical chain of distribution starts with supplies of raw materials to manufacturers, distributors, and retailers. On the horizontal level, the users start with the consumer, his or her family, and go on to third party users or acquirers. With each shift, there lies the probability of having to recognize new duties and obligations with respect to all parties having a legal relationship to those goods. All in all, it can very quickly become complicated, but the UCC and the common law rules with regard to liens, surety, guaranty, and collection provide some very good rules for both debtor and creditor.

Bankruptcy The bankruptcy material presents an excellent opportunity to illustrate how law works as the end product of social philosophies and value judgments. The best place to start is with the “preenlightened” era of debtor’s prisons and the like. History shows us that earlier societies in Western Europe held debtors not only in low regard but sought to criminally punish those who could not repay their obligations. These views eventually gave way to the more liberal view that allows for a fresh start after proper procedures for debt discharge are used.

Debtor’s prisons were holding cells for economic hostages whose ability to get out was directly proportional to the debtor’s ability to get others to pay his debt for him. Many of those dungeons became so crowded that the New World became a dumping ground for detainees. As fate would have it, that migration was most fortuitous for our nation. Very often the same people who were in prison for debt were also the innovators, risk takers, and entrepreneurs who helped build a new economic system less encumbered by class mentalities.

The basic underlying premise of bankruptcy law is founded on a simple reality: bad things happen to good people. How many of us can really provide ourselves with a safe haven from financial disasters brought on by bad health, economic downturns, financial institution failures, and the like? The early bankruptcy laws of England first recognized that businesses can and do fail in spite of the best good faith efforts of their proprietors. That failure should not, in effect, act as a life sentence in keeping that business or its proprietor from reentering the marketplace.

Bankruptcy is really one of the earliest forms of recycling, a recycling of economic opportunity for good faith debtors who deserve a second chance.

As with any legal favor, there are people and business entities that get too greedy when asking for the benefit of the law. Bankruptcy is built on a cornerstone of good faith. Where debtors’ actions are motivated by bad faith attempts to avoid legitimate obligations, both the law and the larger societal public policy is subverted. The history of the law of bankruptcy is riddled with cases of clear abuse and creditor victimization that have created a dilemma for legislators who must draft bankruptcy statutes.

The recent history of federal reforms in the U.S. illustrates Congress’s attempts to deal with the dilemma of trying to make the law more humane while trying to curb abuses. The Bankruptcy Act of 1978 provided for sweeping reforms that sought to destigmatize bankruptcy in an economy that had grown too dependent on credit. Unfortunately, with this liberalization came a number of abuses of the law. Graduates of long and expensive professional studies began their lucrative careers with a bankruptcy discharge of school loans. Many consumers loaded up on all sorts of items on credit and kept them debt free after bankruptcy. Corporations began to use the reorganization provisions of the law as a management wedge to get out from under otherwise binding executory contracts, or even worse, tort judgments. Congress responded with the Bankruptcy Amendments and other legislation and subsequent revisions. This legislation sought to pull in the reins on many of these abuses.

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Specifically, Congress enacted the Bankruptcy Abuse Prevention and Consumer Act of 2005 which makes it more difficult for debtors to escape from their debts under federal bankruptcy law.

II. Chapter Objectives 1. Distinguish between unsecured and secured credit.

2. Describe security interests in real property and the foreclosure of mortgages.

3. Define secured transaction and describe how a security interest in personal property is created and perfected.

4. Compare surety and guaranty arrangements.

5. Describe bankruptcy law and list and describe the types of bankruptcy.

6. List and describe the various forms of personal bankruptcy.

7. Describe how businesses are reorganized using bankruptcy law.

III. Key Question Checklist  What is the difference between secured and unsecured credit?  What are the various ways in which security interests are created in real property?  What is a mechanic’s lien?  What is the difference between a surety arrangement and a guaranty arrangement?  What are the various types of properties that are covered by Article 9 of the UCC?  What are the basic elements of a security agreement required by Article 9 of the UCC?  How is the security interest perfected?  What priorities do the parties claiming rights to the collateral have vis-à-vis each other?  What may the creditor do if the debtor defaults?  What are the various types of bankruptcy?  Assuming Chapter 7 liquidation is sought, what procedural steps apply?  Assuming Chapter 11 reorganization is sought, what procedural steps apply?  Assuming Chapter 13 consumer debt adjustment is sought, what procedural steps apply?

IV. Chapter Outline Introduction to Credit, Secured Transactions, and Bankruptcy – The U.S. economy is a credit economy. Consumers borrow money to make major purchases. Because lenders are sometimes reluctant to lend large sums of money simply on the borrower’s promise to repay, many of them take a security interest in the property purchased or some other property of the debtor, which is called collateral. If the collateral is personal property, it is a secured transaction covered by Article 9 of the Uniform Commercial Code.

Congress has enacted federal bankruptcy laws that provide methods for debtors to be relieved of some debt or enter into arrangements to pay debts in the future. Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which makes it much more difficult for debtors to escape their debts under federal bankruptcy law.

Unsecured and Secured Credit – The party extending credit is the lender or creditor; the party borrowing the money is the borrower, or debtor.

Unsecured Credit – Instead of relying upon collateral to protect payment of a debt, the creditor relies on the debtor’s promise to pay. If the debtor fails to pay, the creditor may bring an action and obtain a judgment against the debtor. The debtor may be judgment-proof if they have little or no property or income that can be garnished.

Secured Credit – Collateral may be used to secure payment on a loan. If the debtor fails to pay when due, the collateral can be repossessed and sold to cover the amount of the loan. If the 136 .

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amount is insufficient to cover the loan, the creditor may sue to recover a deficiency judgment for the difference.

Security Interests in Real Property – A security interest in real property is created if an owner borrows money from a lender and pledges real estate as security for repayment of the loan.

Mortgage – A mortgage is a two-party instrument where the owner/debtor uses his or her real property to secure a mortgage from a creditor/mortgagee.

Note and Deed of Trust – Some states’ laws provide for the use of a deed of trust and note in place of a mortgage. The note is the instrument that evidences the borrower’s debt to the lender; the deed of trust is the instrument that gives the creditor a security interest in the debtor’s property that is pledged as collateral.

Recording Statute – Recording statutes require that mortgages and deeds of trust must be recorded in the county recorder’s office in the county in which the real property is located to put potential lenders and purchasers on notice as to any potential claims against a piece of property.

The nonrecordation of a mortgage or deed of trust does not affect either the legality of the instrument between the mortgagor and the mortgagee or the rights and obligations of the parties.

Foreclosure Sale – A foreclosure sale is a legal procedure by which a secured creditor causes the judicial sale of the secured real estate to pay a defaulted loan. Most states permit foreclosure by power of sale, although this must be expressly conferred in the mortgage or deed of trust. A power of sale is a right stated in a mortgage or deed that permits foreclosure without court proceedings and the sale of secured real estate through an auction.

Deficiency Judgment – Some states permit a deficiency judgment action to be brought to recover any deficiency after the sale from the mortgagor, while other states prohibit these actions under antideficiency statutes. Antideficiency statutes usually apply only to first purchase money mortgages.

Contemporary Environment: Antideficiency Statutes An antideficiency statute is a statute that prohibits deficiency judgments regarding certain types of mortgages, such as those on residential property. Antideficiency statutes usually apply only to first purchase money mortgages (i.e., mortgages that are taken out to purchase houses). Second mortgages and other subsequent mortgages, even mortgages that refinance the first mortgage, usually are not protected by antideficiency statutes.

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Right of Redemption – The right of redemption is a right that allows the mortgagor to redeem real property after default and before foreclosure. It requires the mortgagor to pay the full amount of the debt incurred by the mortgagee because of the mortgagor’s default.

Business Environment: Construction Liens on Real Property Owners of real property often hire contractors and laborers to make improvements to that property. Their investments are protected by state statutes that permit them to file a construction lien (also known as a mechanic’s lien) against the improved real property. Mechanic’s liens are usually subject to the debtor’s right of redemption. In order to have a valid lien, a notice of lien must be filed within a statutorily specified period of time in the county recorder’s office which states the amount owed, the parties involved, and a description of the property, and notice must be sent to the owner of the real property. In order to protect their interests, real property owners should get a written release of lien from all contractors.

Secured Transactions in Personal Property – Lenders often take a security interest or collateral in purchased items or other property in order to protect their interests. These are known as secured transactions. Individuals and businesses purchase or lease various forms of tangible and intangible personal property. Tangible person property includes equipment, vehicles, furniture, computers, clothing, jewelry, etc., while intangible personal property includes securities, patents, trademarks, and copyrights. Often, a lender will extend unsecured credit to a debtor for the purchase of personal property, looking only to the credit standing of the debtor to repay the loan.

Two-party secured transactions occur when a seller sells goods to a buyer on credit and retains a security interest in the goods. Three-party secured transactions occur when a seller sells goods to a buyer who has obtained financing from a third-party lender who takes a security interest in the goods sold.

Landmark Law: Revised Article 9—Secured Transactions Revised Article 9 includes modern and efficient rules that govern secured transactions in personal property. Revised Article 9 includes changes to provisions that have been controversial in the past, as well as new provisions that recognize changes in the commercial environment. Revised Article 9 provides rules for the creation, filing, and enforcement of electronic secured transactions.

Security Agreement – Written security agreements must clearly describe the collateral, contain the debtor’s promise and a list of all terms, establish the creditor’s rights upon default by the debtor, and be signed by the debtor. The rights of a secured party attach to the collateral, provided that the debtor has a current or future right in or to possession of the collateral. Attachment gives the creditor an enforceable security interest against the debtor.

The Floating Lien Concept – A floating lien is one that may attach to a property that was not originally in the possession of the debtor when the agreement was executed.  After-Acquired Property – Any property obtained by the debtor after the security agreement is executed is called after-acquired property  Sale Proceeds – A secured party has the right to receive the proceeds from the sale of any collateral that the debtor disposes of  Future Advances – When a debtor establishes a revolving line of credit, he/she may designate personal property as collateral for future loans against the line of credit Perfecting a Security Interest – Perfecting a security interest will establish the right of a secured creditor against all other creditors who may claim an interest in a piece of collateral.

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1. Perfecting by Filing a Financing Statement – When it is either impractical or impossible for a creditor to take physical possession of collateral, they will often file a financing statement with an appropriate government office, containing the debtor’s name and mailing address, the name of the secured party, and a description of the collateral. Financing statements are good for five years, but may be extended by filing a continuation statement.

State Court Case Case 13.1 Filing a Financing Statement: Pankratz Implement Company v. Citizens National Bank Facts: Rodger House purchased a tractor on credit from Pankratz Implement Company with the tractor being the collateral. The creditor filed a financing statement with the Kansas Secretary of State using the misspelled name of the debtor, “Roger House.” Later, House obtained a loan from Citizens National Bank (CNB) by pledging all equipment that he owned and that he may own in the future as collateral for the loan. CNB filed a financing statement with the Kansas Secretary of State using the correct name of the debtor, “Rodger House.” Several years later, while still owing money to Pankratz and CNB, House filed for bankruptcy. Pankratz filed a lawsuit in Kansas trial court to recover the tractor. CNB challenged the claim, alleging that it should be permitted to recover the tractor. The court of appeals held that Pankratz’s misspelling of House’s first name was seriously misleading and held in favor of CNB. Pankratz appealed.

Issue: Is Pankratz’s filing of the financing statement under the wrong first name of the debtor seriously misleading?

Decision: The supreme court of Kansas affirmed the court of appeals judgment in CNB’s favor.

Reason: The supreme court of Kansas held that the misspelling of the debtor’s name misled creditors and was therefore ineffectual in giving CNB notice of Pankratz’s security interest in the tractor.

Ethics Questions: Students’ answers may vary. Neither of the parties acted unethically in this case. This was a legitimate legal dispute.

2. Perfection by Possession of Collateral – There is no filing requirement when the creditor has physical possession of the collateral.

3. Perfection by a Purchase Money Security Interest in Consumer Goods – Creditors may issue a written purchase money security interest in consumer goods without filing a financing statement or taking possession of the goods through perfection by attachment or the automatic perfection rule.

Priority of Claims – The UCC has established the following rules for determining priority among conflicting claims: 1. Secured versus unsecured claims—Secured creditors have priority over unsecured claims 2. Competing unperfected security interests—When there are two unperfected claims, the first to attach has priority 3. Perfected versus unperfected claims—When one security interest is perfected and the other is not, the perfected claim has priority 4. Competing perfected security interests—When there are two perfected claims, the first perfected claim takes priority Contemporary Environment: Buyer in the Ordinary Course of Business A buyer in the ordinary course of business who purchases goods from a merchant takes the goods free of any perfected or unperfected security interest in the merchant’s inventory, even if the buyer knows of the existence of the security interest.

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Default and Remedies – Article 9 of the UCC defines the rights, duties, and remedies of both the secured party and the debtor in the event of a default. Repossession of goods is the most common way to cure a default. The secured party may then either retain the collateral or sell them to satisfy the debt. A secure creditor who intends to retain the collateral must send notice to the debtor of his intentions, unless the debtor has renounced his rights in writing. A secured party who chooses not to retain the collateral may sell, lease, or otherwise dispose of it in its current condition. Unless otherwise agreed, after a debtor’s default, if the proceeds from the disposition of collateral are not sufficient to satisfy the debt to the secured party, the debtor is personally liable to the secured party for the payment of the deficiency.

Business Environment: Artisan’s Liens on Personal Property State statutes allow workers who supply goods or services to others to be protected by giving them a lien which will prevail over any other security interest in the goods. These super-priority liens are called artisan’s or mechanic’s liens.

E-Secured Transactions – Revised Article 9 (Secured Transactions) contains provisions that recognize the importance of electronic records. Record means information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form. The term record is now used in many of the provisions of Revised Article 9 in place of the term writing. Financing statements to perfect security interests in personal property may be in electronic form and filed and stored as electronic records. Most states permit or require the filing of electronic financing statements, or e-financing statements.

Surety and Guaranty Arrangements – Sometimes a creditor refuses to extend credit to a debtor unless a third person agrees to become liable on the debt. The third person’s credit becomes the security for the credit extended to the debtor. This relationship may be either a surety arrangement or a guaranty arrangement.

Surety Arrangement – This arrangement calls for a third person designated as the surety or codebtor to promise to stand for another’s debt. This surety is an accommodation party or cosigner, but along with the principal debtor, the surety is primarily liable for paying the principal debtor’s debt when it is due.

Guaranty Arrangement – In a guaranty arrangement, a third person, the guarantor, agrees to pay the debt of the principal debtor if the debtor defaults and does not pay the debt when it is due.

In this type of arrangement, the guarantor is secondarily liable on the debt.

Bankruptcy – Bankruptcy law is exclusively federal law; there are no state bankruptcy laws.

Congress enacted the original federal Bankruptcy Act in 1878.

Types of Bankruptcy – The major forms of bankruptcy filings are:  Chapter 7 Liquidation  Chapter 11 Reorganization  Chapter 12 Adjustment of Debt of a Family Farmer or Fisherman with Regular Income  Chapter 13 Adjustment of Debts of an Individual with Regular Income Landmark Law: Bankruptcy Code Over the years, Congress has adopted various bankruptcy laws. Federal bankruptcy law was completely revised by the Bankruptcy Reform Act of 1978. The 1978 act substantially changed— and eased—the requirements for filing bankruptcy. The 1978 act made it easier for debtors to rid themselves of unsecured debt, primarily by filing Chapter 7 liquidation bankruptcy.

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For more than a decade before 2005, credit card companies, commercial banks, and other businesses lobbied Congress to pass a new bankruptcy act that would reduce the ability of some debtors to relieve themselves of unwanted debt through bankruptcy. In response, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This act substantially amended federal bankruptcy law, making it more difficult for debtors to escape unwanted debt through bankruptcy.

Federal bankruptcy law, as amended, is called the Bankruptcy Code, which is contained in Title 11 of the U.S. code. The Bankruptcy Code establishes procedures for filing bankruptcy, resolving creditors’ claims, and protecting debtors’ rights.

Bankruptcy Procedure – Individuals, filing for bankruptcy, must receive counseling through accredited agencies before filing and after filing. Voluntary petitions can be filed by a debtor under the Chapter 7, 11, 12, or 13 bankruptcy clauses. Debtors may be forced into involuntary bankruptcy in the case of either a Chapter 7 or 11 bankruptcy case. A creditor must file a proof of claim stating the amount of his or her claim against the debtor and generally it should be filed within six months of the first meeting of the creditors. A bankruptcy trustee must be appointed in Chapter 7, Chapter 12, and Chapter 13 bankruptcy cases.

Automatic Stay – The filing of a voluntary or an involuntary petition automatically stays—that is, suspends—certain legal actions by creditors against the debtor or the debtor’s property. This is called an automatic stay.

Discharge of Debts – In Chapter 7 (liquidation), Chapter 11 (reorganization), Chapter 12 (family farmer and family fisherman), and Chapter 13 (adjustment of debts) bankruptcies, if the requirements are met, the court grants the debtor a discharge of all or some of the debts. When a discharge in bankruptcy is granted, the debtor is relieved of responsibility to pay the discharged debts. Discharge is one of the primary reasons a debtor files for bankruptcy.

Federal Court Case Case 13.2 Bankruptcy Discharge: Speedsportz v. Lieben Facts: John Reaves is the sole owner and president of a small business called Speedsportz, LLC, which is in the business of refurbishing exotic automobiles. Reaves had been in the business for about 30 years when he met Angela Lieben. Shortly after meeting, they started dating and Lieben moved in with Reaves, who hired her as his company’s office manager and bookkeeper. Lieben’s duties included paying bills, reconciling bank statements, and entering information in the company’s accounting software. Several years later, Reaves ended their relationship and terminated Lieben’s employment. Reaves then discovered irregularities in the company’s bank statements, checks that were written by unauthorized and forged signatures, cash that was missing, and unauthorized ATM withdrawals. Evidence showed that Lieben had previously been convicted of forgery. Lieben subsequently filed for personal bankruptcy. Speedsportz and Reaves filed documents with the bankruptcy court, alleging that Lieben’s debt from her defalcations was not dischargeable in bankruptcy because they had been committed by fraud and embezzlement.

Issue: Did debtor Lieben’s defalcations result from fraud or embezzlement and were therefore not dischargeable in bankruptcy?

Decision: The U.S. bankruptcy court held that Lieben had committed fraud and embezzlement and was liable to Speedsportz for $49,232. The bankruptcy court ruled that this amount owed to Speedsportz could not be discharged in Lieben’s bankruptcy.

Reason: The court noted that entries in Lieben’s diaries and personal emails implicated her in the commission of fraud and embezzlement, and that her related debts were therefore nondischargeable.

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Ethics Questions: Debts related to the commission of fraud and embezzlement, serious crimes, are nondischargeable as a matter of public policy.

Bankruptcy Estate – All personal, real, tangible, and intangible property owned by the debtor at the time of filing is included in the bankruptcy estate, as well as any gifts, inheritance, life insurance proceeds, and divorce settlements that the debtor is entitled to receive within 180 days after the petition is filed are part of the bankruptcy estate. Earnings from the property of the estate are also treated as part of the estate. Exempt property is property of the debtor that he or she can keep and that does not become part of the bankruptcy estate. The creditors cannot claim this property. The Bankruptcy Code permits states to enact their own exemptions. Exemptions under state laws are often more liberal than under the federal guidelines. The federal Bankruptcy Code permits homeowners to claim a homestead exemption of $23,675 in their principal residence.

Fraudulent Transfer – The Bankruptcy Code gives the bankruptcy court the power to void certain fraudulent transfers of a debtor’s property made by the debtor within two years prior to filing a petition for bankruptcy. These are gifts or transfers of property to insiders (for example, relatives) or to non-insiders with the intent to hinder, delay, or defraud a creditor.

Personal Bankruptcy – The majority of bankruptcies are filed by individuals under either Chapter 7 or Chapter 13 of the Bankruptcy Code.

Chapter 7—Liquidation Bankruptcy – Also called straight bankruptcy, this is a familiar form of bankruptcy. In this type of bankruptcy proceeding, the debtor is permitted to keep a substantial portion of his or her assets (exempt assets), the debtor’s nonexempt property is sold for cash and the cash is distributed to the creditors, and any of the debtor’s unpaid debts are discharged. The 2005 act added the median income test and the dollar-based means test that a debtor must pass before being permitted to obtain a discharge of debts under Chapter 7. The 2005 act substantially restricts the ability of debtors to obtain a Chapter 7 liquidation bankruptcy.

Contemporary Environment: Discharge of Student Loans in Bankruptcy Student loans are defined to include loans made by or guaranteed by governmental units, student loans made by nongovernmental commercial institutions such as banks, as well as funds for scholarships, benefits, or stipends granted by educational institutions. The Bankruptcy Code now states that student loans cannot be discharged in any form of bankruptcy unless their nondischarge would cause an undue hardship to the debtor and his or her dependents.

Chapter 13—Adjustment of Debts of an Individual with Regular Income – This type of bankruptcy permits a qualified debtor to propose a plan to pay all or a portion of the debts he or she owes in installments over a specified period of time. Chapter 13 petitions are usually filed by individual debtors who do not qualify for Chapter 7 liquidation bankruptcy and by homeowners who want to protect nonexempt equity in their residence. Chapter 13 enables debtors to catch up on secured credit loans, such as home mortgages, and avoid repossession and foreclosure. If a debtor cannot file for Chapter 13 bankruptcy, he/she could file for Chapter 11 bankruptcy. Only individuals with regular income can file for Chapter 13, and the petition must be voluntary. An individual with regular income means an individual whose income is sufficiently stable and regular to enable such individual to make payments under a Chapter 13 plan. An extension provides for a longer period of time for the debtor to pay his or her debts. A composition provides for the reduction of debts.

The Chapter 13 debtor must file a plan of payment. The debtor must file information about his or her finances, including a budget of estimated income and expenses during the period of the plan.

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The Chapter 13 plan may be either up to three years or up to five years, depending on the debtor’s family income.

The plan must commit to payment of the debtor’s disposable income during the plan period to pay prepetition creditors. Disposable income is defined as current monthly income less amounts reasonably necessary to be expended for the maintenance or support of the debtor and the dependents of the debtor.

Contemporary Environment: Differences Between Chapter 7 and Chapter 13 Bankruptcy There are two major differences between a Chapter 7 and Chapter 13 bankruptcy: (1) In a Chapter 7 bankruptcy, the debtor is granted discharge of unpaid debts at the time of bankruptcy, whereas in Chapter 13 bankruptcy, the debtor is not granted discharge until the threeor five-year plan period has expired; and (2) In a Chapter 7 bankruptcy, the debtor can immediately keep the income he or she earns after discharge, whereas in Chapter 13 bankruptcy, the debtor must pay his or her disposable income earned during the three- or five-year period to pay pre-petition debts.

Business Bankruptcy – Chapter 11 bankruptcy provides a method for reorganizing a debtor’s financial affairs under the supervision of the bankruptcy court. The goal is to reorganize the debt with a new capital structure so that the debtor emerges from bankruptcy as a viable concern.

Chapter 11 is available to individuals, partnerships, corporations, and other business entities.

During a Chapter 11 proceeding, a debtor submits a plan of reorganization to the bankruptcy court and to the creditors and other interested parties.

Several important features of Chapter 11 bankruptcy include: (1) Automatic stay—Filing a Chapter 11 petition automatically stays any actions by creditors.

(2) Executory contracts and unexpired leases—A major benefit of Chapter 11 bankruptcy is that the debtor is given the opportunity to accept or reject certain executory contracts and unexpired leases. Executory contracts or unexpired leases are contracts or leases that have not been fully performed.

(3) Discharge of debts—In its plan of reorganization, the debtor will propose reducing its unsecured debt so that it can come out of bankruptcy with fewer debts to pay than when it filed for bankruptcy. If the plan is approved by the court, the court will confirm the plan of reorganization. The bankruptcy court will confirm a plan of reorganization if the creditors agree to the plan. If unsecured creditors do not agree, the court can use its cram-down authority and make the dissenting class accept the plan. The creditors must receive at least what they would have received if the debtor had declared Chapter 7 liquidation bankruptcy.

V. Key Terms and Concepts  Abusive homestead exemption—Before the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, many wealthy debtors from other states moved their money into principal residences in Florida and Texas to benefit from these states’ generous homestead exemptions.  Accommodation party (surety or co-debtor)—A person who acts as a surety.  After-acquired property—Property that the debtor acquires after the security agreement is executed.  Antideficiency statute—A statute that prohibits deficiency judgments regarding certain types of mortgages, such as those on residential property.  Article I, section 8, clause 4 of the U.S. Constitution—It provides that “The Congress shall have the power . . . to establish . . . uniform laws on the subject of bankruptcies throughout the United States.”

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Article 9 (Secured Transactions) of the Uniform Commercial Code (UCC)—An article of the Uniform Commercial Code that governs secured transactions in personal property.

Artisan’s lien—An artisan’s lien prevails over all other security interests in the goods unless a statutory lien provides otherwise.

Attachment—A prejudgment court order that permits the seizure of a debtor’s property that is in the debtor’s possession while a lawsuit against the debtor is pending.

Automatic stay—The result of the filing of a voluntary or involuntary petition; the suspension of certain actions by creditors against the debtor or the debtor’s property.

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005—A federal act that substantially amended federal bankruptcy law. This act makes it more difficult for debtors to file for bankruptcy and have their unpaid debts discharged.

Bankruptcy Code—The name given to the Bankruptcy Reform Act of 1978, as amended.

Bankruptcy estate—An estate created upon the commencement of a Chapter 7 proceeding that includes all of the debtor’s legal and equitable interests in real, personal, tangible, and intangible property, wherever located, that exist when the petition is filed, minus exempt property.

Bankruptcy law—The goal of bankruptcy law is to balance the rights of debtors and creditors and provide methods for debtors to be relieved of some debt in order to obtain a fresh start.

Bankruptcy Reform Act of 1978—This Act made it easier for debtors to rid themselves of unsecured debt, primarily by filing for Chapter 7 liquidation bankruptcy.

Bankruptcy trustee—A legal representative of the debtor’s estate.

Beneficiary (lender or creditor)—In the context of a deed of trust, the lender-creditor.

Buyer in the ordinary course of business—A person who in good faith and without knowledge that the sale violates the ownership or security interests of a third party buys the goods in the ordinary course of business from a person in the business of selling goods of that kind. A buyer in the ordinary course of business takes the goods free of any third-party security interest in the goods.

Chapter 7—Liquidation (straight bankruptcy)—A form of bankruptcy in which the debtor’s nonexempt property is sold for cash, the cash is distributed to the creditors, and any unpaid debts are discharged.

Chapter 11—Reorganization—A bankruptcy method that allows reorganization of the debtor’s financial affairs under the supervision of the Bankruptcy Court.

Chapter 12—Adjustment of Debts of a Family Farmer or Fisherman with Regular Income—The section of the U.S. Bankruptcy Code that contains special provisions for the reorganization bankruptcy of family farmers and family fishermen.

Chapter 13—Adjustment of Debts of an Individual with Regular Income—A rehabilitation form of bankruptcy that permits bankruptcy courts to supervise the debtor’s plan for the payment of unpaid debts in installments over the plan period.

Collateral—The property in which the security interest is taken.

Composition—Provides for the reduction of a debtor’s debts.

Confirmation—In the context of a bankruptcy organization, the bankruptcy court confirms a plan of reorganization if the creditors agree to the plan.

Construction lien (mechanic’s lien)—A contractor’s, laborer’s, and material person’s statutory lien that makes the real property to which services or materials have been provided security for the payment of the services and materials.

Consumer goods—Goods used primarily for personal, family, or household purposes.

Continuation statement—A continuation statement may be filed up to six months prior to the expiration of a financing statement’s five-year term.

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Country recorder’s office—Most states have enacted recording statutes that require a mortgage or deed of trust to be recorded in the county recorder’s office in the county in which the real property is located. These filings are public record and alert the world that a mortgage or deed of trust has been recorded against the real property. This record gives potential lenders or purchasers of real property the ability to determine whether there are any exiting liens (mortgages) on the property.

Cram-down provision—A method of confirmation of a plan of reorganization where the court forces an impaired class to participate in the plan of reorganization.

Credit—Extension of a loan from one party to another.

Creditor (lender)—The lender in a credit transaction.

Debtor (borrower)—The borrower in a credit transaction.

Deed of trust—An instrument that gives the creditor a security interest in the debtor’s property that is pledged as collateral.

Default—A debtor that does not make the required payments on a secured real estate transaction is in default.

Deficiency judgment—Judgment of a court that permits a secured lender to recover other property or income from a defaulting debtor if the collateral is insufficient to repay the unpaid loan.

Discharge in bankruptcy—The termination of the legal duty of a debtor to pay debts that remain unpaid upon the completion of a bankruptcy proceeding.

Disposable income—Current monthly income less amounts reasonably necessary to be spent for the maintenance or support of the debtor and the debtor’s dependents.

Electronic financing statement (e-financing statement)—A financing statement in the electronic form.

Electronic secured transaction (e-secured transaction)—Revised Uniform Commercial Code (UCC) Article 9 provides rules for the creation, filing, and enforcement of electronic secured transactions.

Executory contract—A contract that has not been fully performed. With court approval, executory contracts may be rejected by a debtor in bankruptcy.

Exempt property—Property that may be retained by the debtor pursuant to federal or state law; debtor’s property that does not become part of the bankruptcy estate.

Extension—Provides a longer period of time for the debtor to pay his or her debts.

Financing statement—A document filed by a secured creditor with the appropriate government office that constructively notifies the world of his or her security interest in personal property.

First purchase money mortgage—Mortgages that are taken out to purchase houses.

Floating lien—A security interest in property that was not in the possession of the debtor when the security agreement was executed; this includes after-acquired property, future advances, and sale proceeds.

Foreclosure sale—A legal procedure by which a secured creditor causes the judicial sale of the secured real estate to pay a defaulted loan.

Fraudulent transfer—Occurs when (1) a debtor transfers property to a third person within one year before the filing of a petition in bankruptcy, and (2) the transfer was made by the debtor with an intent to hinder, delay, or defraud creditors.

Future advances—Personal property of the debtor that is designated as collateral for future loans from a line of credit.

Guarantor—A third person who agrees to pay the debt of the principal debtor if the debtor defaults.

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Guaranty arrangement—An arrangement where a third party promises to be secondarily liable for the payment of another’s debt.

Homestead exemption—Equity in a debtor’s home that the debtor is permitted to retain.

Individual with regular income—An individual whose income is sufficiently stable and regular to enable the individual to make payments under a Chapter 13 plan.

Intangible personal property—Securities, patents, trademarks, and copyrights.

Involuntary petition—A petition filed by creditors of a debtor that alleges that the debtor is not paying his or her debts as they become due.

Judgment-proof—A debtor is judgment-proof if he or she has little or no property or no income that can be garnished.

Land sale contract (land contract)—A contract in which the owner of real property agrees to sell designated property to the purchaser, who agrees to pay the purchase price to the owner-seller over an agreed-upon period of time.

Lien release (release of lien)—Most state statutes permit an owner of real property to have subcontractors, laborers, and material persons who will provide services or materials to a real property project to sign a written lien release (also called a release of lien) releasing any lien they might otherwise assert against the property. A lien release can be used by the property owner to defeat a statutory lienholder’s attempt to obtain payment.

Means test—A calculation that establishes, by law, a bright-line test to determine whether the debtor has sufficient disposable income to pay prepetition debts out of post-petition income.

Median income test—A bankruptcy rule that states that if a debtor’s median family income is at or below the state’s median family income for a family the same size as the debtor’s family, the debtor can receive Chapter 7 relief.

Mortgage—A collateral arrangement where a property owner borrows money from a creditor who uses a deed as collateral for repayment of the loan.

Mortgagee—The creditor in a mortgage transaction.

Mortgagor—The owner-debtor in a mortgage transaction.

Non-recordation of a mortgage—The mortgagor is obligated to pay the amount of the mortgage according to the terms of the mortgage, even if the document is not recorded.

Note—(1) An instrument that evidences the borrower’s debt to the lender; and (2) a debt security with a maturity of five years or less.

Notice of lien—Notice that an outstanding security interest exists on certain property.

The lienholder must file a notice of lien with the county recorder’s office in the county in which the property subject to the lien is located.

Perfection by attachment (automatic perfection rule)—A creditor who extends credit to a consumer to purchase a consumer good does not have to file a financing statement or take possession of the goods to perfect his or her security interest. This interest is called perfection by attachment.

Perfection by filing a financing statement—The creditor files a financing statement with the appropriate government office.

Perfection by possession of collateral—If a secured creditor has physical possession of the collateral, no financing statement has to be filed: The creditor’s possession is sufficient to put other potential creditors on notice of his or her secured interest in the property.

Perfection by a purchase money security interest in consumer goods—A creditor who extends credit to a consumer to purchase a consumer good under a written security

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agreement obtains a purchase money security interest in the consumer good. The agreement automatically perfects the creditor’s security interest at the time of the sale.

Perfection of a security interest—Establishes the right of a secured creditor against other creditors who claim an interest in the collateral.

Personal property—Property that consists of tangible property such as automobiles, furniture, and jewelry; intangible property such as securities, patents, and copyrights; and instruments, chattel paper, documents of title, and accounts.

Petition for bankruptcy—A document filed with the bankruptcy court that sets the bankruptcy proceedings into motion.

Plan of payment—The debtor must file a plan of payment. The debtor must include information about his or her finances, including a budget of estimated income and expenses during the period of the plan.

Plan of reorganization—A plan that sets forth a new proposed capital structure for a debtor to assume when it emerges from Chapter 11 reorganization bankruptcy.

Power of sale—A power stated in a mortgage or deed that permits foreclosure without court proceedings and the sale of certain property through an auction.

Primarily liable—The surety is primarily liable for paying the principal debtor’s debt when it is due.

Priority of claims—The order in which conflicting claims of creditors in the same collateral are solved.

Proof of claim—A document required to be filed by unsecured creditors that states the amount of their claim against the debtor.

Proof of interest—A document required to be filed by an equity security holder that states the amount of his or her interest against the debtor.

Purchase money security interest—An interest a creditor automatically obtains when it extends credit to a consumer to purchase consumer goods.

Reconveyance—When a mortgage is repaid in full, the lender files a written document called a reconveyance, sometimes referred to as satisfaction of a mortgage, with the county recorder’s office. This is proof that the mortgage has been paid.

Record—Information that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable form.

Recording statute—A state statute that requires the mortgage or deed of trust to be recorded in the county recorder’s office of the county in which the real property is located.

Reorganization bankruptcy—Chapter 11 bankruptcy; a bankruptcy method that allows the reorganization of the debtor’s financial affairs under the supervision of the bankruptcy court.

Repossession—A right granted to a secured creditor to take possession of the collateral upon default by the debtor.

Revised Article 9 (Secured Transactions) of the UCC—An article of the Uniform Commercial Code that governs secured transactions in personal property.

Right of redemption—A right that allows the mortgagor to redeem real property after default and before foreclosure. It requires the mortgagor to pay the full amount of the debt incurred by the mortgagee because of the mortgagor’s default.

Sale proceeds—The resulting assets from the sale, exchange, or disposal of collateral subject to a security agreement.

Secondarily liable—The guarantor is obligated to pay the debt only if the principal debtor defaults and the creditors have attempted unsuccessfully to collect the debt from the debtor.

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Secretary of state—A financing statement can be filled with the secretary of state.

Secured credit—Credit that requires security (collateral) to secure payment of the loan.

Secured creditor (secured party)—The creditor who has a security interest in collateral.

Secured transaction—A transaction that is created when a creditor makes a loan to a debtor in exchange for the debtor’s pledge of personal property as security.

Security agreement—The agreement between the debtor and the secured party that creates or provides for a security interest.

Security interest in personal property—To minimize the risk associated with extending unsecured credit, a creditor requires a security interest in the debtor’s personal property.

Security interest in real property—To minimize the risk associated with extending unsecured credit, a creditor requires a security interest in the debtor’s real property.

Statutory period of redemption—Most states allow the mortgagor to redeem real property for a specified period (usually six months or one year) after foreclosure. This is called the statutory period of redemption.

Student loan—Indebtedness incurred in the pursuit of higher education. Student loans are defined to include loans made by or guaranteed by governmental units, and loans made by nongovernmental commercial institutions such as banks.

Super-priority lien—If a worker, in the ordinary course of business, furnishes services or materials to someone with respect to goods and receives a lien on the goods by statute, this artisan’s lien prevails over all other security interests in the goods unless a statutory lien provides otherwise. Thus, such liens are often called super-priority liens.

Surety (co-debtor)—The third person who agrees to be liable in a surety arrangement.

Surety arrangement—An arrangement where a third party promises to be primarily liable with the borrower for the payment of the borrower’s debt.

Taking possession of the collateral—Most secured parties seek to cure a default by taking possession of the collateral. This taking is usually done by repossession of the goods from the defaulting debtor.

Tangible personal property—Tangible personal property includes equipment, vehicles, furniture, computers, clothing, jewelry, and such.

Three-party secured transaction—It occurs when a seller sells goods to a buyer who has obtained financing from a third-party lender who takes a security interest in the goods sold.

Trustee—In the context of a deed of trust, legal title to real property is placed with a trustee (usually a trust corporation) until the amount borrowed has been paid.

Trustor (owner-debtor)—In the context of a deed of trust, the owner-debtor. Although in a deed of trust arrangement legal title to the property is vested in the trustee until the amount borrowed has been paid, the trustor has full legal rights to possession of the real property.

Two-party secured transaction—It occurs when a seller sells goods to a buyer on credit and retains a security interest in the goods.

UCC Financing Statement (Form UCC-1)—A document filed by a secured creditor with the appropriate government office that constructively notifies the world of his or her security interest in personal property.

Undue hardship in bankruptcy—Undue hardship is construed strictly and is difficult for a debtor to prove unless he or she can show severe physical or mental disability or that he or she is unable to pay for basic necessities such as food or shelter for his or her family.

Unexpired lease—Contracts or leases that have not been fully performed.

Unsecured credit—Credit that does not require any security (collateral) to protect the payment of the debt.

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Unsecured creditor—A creditor who has not taken any security (collateral) to protect the payment of the debt.

U.S. Bankruptcy Courts—Special federal courts that hear and decide bankruptcy cases.

U.S. Trustee—Federal government official who has responsibility for handling and supervising many of the administrative tasks associated with a bankruptcy case.

Voluntary petition—A petition filed by the debtor stating that the debtor has debts.

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Chapter 14 Small Business, General Partnerships, and Limited Partnerships Why is choice of partner an important decision?

I. Teacher to Teacher Dialogue One of the key roles of attorneys engaged in the practice of modern business law is advising their clients on the selection of the best venue for doing business. What seems like a relatively limited number of options is, in fact, quite extensive. The choices run the gamut from the simplest lemonade stand to a multinational publicly traded corporation.

With each choice comes a list of pros and cons in the eyes of the law. For example, if a person seeks maximum privacy in his or her financial affairs along with the least possible accountability to others, a private form of sole proprietorship may be best. Compare, however, the businessperson who wants to leverage the maximum utilization of other people’s money while limiting her personal financial exposure. That person may find the corporate form best suited for her needs.

The law has something for everyone. The real issue is first finding out what options are legally available and then choosing the best fit. That fit should be tailored by sound advice from a number of quarters including law, accounting, finance, and business management strategy. It is this interdependent equation that makes the practice of business law so difficult yet so interesting.

The vast majority of the users of this book will never go to law school. Yet, that same majority will be influenced every working day by the legal business entity choices made in whatever business pursuits they chose.

Sole proprietorship is still the most widely used form of business entity even though it may not be the most important in sheer economic terms. With the advent of the information highway and more emphasis on entrepreneurial niche marketing of goods and services, this form of business may enjoy a renaissance in the 21st century. The law of sole proprietorship is, in fact, derived from a combination of property, contract, agency, and tort law doctrines. The practice of law for sole proprietorships is akin to the medical family doctor. Every sort of business issue ranging from taxes to zoning may confront this businessperson. Yet in spite of the high risk and sometimes marginal rewards, few sole proprietors would willingly give up their personal control over their fate.

The operation of a partnership is one of the oldest recognized methods of cooperative business conduct. Many of its antecedents go back to the age of chivalry where the duties of loyalty were paramount. “All for one and one for all” was more than just a rallying cry before battle. The phrase connoted an expectation that made your acts the acts of your colleague and vice versa. A legal oneness came to be recognized between partners and the third parties with whom they dealt. Subsequent evolution of partnership law has carried forth this unity. Modern contract law, tort law, and especially agency law all reflect this commonality when it comes to partnerships. Partners are expected to be responsible for each other’s acts in the eyes of the law.

These responsibilities may not always seem fair to the layperson. Remember, however, the benefit/burden dichotomy illustrated in the law of the agency. The principal stands to gain much from the efforts of his or her agent. That gain may be offset by the costs incurred for the agent’s acts. We also see that the pendulum can swing both ways in partnership law. A partner is an agent of the partnership and yet is also a principal. Agency law dominates as the foundation of partnership law.

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Given the long and sometimes tortuous entanglements that people find themselves in, maybe they should think long and hard before partnering with someone legally. Remember, both partners have a lot of latitude in contracting rights and duties between themselves, but less so visà-vis third parties under the Uniform Partnership Act. Limited partnerships remain, in many ways, the best of both worlds. They can provide the flexibility of partnership while affording limited liability exposure to investors. But as with all deals that seem too good to be true, there is no free lunch. The rules of the legal road must be strictly complied with and failure to do so leads to often severe consequences. Investment is the key to the original notion of limited partnership. The idea was to create a middle ground between pure partnership and an entity with a totally autonomous existence.

Today’s modern laws of limited partnerships are found in two key statutes: the original 1916 Uniform Limited Partnership Act and its heir apparent, the Revised Uniform Limited Partnership Act, first promulgated in 1976. Even though there are substantial differences between the two versions, they remain the same with regard to several key provisions: 1. Both call for statutory creation (as opposed to just contract creation) of limited partnerships, including the use of a certificate of limited partnership.

2. Both call for two key classes of partners to be in place: at least one general partner with unlimited traditional partner’s liability and a class of limited partners who normally can be held liable only to the extent of their capital contribution.

3. Both statutes generally limit the amount of activity a limited partner may engage in regarding the business as a price of having limited liability protections.

4. Both use the general partnership principles of the Uniform Partnership Act as a fallback position if their respective statutory requirements are not complied with.

Among other things, this chapter is designed to introduce students to four key issues in partnership law. They are the formation of a partnership, the operation of a partnership, the dissolution of a partnership, and an overview of limited partnerships. Persons entering into a partnership arrangement must do so voluntarily and with their legal eyes open to the ramifications of their bonding.

As for the dissolution of a partnership, compare its existence with that of a corporation. One of the key distinctions between the partnership form of doing business and corporate format is the corporation’s ability to have an indefinite or perpetual existence. Under state laws of incorporation, a corporation is allowed to continue its juristic existence in spite of the death of its key players. This is not so with partnerships. Partnerships are much more personal. When the partner is gone, so is the partnership. One of the questions students frequently ask is: How is it that multinational business organizations such as large accounting or law firms stay in business as partnerships when they frequently lose partners through death or changes in partnership associations? Technically, with each of these changes, the partnership is ended, and a new one is created. A well-crafted partnership agreement should have, as one of its key components, an orderly process of succession in case of death or termination. When these circumstances are properly planned for, the transition is seamless, and the life of the new partnership goes on where the old one left off.

Most partnerships are not, however, large and multinational in scale. Most are created and operated by individuals who have sought to capitalize on their respective economic or talent contributions by acting together in the legal sense. These business ventures could be set for a short-term, specific goal, such as erecting a building, or extend to a full professional career as a licensed practitioner of law, medicine, or accounting. We must keep in mind, however that sometimes the best intentions involved in forming a partnership do not always work out in the strain of working with someone else.

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II. Chapter Objectives 1. Define entrepreneurship and describe the types of businesses that an entrepreneur can use to operate a business.

2. Define sole proprietorship and describe the liability of a sole proprietor.

3. Define general partnership and describe how general partnerships are formed and operated.

4. Describe the liability of general partnerships and the liability of general partners of a general partnership.

5. Describe the dissolution and winding up of general partnerships.

6. Define limited partnership and describe how limited partnerships are formed and operated.

7. Describe the liability of limited partnerships and the liability of general partners and limited partners of a limited partnership.

8. Describe the dissolution and winding up of limited partnerships.

9. Define a limited liability limited partnership and describe the liability of partners.

III. Key Question Checklist  What are your objectives in doing business, and what business entity choice best meets those objectives?  What are the advantages and disadvantages of doing business as a sole proprietor?  What other forms of doing business are there?  What are the rights and duties of general partners?  How can a partnership be dissolved by acts of the partners?  How can a partnership be dissolved by operation of law?  How can a partnership be dissolved by judicial decree?  Was the limited partnership properly formed?  What are the rights and duties of the partners?  Do third parties have priority rights as creditors?

IV. Chapter Outline Introduction to Small Business, General Partnerships, and Limited Partnerships – The operation of a business as a sole proprietorship, general partnership, limited partnership, limited liability partnership, limited liability company or corporation depends on many factors, including the ease and cost of formation, the capital requirements of the business, the flexibility of management decisions, government restrictions, personal liability, tax considerations, and the like.

Entrepreneurship – An entrepreneur is a person who forms and operates a business, alone or with others. These businesses hire employees, provide new products and services, and contribute to the growth of economies of countries.

Entrepreneurial Forms of Conducting Business – The major forms for conducting businesses and professions are as follows:  Sole proprietorship  General partnership  Limited partnership  Limited liability limited partnership  Limited liability partnership  Limited liability company 152 .

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Corporation

Sole Proprietorship – The sole proprietorship is the simplest form of business. As the name indicates, the owner is the business. It is easy to form and does not cost a lot. The owner has the right to make all management decisions. He owns all of the business, receives all of the profit, and carries the tax liability on his personal income tax. The sole proprietorship can be easily transferred or terminated at any time. The disadvantages include access to capital, which is generally limited to personal funds and loans, and the owner is personally liable for all contracts and torts committed by himself or his employees in the course of business.

Creation of a Sole Proprietorship – There are no formalities and no government approvals required, although you might need to purchase a business license from the municipality where the business is located.

Business Environment: “d.b.a.” Trade Name Trade names are commonly designated as d.b.a., which usually requires the filing of a fictitious business name statement (or certificate of trade name) with the appropriate government agency.

Personal Liability of a Sole Proprietor – The owner has unlimited personal liability for the obligations of the sole proprietorship. This means that creditors of a sole proprietorship may recover claims against the business from the sole proprietor’s personal assets (home, automobile, bank accounts, etc.)

State Court Case Case 14.1 Sole Proprietorship: Bank of America, N.A. v. Barr Facts: Based on documents signed by Barr on behalf of The Stone Scone, Fleet Bank approved a $100,000 unsecured small business line of credit for The Stone Scone. The bank sent account statements addressed to both The Stone Scone and Barr. For four years, Fleet Bank provided funds to The Stone Scone. After that time, however, The Stone Scone did not make any further payments on the loan, leaving $91,444 in unpaid principal. Pursuant to the loan agreement, interest on the unpaid principal balance continued to accrue at a rate of 6.5 percent per year. Bank of America, N.A., who had acquired Fleet Bank, sued The Stone Scone and Barr to recover the unpaid principal and interest. Barr stipulated to a judgment against The Stone Scone, which she had converted to a limited liability company, but denied personal responsibility for the unpaid debt. The trial court found Barr personally liable for the debt. Barr appealed.

Issue: Is Barr, the sole owner of The Stone Scone, personally liable for the unpaid debt?

Decision: The supreme judicial court affirmed the trial court’s judgment that held Barr personally liable.

Reason: An individual doing business as a sole proprietor, even when business is done under a different name, remains personally liable for all of the obligations of the sole proprietorship.

Ethics Questions: A sole proprietor bears the risk of the loss of the business; that is, the owner will lose his or her entire capital contribution if the business fails. In addition, the sole proprietor has unlimited personal liability for business debts. Such is the nature of the sole proprietorship.

Barr did not act ethically in denying responsibility for The Stone Scone’s debts.

Taxation of a Sole Proprietorship – Since it is not a separate entity, the sole proprietorship is taxed on the owner’s income tax return for both state and local taxes.

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General Partnership – General partnerships have been recognized since ancient times. The English common law of partnerships governed early U.S. partnerships, and the individual states expanded the body of partnership law.

Definition of a General Partnership – A general partnership, or ordinary partnership, is a voluntary association of two or more persons to carry on a business for profit, regardless of whether the persons intended to form a partnership.

Landmark Law: Uniform Partnership Act and Revised Uniform Partnership Act The Uniform Partnership Act (UPA) codifies partnership law. The goal of the UPA is to establish consistent and uniform partnership law throughout the United States. It has been adopted in whole or in part by the vast majority of states. A Revised Uniform Partnership Act (RUPA) has been issued by the National Conference of Commissioners on Uniform State Laws. The RUPA has been adopted by the majority of states and replaces the UPA in those states.

Formation of a General Partnership – To be a partnership, a business must be a voluntary association of at least two persons that are carrying on a business as co-owners for profit. The formation requires little or no formality. The courts will consider receipt of a share of the business profits and losses as prima facie evidence of a partnership, as opposed to right to management.

Duration of a General Partnership – There are two types of general partnerships: (1) Partnership at will—A partnership where the partners have agreed to form a partnership but have not agreed to a fixed duration of the partnership; and (2) Partnership for a term—A partnership with a fixed duration. In this type of partnership, the partners have agreed that their partnership will terminate at some time in the future.

Name of a General Partnership – Ordinary partnerships can operate under the name of any one or more of the partners or under a fictitious name, if a proper filing has been made with the appropriate governmental body.

Business Environment: General Partnership Agreement The agreement may be oral, written, or implied by the conduct of the partners. The Statute of Frauds will require a written partnership agreement if the partnership is to exist for over a year or deals with real estate.

Taxation of General Partnerships – Partnerships’ incomes and losses flow through to the partners’ personal income tax returns.

Right to Participate in Management – Absent to an agreement to the contrary, all partners have equal rights to participate in management.

Right to Share in Profits – Unless there is an agreement stating otherwise, all partners have a right to an equal share in the profits and losses. If the agreement explains the share of profits, but is silent as to the losses, the losses are shared in the same percentage. If the agreement details the share of losses but not profits, the profits are shared evenly.

Right to an Accounting – Partners cannot sue the partnership, but, instead, can bring an action for an accounting, wherein the court will review the partnership to determine and award each partner their share.

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Liability of General Partnerships and General Partners – General partners must deal with third parties in conducting partnership business. This often includes entering into contracts with third parties on behalf of the partnership. Partners, employees, and agents of the partnership sometimes injure third parties while conducting partnership business, with resulting legal implications regarding liability of the general partnership and its partners.

Liability of General Partnerships – A general partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership. A general partnership is liable for contracts entered into on behalf of the partnership.

A general partnership is also liable if a tortious act is committed by a person acting within the ordinary course of partnership business or with the authority of co-partners.

Liability of General Partners – General partners have unlimited personal liability for the debts and obligations of the partnership. The unlimited personal liability of a general partner means that creditors may recover unpaid claims against the partnership from a general partner’s personal assets.

Tort Liability of General Partners – The partnership is liable for any acts caused by a partner, employee, or agent within the ordinary course of business. Each partner is jointly and severally liable for torts and breaches of trust. A third party may sue one or more of the partners and recover a judgment against them. A release of one partner does not release the others. The partner sued or recovered against may seek indemnification from the other partners.

Contract Liability of General Partners – Partners are jointly liable for contracts. A party must name all partners in a lawsuit in order to collect against any of the partners or the partnership.

Releasing a single partner releases all. If a partner is made to pay more than their share, they may seek indemnification from the other partners.

Liability of Incoming Partners – A new partner is only liable for antecedent debts to the amount of their capital contribution, but will be personally liable for all debts incurred after they become a partner.

Dissolution and Winding up of General Partnerships – A partnership for a term is for a fixed term or until a particular event occurs, while a partnership at will is for an unspecified period.

With the former, the partnership automatically dissolves at the time proscribed or upon the occurrence of the event. A partnership at will can be dissolved at any time.

Wrongful Dissociation – Although a partner has the power to withdraw at any time, he may not have the right, and will be held liable for any damages the wrongful dissolution caused.

Winding Up of a General Partnership and Distribution of Assets – Partnerships assets should be liquidated, and payment made first to creditors and then creditor-partners. If assets remain, the capital contribution of each partner should be returned, and any remaining monies should be distributed as profits.

Continuation of a General Partnership – The remaining partners may enter into a continuation agreement, dissolving the old partnership and creating a new one.

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Business Environment: Right of Survivorship of General Partners The surviving partners receive the partnership property from a deceased partner through the right of survivorship. His heirs or beneficiaries receive only the value of the deceased partner’s share.

Liability of Outgoing Partners – If a general partnership is dissolved, each general partner is personally liable for debts and obligations of the partnership that exist at the time of dissolution.

Limited Partnership – All states have enacted statutes that provide for the creation of limited partnerships. In most states, these partnerships are called limited partnerships, or special partnerships.

Landmark Law: Revised Uniform Limited Partnership Act and Uniform Limited Partnership Act (2001) The Revised Uniform Limited Partnership Act (RULPA) is a revision of the Uniform Limited Partnership Act (ULPA) that provides a comprehensive law for the formation, operation, and dissolution of limited partnerships.

Definition of a Limited Partnership – A limited partnership, also referred to as an LP, is a partnership that has one or more general partners and one or more limited partners. The general partners invest capital, manage the business, and have unlimited personal liability for all partnership debts, while limited partners invest capital but have no management participation, and are liable only to the extent of their capital contribution. A limited partnership must have at least one general partner and one limited partner, which may be the same person. Natural persons, limited partnerships, trusts, estates, partnerships, associations, and corporations may be general or limited partners.

Formation of a Limited Partnership – The creation of a limited partnership is formal and requires public disclosure. The entity must comply with the statutory requirements of the RULPA (2001) or RULPA. A certificate of limited partnership must be filed with the secretary of state of the state in which the limited partnership is formed. The certificate must contain the name of the limited partnership, the name and mailing address of each general partner, and other information required by law or that the partners determine should be included.

Defective Formation – If there is a substantial defect in the creation of a limited partnership, persons who thought they were limited partners may be liable as general partners. Defects in the filing of or actual certificate may be corrected through filing an amendment or by withdrawing from participation and filing a certificate of withdrawal.

Name of a Limited Partnership – Under the UPA (2001), the name of a limited partnership must contain the phrase “limited partnership” or the abbreviations “L.P.” or “LP.” Business Environment: Limited Partnership Agreement The limited partnership agreement, or articles of limited partnership, sets forth the rights and duties of the general and limited partners, the terms and conditions regarding the operations, termination, and dissolution of the partnership, etc. Except as provided by law, the provisions of the partnership agreement expressly control over the language of the ULPA (2001) and RULPA. Taxation of Limited Partnerships – Limited partnerships do not pay federal income taxes.

Instead, there is flow-through taxation whereby the income and losses of the partnership flow onto and have to be reported on the general and limited partners’ personal income tax returns.

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Sharing of Profits and Losses and Distributions – A limited partnership agreement may specify how profits and losses and distributions from the limited partnership are to be allocated among the general and limited partners. If there is no written agreement, profits and losses and distributions from a limited partnership are shared on the basis of the value of each partner’s capital contribution to the partnership at the time of the distribution.

Management of a Limited Partnership – Each general partner has an equal right to participate in the management of a limited partnership and the conduct of the limited partnership’s activities.

Under the RULPA, a limited partner is liable as a general partner if his or her participation in the control of the business is substantially the same as that of a general partner, but the limited partner is liable only to persons who reasonably believed him or her to be a general partner. This is called the control rule.

Business Environment: Limited Partners Permitted Management Powers Section 303 of the RULPA permits limited partners to participate in certain management-related activities of a limited partnership without losing their limited liability shield. This is referred to as the “safe harbor” provision. A limited partner may attend meetings of the general partners, consult with and give advice to general partners, act as an agent or employee or contractor for the partnership or for a general partner, function as a surety of partnership debts, and participate in the winding up of the partnership. In addition, Section 303 permits limited partners to vote on certain matters.

Liability of Limited Partnerships, General Partners, and Limited Partners – Partners, employees, and agents of limited partnerships sometimes injure third parties while conducting partnership business, with resulting legal implications regarding the liability of limited partnerships and the liability of general partners and limited partners.

Liability of Limited Partnerships – According to the UPA (2001), a limited partnership is liable for a partner’s tortious conduct and contracts entered into on behalf of the partnership. A limited partner does not have the right of the power to act for or bind the limited partnership.

Liability of General Partners – General partners have unlimited personal liability for all debts and obligations of the limited partnership. General partners are jointly and severally liable for all obligations of the limited partnership whether arising in contract, tort, or otherwise.

Liability of Limited Partners – Limited partners are liable only for the debts and obligations of the limited partnership up to their capital contributions; they are not personally liable for the debts and obligations of the limited partnership.

Liability of Incoming Partners – A person who becomes a general partner of an existing limited partnership is not personally liable for an obligation of the limited partnership that was incurred before the person became a general partner. However, a new general partner is liable for the existing debts and obligations (antecedent debts) of the partnership to the extent of his or her capital contributions. The incoming general partner is personally liable for debts and obligations incurred by the limited partnership after becoming a partner.

Dissolution and Winding up of Limited Partnerships – Under ULPA (2001) and RULPA, a limited partnership may be dissolved. The ULPA (2001) provides for the following ways for dissolution of a limited partnership: (1) The happening of an event specified in the limited partnership agreement (for example, the specified undertaking of the limited partnership has been completed or accomplished; 157 .

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(2) The consent of all general partners and the consent of the limited partners who own the majority of the rights to receive distributions; or (3) After withdrawal of a general partner, the partners owning a majority of the rights to receive distributions as partners consent to dissolve the partnership.

Winding Up of a Limited Partnership and Distribution of Assets – The winding up of a limited partnership follows its dissolution. The process of winding up a limited partnership consists of the liquidation (sale) of partnership assets and the distribution of the proceeds or other assets to satisfy claims against the partnership. The ULPA (2001) provides the following order of distribution of assets: (1) creditors (including partners who are creditors); and (2) settlement of partners’ accounts.

If the limited partnership assets are insufficient to satisfy obligations to creditors, each general partner must contribute, in proportion to their right to receive distributions, the amount that would satisfy the payment owed to creditors. If a general partner does not contribute his or her assessed proportion, the other partners must pay the unpaid obligation in proportion to their right to receive distributions. General partners who have paid additional contributions have the right to recover this amount from the general partner who has not paid his or her share of the limited partnership’s obligations.

V. Key Terms and Concepts  Action for an accounting—A formal judicial proceeding in which the court is authorized to (1) review the partnership and the partners’ transactions, and (2) award each partner his or her share of the partnership assets.  Antecedent debt—A new partner who is admitted to a general partnership is liable for the existing debts and obligations (antecedent debts) of the partnership only to the extent of his or her capital contribution.  Certificate of limited partnership—A document that two or more persons must execute and sign that makes the limited partnership legal and binding.  Continuation agreement—It is good practice for the partners of a partnership to enter into a continuation agreement that expressly sets forth the events that allow for continuation of the partnership, the amount to be paid to outgoing partners, and other details.  Contract liability—A general partner who is made to pay more than his or her proportionate share of contract liability may seek indemnification from the partnership and from those partners who have not paid their share of the loss.  Control rule—In the context of a limited partnership, it refers to the general rule that limited partners who take part in the management of the affairs of a limited partnership who have not been expressly elected to office do so, lose their limited liability shield and become general partners, and are personally liable for the debts and obligations of the limited partnership.  d.b.a. (doing business as)—A designation for a business that is operating under a trade name.  Defective formation—Occurs when (1) a certificate of limited partnership is not properly filed, (2) there are defects in a certificate that is filed, or (3) some other statutory requirement for the creation of a limited partnership is not met.  Dissolution of a general partnership—The change in the relationship of partners in a general partnership caused by any partner ceasing to be associated in the carrying on of the business.  Dissolution of a limited partnership—Just like a general partnership, a limited partnership may be dissolved.

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Entrepreneur—A person who forms and operates a new business either by himself or herself, or with others.

Entity theory of general partnerships—The Revised Uniform Partnership Act (RUPA) is based on the entity theory of general partnership; that is, a partnership is an entity distinct from its partners.

Family limited partnership (FLP)—A limited partnership that is formed by family members to hold family businesses and investments.

Fictitious business name statement (certificate of trade name)—A document that is filed with the state that designates a trade name of a business, the name and address of the applicant, and the address of the business.

Flow-through taxation—General partnerships do not pay federal income taxes. Instead, the income and losses of partnership flow onto, and have to be reported on, the individual partners’ personal income tax returns. This is called flow-through taxation.

Foreign limited partnership—A limited partnership may register as a foreign limited partnership in states other than its state of formation in which it will conduct business.

General partner (ordinary partner or partner)—A person liable for the debts and obligations of a general partnership.

General partnership (ordinary partnership or partnership)—An association of two or more persons to carry on as co-owners of a business for profit [UPA § 6(1)].

General partnership agreement (articles of general partnership or articles of partnership)—A written agreement that partners sign to form a general partnership.

Incoming partner—The incoming partner is personally liable for debts and obligations incurred by the general partnership after becoming a partner.

Information return—A general partnership has to file an information return with the government, telling the government how much income was earned or the amount of losses incurred by the partnership. This way, the government tax authorities can track whether partners are correctly reporting their income or losses.

Joint and several liability—Partners are jointly and severally liable for tort liability of the partnership. This means that the plaintiff can sue one or more of the partners separately.

If successful, the plaintiff can recover the entire amount of the judgment from any or all of the defendant-partners.

Joint liability—Partners are jointly liable for contracts and debts of the partnership. This means that a plaintiff must name the partnership and all of the partners as defendants in a lawsuit.

Liability of a general partnership—A general partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership.

Liability of a limited partnership—A limited partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a general partner acting in the ordinary course of activities of the limited partnership or with authority of the partnership.

Limited liability limited partnership (LLLP)—A special type of limited partnership that has both general partners and limited partners, where both the general and limited partners have limited liability and are not personally liable for the debts of the LLLP. Limited liability of limited partners—Partners in a limited partnership who invest capital but do not participate in management and are not personally liable for partnership debts beyond their capital contributions.

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Limited partners of a limited partnership—Partners in a limited partnership who invest capital but do not participate in management and are not personally liable for partnership debts beyond their capital contributions.

Limited partnership (LP)—A type of partnership that has two types of partners: (1) general partners and (2) limited partners.

Limited partnership agreement (articles of limited partnership)—A document that sets forth the rights and duties of the general and limited partners; the terms and conditions regarding the operation, termination, and dissolution of the partnership; and so on.

Outgoing partner—A partner who leaves the partnership either voluntarily or involuntarily.

Ownership interest—A vested interest in property rights.

Partnership at will—A partnership with no fixed duration.

Partnership for a term—A partnership with a fixed duration.

Revised Uniform Limited Partnership Act (RULPA)—A 1976 revision of the ULPA that provides a more modern comprehensive law for the formation, operation, and dissolution of limited partnerships.

Revised Uniform Partnership Act (RUPA)—A Revised Uniform Partnership Act (RUPA) has been issued by the National Conference of Commissioners on Uniform State Laws, but it has not been adopted by many states.

Right of survivorship of general partners—A rule which provides that upon the death of a general partner, the deceased partner’s right in specific partnership property vests to the remaining partner or partners; the value of the deceased general partner’s interest in the partnership passes to his or her beneficiaries or heirs.

Right to participate in management—A situation in which, unless otherwise agreed, each partner has a right to participate in the management of a partnership and has an equal vote on partnership matters.

Right to share in profits—The right to share in the profits of the partnership is considered to be the right to share in the earnings from the investment of capital.

Section 303 of the Uniform Limited Partnership Act (2001)—Permits limited partners to participate in the management of a limited partnership without losing their limited liability shield.

Sole proprietor—The owner of a sole proprietorship.

Sole proprietorship—A form of business where the owner is actually the business; the business is not a separate legal entity.

Statement of termination—A dissolved limited partnership that has completed winding up shall file a statement of termination with the secretary of state. Termination ends the legal existence of the partnership.

Tenant in partnership—A general partner is a co-owner with the other partners of the specific partnership property as a tenant in partnership.

Tort liability—The partnership and partners who are made to pay tort liability may seek indemnification from the partner who committed the wrongful act.

Trade name—A sole proprietorship can operate under the name of the sole proprietor or a trade name. Operating under a trade name is commonly designated as d.b.a. (doing business as).

Uniform Limited Partnership Act (ULPA)—The ULPA contains a uniform set of provisions for the formation, operation, and dissolution of limited partnerships.

Uniform Limited Partnership Act (2001) (ULPA (2001) or Re-ULPA)—A model act that significantly modernized the provisions of limited partnership law.

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Uniform Partnership Act (UPA)—Model act that codifies partnership law. Most states have adopted the UPA in whole or in part.

Unlimited personal liability—No limit to individual responsibility for debts and other obligations.

Unlimited personal liability of a general partner—A general partner’s personal liability for the debts and obligations of the general partnership.

Unlimited personal liability of a sole proprietor—The personal liability of a sole proprietor for all the debts and obligations of a sole proprietorship.

Winding up—Process of liquidating the partnership’s assets and distributing the proceeds to satisfy claims against the partnership.

Wrongful dissolution—When a partner withdraws from a partnership without having the right to do so at that time.

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Chapter 15 Limited Liability Companies, Limited Liability Partnerships, and Special Forms of Business What is the commotion about LLCs? I. Teacher to Teacher Dialogue The advent of limited liability companies in our system of jurisprudence reflects a synthesis of both something new and something old. Various forms of limited liability companies have been used in other parts of the world for many years. For example, Germany is considered to be the latest country to add this form of doing business, and its enabling statute is “only” a century old.

What is it, then, that kept U.S. jurisprudence from adopting this form of business for so many years? In a word: taxes. More specifically, the specter of double taxation on corporations held back the implementation of limited liability companies. Traditional interpretations of state laws allowing for limited liability focused on corporate laws. As such, the possibility for legitimate tax structure avoidance was severely limited to the rules and regulations covering “Sub-S” corporations. Subchapter S was first added to the Internal Revenue Code in 1958 and has undergone numerous revisions and updates since. The essence of these provisions has been to allow a corporation to avoid double taxation only under very limited constraints outlined in Internal Revenue Code § 1361, et al.

With increasing pressures to attract more overseas capital and investment into the United States, a number of states decided to create new forms of business entities. They would not only be familiar to overseas investors who were already comfortable with the limited liability company, but also gain the Internal Revenue Service imprimatur for being taxed like a partnership and still provide limited liability to all participants in the entity. Wyoming was the first to venture forth in heralding the modern era of L.L.C. laws in the U.S. In 1977, Wyoming passed its L.L.C. law, and in 1978, the I.R.S. issued its Revenue Ruling (Rev.Rul.88-76, 1988-2 C.B.360), which accorded partnership tax treatment to the Wyoming L.L.C. This was the first of many rulings on similar statutes adopted by virtually all states. The I.R.S. subsequently adopted the “check-the-box” and the rest is history.

Because of all the possible permutations that have evolved since this opening foray into limited liability company laws, the demand for a uniform statute was not unexpected. This chapter focuses on the main element of the Uniform Limited Liability Company Act as promulgated by the National Conference of Commissioners on Uniform State Laws. This act, in effect, seeks to “marry” the best elements of agency, partnership, and corporate law into a format that allows for uniformity and predictability on these issues throughout the U.S. As with any major turn in the process of legal evolution, we are witnessing a work in progress. The final product is far from complete, but it surely has come a long way in a generation.

As we have seen in earlier chapters, business entity choices are strategic decisions based on a number of factors. These elements include choosing the best options for potential capital investment and financing growth, protection from personal liability, and tax planning. No one entity format is ideal for all objectives. However, recent trends have led to the use of the limited liability company format as the best vehicle for providing the “best of both worlds”—the single layered conduit taxation of proprietorships and partnerships with the limited personal liability accorded to shareholders of a corporation.

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Franchises are a way of doing business around the world. The objective of this chapter involves an introduction to the concept of franchising. The world of franchising combines concepts of marketing, management, finance, and many other diverse skills into a special kind of cooperative venture that is facilitated through the law. Like any “business marriage,” it can lead to the best of all worlds or the worst. Careful planning, skilled research, and, most of all, a good faith willingness to let each participant do what he or she does best appears to be the key to today’s most successful franchise operations. Under the franchise system, there is ample evidence of the positive effects of good franchise planning. The original basic technology, patent, process, or other trademarked service or product is allowed to reach many more users or consumers through a franchise system. With intelligent planning and quality control, the original franchisor of the product or service can see phenomenal growth through the use of equity-sharing participants in that growth. Witness the fast food industry, convenience stores, food product production, all sorts of consumer good retailing systems, or even professional sports teams. All of these industries rely on the franchise concept to further their businesses.

Another interesting aspect of franchising is its tie to basic capitalism for the little guy. With sufficient start-up capital and a willingness to provide a lot of personal effort, the franchising concept allows the small businessperson to ride the coattails of the goodwill, advertising, and technology developed by large multinational enterprises.

There are some down sides to franchising as well. The “get rich quick” mentality of franchising has led to a number of abuses on the part of would-be franchisors. Many people have lost substantial sums of money trying to invest in pie-in-the-sky sales of bogus franchises. In addition, the franchise industry has seen more than its share of pyramid schemes, shallow capitalizations, adhesion contracts, and similar behavior in violation of the antitrust laws. It is interesting to note that many of the rules promulgated by the Federal Trade Commission are designed to protect persons about to enter into franchise agreements rather than the ultimate consumer of the franchise’s goods or services.

In addition, the franchise device has not always served the third party well. Because a franchisee is an independent contractor, the franchisor is not normally responsible to third parties for torts or contracts that the franchisee has been involved with. That may sound well and good in legal terms, but does it always make equitable sense? If the consumer of the goods or services thought he or she was dealing with a megacorporation, why not hold a megacorporation responsible rather than just its franchisee? Possibly have the students consider this as they proceed.

II. Chapter Objectives 1. Define limited liability company (LLC) and describe the formation of an LLC. 2. Describe the liability of limited liability companies and the limited liability of members of an LLC. 3. Compare the management of a member-managed LLC and a manager-managed LLC. 4. Describe the dissolution and winding up of limited liability companies 5. Define limited-liability partnership (LLP) and describe the formation of an LLP. 6. Describe the liability of limited liability partnerships and the limited liability of the partners of an LLP. 7. Describe the dissolution and winding up of limited liability partnerships.

8. Define franchise and describe various forms of franchises.

9. Define licensing and describe how intellectual property and software are licensed.

10. Define joint venture and describe the advantages of using a joint venture.

11. Define strategic alliance and describe the advantages of entering into a strategic alliance.

III. Key Question Checklist  How is a limited liability company organized?

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How is a limited liability company operated?

What are the fiduciary duties of loyalty and care owed to an LLC? How is an LLC dissolved and wound up?

What are the basic elements of a franchise agreement?

What are the key terms in a franchise agreement?

What are the statutory requirements regarding a franchise agreement?

What is involved in licensing?

IV. Chapter Outline Introduction to Limited Liability Companies, Limited Liability Partnerships, and Special Forms of Business – A limited liability company (LLC) is an unincorporated business entity that combines the more favorable aspects of partnerships and corporations. Most states have enacted laws that permit certain types of professionals, such as accountants, lawyers, and doctors, to operate as limited liability partnerships (LLPs). Franchising is an important method for distributing goods and services to the public. Special forms of businesses are used in domestic and international commerce. Licensing permits one business to use another business’s trademarks, service marks, trade names, and other intellectual property in selling goods or services. Joint ventures allow two or more businesses to combine their resources to pursue a single project or transaction. Strategic alliances are often used to enter foreign markets.

Limited Liability Company (LLC) – LLCs are creatures of state law, not federal law. They are allowed to operate as separate legal entities distinct from their members. An LLC is treated as a person in order to be able to carry out its business affairs.

Landmark Law: Uniform Limited Liability Company Act and Revised Uniform Limited Liability Company Act The Uniform Limited Liability Company Act (ULLCA) codifies LLC law. Its goal is to establish comprehensive LLC law that is uniform throughout the United States. The ULLCA was revised in 2006, and this revision is called the Revised Uniform Limited Liability Company Act (RULLCA). Many states have adopted all or part of the ULLCA or the RULLCA as their LLC law.

Taxation of LLCs – The IRS has held that LLCs will be taxed as partnerships, unless they elect to be taxed as corporations. Thus, an LLC is not taxed at the entity level, but its income or losses are reported on the members’ individual income tax returns. This called “flow through” taxation, and avoids double taxation.

Formation of an LLC – The ULLCA and the RULLCA authorize that an LLC may be organized by one or more persons. Most LLCs are formed by entrepreneurs when they start new businesses.

Existing businesses such as sole proprietorships, general partnerships, limited partnerships, and corporations can convert to LLC status.

State of Organization – An LLC can be organized in only one state, even though it can conduct business in all other states.

Name of a Limited Liability Company – They are designated by either the words “limited liability company,” “limited company,” or the abbreviations LLC, L.L.C., LC, or L.C. Articles of Organization and Certificate of Organization – The articles of organization (which some states call a certificate of organization) must set forth the name of the LLC, the address of 164 .

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its initial office, the name and address of the initial agent for service of process, and other information deemed relevant by the organizers. The articles are filed with the secretary of state.

Business Environment: Limited Liability Company Operating Agreement Members of an LLC may enter into a limited liability company operating agreement that regulate the affairs of the company and the conduct of its business and governs relations among the members, managers, and the company. The provisions agreed to in the operating agreement take precedence over the rules of the ULLCA and the RULLCA. If members of an LLC do not have an operating agreement, then the rules of the state’s LLC law become the default rules that govern the LLC. If there is an operating agreement but it fails to provide for an essential terms or contingency, the provisions of the relevant LLC law apply and serve as a gap-filling device to the members’ agreement.

Share in Profits and Distributions – The members of an LLC may agree how profits, losses, and distributions will be shared by members. If there is not such agreement, the ULLCA provides that profits and losses are allocated according to the value of each members’ capital contribution to the LLC. The RULLCA provides that if there is no prior agreement, then profits and losses will be shared per capita; that is, equally among members event if their capital contributions to the LLC were not equal.

Distributional Interest – This is a member’s ownership interest in an LLC. It is personal property and is freely transferable in whole or in part. A transfer of an interest in an LLC does not entitle the transferee to become a member of the LLC or to exercise any right of a member. A transfer entitles the transferee to receive only the share of the profits or other distributions from the LLC, of which the transferor would have been entitled.

Liability of Limited Liability Companies and Limited Liability of Members – In the course of conducting business, the agents and employees of an LLC may enter into contracts on behalf of the LLC. Sometimes, the LLC may not perform these contracts. Additionally, the agents or employees of an LLC may be involved in accidents or otherwise cause harm to third parties when acting on LLC business. These issues raise liability implications for the LLC, its members, and its managers.

Liability of a Limited Liability Company – An LLC is liable for any loss or injury caused to a person as a result of a wrongful act or omission by a member, a manager, an agent, or an employee of the LLC who commits the wrongful act while acting within the ordinary course of business of the LLC, or with authority of the LLC. An LLC is liable for members’ or managers’ tortious conduct and for contracts entered on behalf of the company while they are acting within LLC authority.

Members’ Limited Liability – The general rule is that members of an LLC are not personally liable to third parties for the debts, obligations, and liabilities of an LLC beyond their capital contribution. The debts, obligations, and liabilities of an LLC, whether arising from contracts, torts, or otherwise, are solely those of the LLC.

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State Court Case Case 15.1 Limited Liability Company: Siva v 1138 LLC Facts: Siva entered into a written lease agreement with 1138 LLC whereby 1138 LLC leased premises in Siva’s commercial building for a term of five years at a monthly rental of $4,000.

1138 LLC began operating a bar on the premises. Six months later, 1138 LLC was in default and breach of the lease agreement. Siva sued 1138 LLC and Richard Hess, a member of 1138 LLC, to recover damages. Siva received a default judgment against 1138 LLC, but there was no money in 1138 LLC to pay the judgment. Hess, who had been sued personally, defended. The trial court found in favor of Hess and dismissed Siva’s complaint against Hess. Siva appealed.

Issue: Is Richard Hess, a member-owner of 1138 LLC, personally liable for the debt owed by the LLC to Siva?

Decision: The court of appeals affirmed the decision of the trial court that dismissed Siva’s complaint against Hess.

Reason: No evidence could show that Hess purposely undercapitalized 1138 LLC, or that he formed the limited liability company in an effort to avoid paying creditors. Also, the evidence did not show that Siva was misguided as to the fact he was dealing with a limited liability company.

So Hess, as a member-owner of 1138 LLC, was not personally liable for the debt that the LLC owed to Siva.

Ethics Questions: Students’ answers may vary. Hess owed no ethical duty to personally pay the debt. The LLC owed a duty not to spend beyond what they had, but no individual member owed any duty to make up the shortage. Siva was unethical in attempting to get the money from a member.

Liability of Managers – Managers of LLCs are not personally liable for the debts, obligations, and liabilities of the LLC they manage.

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Management of a Limited Liability Company – An LLC can be either a member-managed LLC or a manager-managed LLC. An LLC is a member-managed LLC unless it is designated as a manger-managed LLC in its articles of organization or in its operating agreement.

Member-Managed LLC – In a member-managed LLC, each member has equal management rights.

Manager-Managed LLC – In a manager-managed LLC, each manager has equal management rights, but members that are not designated as managers have no management rights.

Nonmembers may be managers.

Agency Authority to Bind an LLC to Contracts – In member-managed LLCs, all members have agency authority to bind the LLC to contracts. In a manager-managed LLC, only managers can bind the LLC to contracts.

Duty of Loyalty – Members of member-managed LLCs and managers in manager-managed LLCs owe a fiduciary duty of loyalty to the LLC. This is a duty to be honest in their dealings with the LLC and to not act adversely to the interests of the LLC. No Fiduciary Duty Owed – Members that are not managers in manager-managed LLCs owe no duty of loyalty or care to the LLC or its other members.

Business Environment: Advantages of Operating a Business as an LLC Some of the advantages of operating a business as an LLC are:  An LLC can have any number of member-owners, whereas an S corporation can have only 100 shareholders  An LLC has flow-through taxation the same as general and limited partnerships and S corporations  An LLC can have nonresident alien member-owners  An S corporation can have only one class of stock, whereas an LLC can have more than one class of interest  Members of LLCs can manage the business and still have limited liability  An LLC can be owned by one owner in most states Dissolution and Winding up of Limited Liability Companies – According to the ULLCA, the dissolution of a limited liability company occurs by: (1) An event specified in the operating agreement; (2) The consent of the number or percentage of members specified in the operating agreement; (3) An event that makes it unlawful to carry on the business of the LLC; (4) On application by a member, a court issues an order or determination that the LLC need be dissolved; and (5) Expiration of the term of the LLC. The RULLCA additionally provides for the dissolution of an LLC upon the affirmative vote of all members.

Winding Up of an LLC and Distribution of Assets – The process of winding up an LLC consists of the liquidation (sale) of the LLC assets and the distribution of the proceeds to satisfy claims against the LLC. After LLC assets have been liquidated and reduced to cash, the proceeds are distributed to satisfy claims against the LLC in the following order: (1) Creditors (including members who are creditors); and (2) Settlement of members accounts.

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Continuation Agreement – This is an agreement providing that an LLC will be continued following the withdrawal of a member or other specified event. This usually involves a buyout of a withdrawing member’s interest in the LLC. Limited Liability Partnership (LLP) –The LLP is a special form of partnership in which all partners are limited partners, and there are no general partners. This is a preferred form of organization for many professionals, including accountants, lawyers, and doctors.

Landmark Law: Uniform Limited Liability Partnership Amendments In 1996, the National Conference of Commissioners on Uniform State Laws adopted the Uniform Limited Liability Partnership Amendments (ULLPA) to the Uniform Partnership Act. These LLP amendments now appear as part of the Revised Uniform Partnership Act (RUPA).

The ULLPA amends the RUPA to provide for the formation, operation, and termination of limited liability partnerships. Many states have adopted the RUPA, as amended by the ULLPA, as their LLP law. Some states have adopted separate LLP statutes. State statutes that govern LLPs are commonly referred to as limited liability partnership codes or limited liability partnership acts.

Formation of a Limited Liability Partnership – For a partnership to become an LLP, there must be an affirmative vote to choose LLP status by the number of partners that is necessary to amend the partnership agreement. The partnership must then file a statement of qualification (also known as articles of limited liability partnership) with the secretary of state that states: (1) The name of the LLP; (2) The address of the partnership’s principal office: and (3) A statement that the partnership elects to become a limited liability partnership.

The LLP is a domestic limited liability partnership in the state in which it is organized. An LLP may do business in other states—to do so, the LLP must register as a foreign limited liability partnership in any state in which it wants to conduct business.

Name of a Limited Liability Partnership – The name of a limited liability partnership must contain the phrase “Registered Limited Liability Partnership” or “Limited Liability Partnership” or the abbreviation “R.L.L.P.,” “L.L.P.,” “RLLP,” or “LLP.” Business Environment: Limited Liability Partnership Agreement Although not required, most LLPs have a written limited liability partnership agreement. A written document is important evidence of the terms of the LLP agreement, particularly if a dispute arises among the partners. The provisions of the partnership agreement take priority over the language of a state’s LLP statute. If partners do not have a partnership agreement, then the rules of the state’s LLP law become the default rules that govern the LLP and the relationship of the partners to the LLP and to each other. If a partnership agreement exists but it fails to provide for an essential term or contingency, the provisions of the relevant LLP law apply and serve as a gap-filling device to the partners’ agreement.

Taxation of a Limited Liability Partnership – LLPs enjoy the flow-through tax benefit of other types of partnerships—that is, there is no tax paid at the partnership level, and all profits and losses are reported on the individual partners’ income tax returns. Thus, there is no double taxation of the entity and the owners.

Right to Participate in Management – Each partner of an LLP has an equal right to participate in the management and conduct of partnership business. Unless otherwise agreed, each partner

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has one vote, regardless of the proportional size of his or her capital contribution or share in the partnership’s profits. A simple majority decides most ordinary partnership matters.

Right to Share in Profits – Unless otherwise agreed, each partner of an LLP has an equal right to share in profits of the partnership. Each partner is chargeable with a share of the partnership losses in proportion to the partner’s share of the LLP’s profits. The partners also have an equal right to share in the earnings from the investment of capital. LLP agreements can provide that profits and losses are to be allocated in proportion to the partners’ capital contributions or in any other manner.

Liability of Limited Liability Partnerships and Limited Liability of Partners – The LLP must deal with third parties in conducting partnership business. This often includes entering into contracts with third parties. Partners, as well as employees and agents of the LLP, sometimes injure third parties while conducting partnership business. Such actions create potential liability issues for LLPs and their partners.

Liability of a Limited Liability Partnership – A partner who enters into a contract in the LLP’s name for carrying on the ordinary course of the partnership’s business binds the partnership.

Contracts entered into by partners on behalf of LLPs typically included contracts with suppliers, customers, lenders, landlords, employees, or other contracts. An LLP is liable for contracts entered into on behalf of the partnership.

Sometimes, partners or employees of LLPs commit tortious conduct that causes injury to a third person. This tort could be caused by a negligent act, a breach of trust, or intentional tort. The LLP is liable if the act is committed while the person is acting within the ordinary course of partnership business.

Limited Liability of Partners – In an LLP, there does not have to be a general partner who is personally liable for the debts and obligations of the partnership. Instead, all partners are limited partners who have limited liability and stand to lose only their capital contribution if the partnership fails. None of the partners is personally liable for the debts and obligations of the partnership beyond his or her capital contribution.

Duty of Loyalty – A partner of an LLP owes a duty of loyalty to the LLP. The duty of loyalty of partners of a limited liability partnership means that the partners must act honestly in their dealings with the LLP. The duty of loyalty includes the duty not to: (1) Make secret profits or benefits; (2) Usury the LLP’s opportunities; (3) Deal with the LLP while having an adverse interest with the LLP; (4) Compete with the LLP; or (5) Represent any party who has interests adverse to those of the LLP. Business Environment: Accounting Firms Operate as LLPs Prior to the advent of the limited liability partnership (LLP) form of doing business, accounting firms operated as general partnerships. As such, the general partners were personally liable for the debts and obligations of the general partnership. Many lawsuits were brought in conjunction with the failure of large commercial banks and other large firms that accountants had audited. To address this issue, state legislatures created a new form of business, the LLP. This entity was particularly created for accountants, lawyers, and other professionals to offer their services under an umbrella of limited liability. The partners of an LLP have limited liability up to their capital contribution; the partners do not have personal liability for the debts and liabilities of the LLP, however.

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Dissolution and Winding Up of Limited Liability Partnerships – The RUPA provides for the dissolution of an LLP. Where an LLP is a partnership at will, it is dissolved when the general partnership receives notice from a general partner of their express will to withdraw as a partner.

Where an LLP is a partnership for a term that is for a specific time or purpose, the LLP dissolves automatically upon the expiration of the time or the accomplishment of the objective.

A partner who withdraws from a partnership for a term prior to the expiration of the term does not have the right to dissolve the partnership. The partner’s action causes a wrongful dissolution of the partnership. A partner who wrongfully withdraws from an LLP is liable to the partnership and other parnters for damages caused by the wrongful dissolution.

Winding Up of an LLP and Distribution of Assets – Winding up consists of the liquidation (sale) of partnership asses and the distribution of the proceeds to satisfy claims against the partnership. After a LLP’s assets have been liquidated and reduced to cash, the proceeds are distributed to satisfy claims against the LLP. Under the RUPA, the debts are satisfied in the following order: (1) creditors (including partners who are creditors); and (2) Settlement of partners’ accounts.

Continuation Agreement – An LLP’s operating agreement may contain a continuation agreement that provides for the continuation of the LLP upon the withdrawal of a partner or other specified event. This usually involves a buyout of a withdrawing partner’s interest in the LLP. The partners can agree on the price of the buyout, whether the payment to the withdrawing partner will be made immediately or by installments, or when the LLP ends.

Franchise – A franchise is established when one party (the franchisor, or licensor) licenses another party (the franchisee, or licensee) to use the franchisor’s trade name, trademarks, commercial symbols, patents, copyrights, and other property in the distribution and selling of goods and services.

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Types of Franchises – The four basic forms of franchises are:  Distributorship Franchise – A distributorship franchise is when a franchisor manufactures a product and licenses retail dealers to sell the product.  Processing Plant Franchise – Processing plant franchises occur when the franchisor provides a secret formula or intellectual property to the franchisee, who then manufactures and distributes the product to retailers.  Chain-Style Franchise – In a chain-style franchise, the franchisor licenses the franchisee to make and sell its products or services to the public from a retail outlet serving an exclusive geographical territory.  Area Franchise – In an area franchise, the franchisor authorizes the franchisee to negotiate and sell franchises on behalf of the franchisor. The area franchisee is called a subfranchisor.

Franchise Agreement – Prospective franchisees file an application with a franchisor that provides detailed information. If approved, the parties enter into a franchise agreement. A franchisor’s ability to maintain the public’s perception of the quality of the goods and services associated with its trade name, trademarks, and service marks is the essence of its success.

Franchisors are often owners of trade secrets, including product formulas, business plans and models, and other ideas.

Liability of Franchisors and Franchisees – The franchisor and franchisee are separate legal entities, with the franchisee being treated as an independent contractor. Franchisees are liable on their own contracts and are liable for their own torts. Franchisors are liable for their own contracts and torts. Generally, neither party is liable for the contracts or torts of the other.

State Court Case Case 15.2 Franchise Liability: Rainey v. Domino’s Pizza, LLC Facts: Domino’s granted a franchise to TDBO, Inc., to operate a franchise restaurant in Gorham, Maine. The agreement expressly stated that TDBO was an independent contractor and that Domino’s was not liable for TDBO’s debts and obligations. Edward Langen was an employee of TDBO. Paul Rainey, while riding his motorcycle, was seriously injured in a collision with a car driven by Langen, who was delivering a pizza for his employer. Rainey sued Langen, TDBO, and Domino’s, alleging negligence and vicarious liability. Domino’s moved for summary judgment on the negligence and vicarious liability counts. The trial court granted Domino’s motion for summary judgment, finding that Domino’s was not vicariously liable for its franchisee’s negligence. Rainey appealed this judgment.

Issue: Under the facts of this case, can Domino’s be held vicariously liable for the alleged negligence of its franchisee TDBO? Decision: The court found that Domino’s was not vicariously liable for the alleged negligence of its franchisee TDBO and affirmed the trial court’s grant of summary judgment in favor of Domino’s.

Reason: The most important factor to be considered in distinguishing between employees and independent contractors is the “right to control.” The quality, marketing, and operational standards present in the agreement do not establish the supervisory control or right of control necessary to impose vicarious liability.

Ethics Questions: The agreement between Domino’s and TDBO expressly stated that TDBO was an independent contractor and that Domino’s was not liable for TDBO’s debts and obligations. Thus, Domino’s breached its duty of ethics by denying liability in this case.

However, it would be practically impossible for franchisors to control each and every aspect of its franchisees’ business operations. If franchisors were held vicariously liable for the debts and

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obligations of their franchisees, franchising might no longer remain profitable for franchisors.

Such liability exposure could have a chilling effect on the franchise form of business operation.

Licensing – Licensing is a business arrangement that occurs when the owner of intellectual property (the licensor) contracts to permit another party (the licensee) to use the intellectual property.

Joint Venture – A joint venture is an arrangement in which two or more business entities combine their resources to pursue a single project or transaction. In a joint venture partnership, each joint venture is liable for the debts and obligations of the joint venture partnership. In a joint venture corporation, the joint venturers are shareholders of the joint venture corporation. The joint venture corporation is liable for its debts and obligations. The joint venturers are liable for the debts and obligations of the joint venture corporation only up to their capital contributions to the joint venture corporation.

Strategic Alliance – A strategic alliance is an arrangement between two or more companies whereby they agree to ally themselves and work together to accomplish a designated objective. A strategic alliance allows the companies to reduce risks, share costs, combine technologies, and extend their markets. Strategic alliances are often used to conduct international business.

V. Key Terms and Concepts  Area franchise (area development franchise or master franchise)—The franchisee is authorized to sell franchises on behalf of the franchisor within a geographical area.  Articles of organization (certificate of organization)—The formal documents that must be filed at the secretary of state’s office of the state of organization of a limited liability company (LLC) to form the LLC.  Chain-style franchise—The franchisor licenses the franchisee to make and sell its products or distribute services to the public from a retail outlet serving an exclusive territory.  Continuation agreement—An agreement that provides that an LLC will be continued following the withdrawal of a member or other specified event.  Dissolution of a limited liability company—Occurs by: (1) an event specified in the operating agreement; (2) the consent of the number or percentage of members specified in the operating agreement; (3) an event that makes it unlawful to carry on the business of the LLC; (4) on application by a member, a court issues an order or determination that the LLC need be dissolved; and (5) the expiration of the term of the LLC.  Dissolution of a limited liability partnership—Upon dissolution of a limited liability partnership, the process of winding up the partnership commences. This consists of the liquidation (sale) of partnership assets and the distribution of the proceeds to satisfy claims against the partnership.  Distributional interest—A member’s ownership interest in an LLC that entitles the member to receive distributions of money and property from the LLC.  Distributorship franchise—The franchisor manufactures a product and licenses a retail franchisee to distribute the product to the public.  Domestic limited liability company—The limited liability company is a domestic LLC in the state in which it is organized.  Domestic limited liability partnership—The limited liability partnership is a domestic LLP in the state in which it is organized.

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Duty of loyalty of members of a limited liability company—A duty owned by a member of a member-managed LLC and a manager of a manager-managed LLC to be honest in his or her dealings with the LLC and to not act adversely to the interests of the LLC. Duty of loyalty of partners of a limited liability partnership—This means that the partners must act honestly in their dealings with the LLP. Partners who violate their duty of loyalty are liable for damages caused to the LLP or other partners.

Flow through taxation—An LLC is not taxed at the entity level, but its income or losses “flow through” to the members’ individual income tax returns.

Foreign limited liability company—If an LLC wants to do business in a state where it is not organized, the LLP must register as a foreign LLC. Foreign limited liability partnership—If an LLP wants to do business in a state where it is not organized, the LLP must register as a foreign LLP. Franchise—Established when one party licenses another party to use the franchisor’s trade name, trademarks, commercial symbols, patents, copyrights, and other property in the distribution and selling of good and services.

Franchise agreement—An agreement that a franchisor and franchisee enter into that sets forth the terms and conditions of a franchise.

Franchise application—The franchise application often includes detailed information about the applicant’s previous employment, financial and educational history, credit status, and so on.

Franchisee (licensee)—The party who is granted the franchise and license by a franchisor in a franchise arrangement.

Franchisor (licensor)—The party who grants the franchise and license to a franchisee in a franchise arrangement.

Joint venture—An arrangement in which two or more business entities combine their resources to pursue a single project or transaction.

Joint venture corporation—A corporation owned by two or more joint venturers that is created to operate a joint venture.

Joint venture partnership—If a joint venture is operated as a partnership, each joint venturer is considered a partner of the joint venture. In a joint venture partnership, each joint venturer is liable for the debts and obligations of the joint venture partnership.

Joint venturer—A party to a joint venture.

License—Business arrangement in which one party which holds a trademark, service mark, trade name, or other intellectual property licenses another party to use them in distribution of goods, services, or software.

Licensee—The party to whom a license is granted.

Licensing—A business arrangement that occurs when the owner of intellectual property (the licensor) contracts to permit another party (the licensee) to use the intellectual property.

Licensor—The party who grants a license.

Limited liability company (LLC)—An unincorporated business entity that combines the most favorable attributes of general partnerships, limited partnerships, and corporations.

Limited liability company codes (limited liability company acts)—State statutes that regulate the formation, operation, and dissolution of LLCs. Limited liability company operating agreement—An agreement entered into among members that governs the affairs and business of the LLC and the relations among members, managers, and the LLC. Limited liability of members of LLCs—Members are liable for the LLC’s debts, obligations, and liabilities only to the extent of their capital contributions.

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Limited liability of partners of LLPs—The liability of LLP partners for the LLP’s debts, obligations, and liabilities is limited only to the extent of their capital contributions.

Partners of LLPs are not personally liable for the LLPs’ debts, obligations, and liabilities.

Limited liability partnership (LLP)—A special form of partnership in which all partners are limited partners, and there are no general partners.

Limited liability partnership codes (limited liability partnership acts)—LLPs are creatures of state law, not federal law. These statutes are commonly referred to as limited liability partnership codes.

Limited liability partnership agreement—Although not required, most LLPs have a written limited liability partnership agreement. A written document is important evidence of the terms of the LLP agreement, particularly if a dispute arises among the partners.

The general partners may tailor the structure of the partnership agreement to meet their business needs. The parties can agree to almost any terms in their partnership agreement, except terms that are illegal.

Manager-managed limited liability company—An LLC that has designated in its articles of organization that it is a manager-managed LLC. Member—An owner of an LLC. Member-managed limited liability company—An LLC that has not designated that it is a manager-managed LLC in its articles of organization.

Processing plant franchise—The franchisor provides a secret formula or process to the franchisee, and the franchisee manufactures the product and distributes it to retail dealers.

Revised Uniform Limited Liability Company Act (RULLCA or Re-ULLCA or Uniform Limited Liability Company Act (2006))—The ULLCA was revised in 2006, and this revision is called the Revised Uniform Limited Liability Company Act (RULLCA).

Revised Uniform Partnership Act (RUPA)—Many states have adopted the RUPA, as amended by the Uniform Limited Liability Partnership Amendments (ULLPA), as their LLP law.

Right to participate in management—One of the benefits of an LLP is that all partners are allowed to be involved in the management of the LLP. Each partner of an LLP has an equal right to participate in the management and conduct of partnership business.

Right to share in profits—Unless otherwise agreed, each partner of an LLP has an equal right to share in the profits of the partnership.

Service mark—A distinctive mark, symbol, name, word, motto, or device that identifies the services of a particular franchisor.

Statement of qualification (articles of limited liability partnership)—The formal documents that must be filed at the secretary of state’s office of the state of organization of an LLP to form the LLP. Strategic alliance—An arrangement between two or more companies whereby they agree to ally themselves and work together to accomplish a designated objective. A strategic alliance allows the companies to reduce risks, share costs, combine technologies, and extend their markets.

Subfranchisor—In an area franchise, the franchisor authorizes the franchisee to negotiate and sell franchises on behalf of the franchisor. The area franchisee is called a subfranchisor.

Tortfeasor—A person who intentionally or unintentionally (negligently) causes injury or death to another person. A person liable to the persons he or she injures and to the heirs of the persons who die because of his or her conduct.

Trademark—A distinctive mark, symbol, name, word, motto, or device that identifies the goods of a particular franchisor.

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Trade secret—Ideas that make a franchise successful but that do not qualify for trademark, patent, or copyright protection.

Uniform Limited Liability Company Act (ULLCA)—A model act that provides comprehensive and uniform laws for the formation, operation, and dissolution of LLCs. Uniform Limited Liability Partnership Amendments (ULLPA)—In 1996, the National Conference of Commissioners on Uniform State Laws adopted the Uniform Limited Liability Partnership Amendments (ULLPA) to the Uniform Partnership Act. These LLP amendments now appear as part of the Revised Uniform Partnership Act (RUPA).

Winding up—The liquidation of a limited liability company’s assets and the distribution of the proceeds to satisfy claims against the company.

Wrongful dissolution—A partner who withdraws from a partnership for a term prior to the expiration of the term does not have the right to dissolve the partnership. The partner’s action causes a wrongful dissolution of the partnership. A partner who wrongfully withdraws from an LLP is liable to the partnership and other partners for damages caused by the wrongful dissociation.

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Chapter 16 Corporations and Corporate Governance What is a corporation?

I. Teacher to Teacher Dialogue Corporations can provide many advantages for business including perpetual existence, limited liability, and numerous tax and other legal opportunities to massage the system. These advantages are not free, nor are they always easily obtained. Corporate law has always been more technically intricate and demanding of legal practitioners. It can also be more unforgiving to its users than sole proprietorships or partnerships if mistakes are made in its formation and financing. The stakes are simply greater because over eighty-five percent of business done in the U.S. uses the corporate format. This chapter has several objectives: to illustrate how the corporate form is established legally and how it is infused with funds. In addition, the process of establishing the basic ground rules for the key players will be examined.

The formation of a corporation starts with a contracting process initiated by a person called a promoter. A promoter of a new corporation is really the catalyst that brings together the diverse elements of law, finance, entrepreneurial talent, and technical competence that will eventually drive the fortunes of the new business entity. The role of promoter is also tied to the laws of contract, fiduciaries, and agency. He or she is expected to act for the benefit of the eventual corporation and can be expected to be personally liable for contracts entered into on its behalf in the interim.

The promoter’s main duties are bifurcated towards two main audiences—the state and potential investors. He or she will be involved in contracts with both of these constituencies. With regard to the state, the actual creation of the new corporate entity is the outgrowth of a document called the charter. This document is the foundation contract between the promoter and the state.

The charter takes the form of a certificate of incorporation. This certificate provides the official state-sanctioned ground rules under which the new corporate entity will be allowed to do business. Violation of these ground rules can lead to an eventual corporate death penalty, the revocation of the charter. The second critical task of the promoter is to find legal methods for the start-up of the corporation so that it may be infused with funds. The corporate form is unparalleled in its ability to be a fund-raiser. These funds are generated by two basic methods— debt and equity financing.

Once the proper procedures for the establishment of the corporation have been complied and adequate financing has been secured, the next step is to see what the basic ground rules will be for key players in this arena. The leading protagonists will be the board of directors, shareholders, and managers of the corporation. The distinctions among these roles are sometimes blurred when it comes to the formation and management of corporations. Yet failure to honor these distinctions can lead to disastrous consequences.

When most people are asked about the associations they have with the word “corporation,” they think of the large companies mentioned in the financial news of the day.

Usually this group of companies will encompass those entities listed in the Fortune 500, the Dow Jones Industrial, or companies publicly traded on the New York or American Stock Exchanges.

In terms of financial importance, these companies certainly do dominate the corporate landscape. The world of corporations has, however, a much less public face—the face of the closely held corporation. Black’s Law Dictionary defines a close corporation as “one where the shares are held by a single or closely knit group of shareholders.” Generally, there are no public 176 .

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investors and its shareholders are active in the conduct of the business. The vast majority of forprofit business entities using the corporate form are, in fact, closely held. Only five percent of all corporations are publicly traded. In the world of closely held corporations, stock ownership is not widely dispersed, and control is held in virtual perpetuity through proxies and other mechanisms within the “closed” group.

What is interesting about this two-sided (public vs. closed) corporate landscape is that, except for some special rules set out in individual state closed corporation statutes, the rules of corporate formation are virtually the same for both. The basic rights, duties, and expectations of shareholders, directors, and corporate officers are the same on paper for both large and small corporations. The reality is far different. The hows, whys, and wherefores of control over, for example G.M., are completely different from a small family business. Both entities must comply with the rules, however. Once these rules have been established in the formation process, subsequent chapters will proceed to examine the rights, duties, and liabilities of these persons not only vis-à-vis each other, but also with respect to third parties who deal with them. Remember, most people who get in trouble with corporate law do so not because they are bad managers, directors, or shareholders. They get into trouble because they sometimes do not follow the rules of corporate formation and operation.

This chapter lends itself to the old “black letter” law approach because of the sheer volume of rules, definitions, and procedures set out in these materials. One of the most important aspects of this entire body of law is to constantly remind students that the use of the corporate form constitutes a favor, not an entitlement, in the eyes of the law. The law allows for many distinct advantages to the corporate entity; but what the law gives with one hand, it can take away with the other. How to protect those corporation-based prerequisites is really what this chapter is all about. Where the rules of the corporate law road are honored, safe passage and a restful reward are assured. Where they are not, personal liability looms near. Thus, as a matter of teaching technique, it might be helpful to present this material in the following order: 1. A diagram of the corporate lines of authority.

2. The respective rights and duties of the various parties in that line of authority.

3. A listing of responsibilities and liabilities of these parties not only to each other, but also to key third parties such as shareholders and parties having a contract or tort nexus with the corporation.

In all three scenarios try to give case examples that illustrate the rule of law being discussed.

II. Chapter Objectives 1.

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Define corporation and list the major characteristics of a corporation.

Describe the limited liability of shareholders of a corporation.

Describe the process of incorporating and forming a corporation.

Describe how a corporation is financed by equity securities and debt securities.

Define shareholder and describe the rights of shareholders of corporations.

Define board of directors and describe the duties of members of boards of directors of corporations.

7. Define corporate officer and describe the duties and scope of authority of corporate officers.

8. Describe directors’ and officers’ duty of loyalty and duty of care and define the business judgment rule.

9. Describe how the Sarbanes-Oxley Act affects corporate governance.

10. Define merger, share exchange, and tender offer and describe the process of corporate acquisition.

11. Describe how a corporation is dissolved and terminated.

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12. Examine the use of multinational corporations in conducting international business.

III. Key Question Checklist    

What are the fiduciary duties of a director?

When will a shareholder be held responsible for the actions or omissions to third parties?

When can a shareholder act against wrongful actions of a corporation?

How does the Sarbanes-Oxley Act affect corporations?

IV. Chapter Outline Introduction to Corporations and Corporate Governance – Corporations are the most dominant form of business organization in the United States, generating more than 85 percent of the country’s gross business receipts. Owners of corporations are called shareholders.

Shareholders elect the board of directors and vote on fundamental changes in the corporation. The directors are responsible for making policy decisions and employing officers. Officers are responsible for the corporation’s day-do-day operations.

Nature of the Corporation – A corporation is a fictitious legal entity that is created according to statutory requirements. Corporation codes regulate the formation, operation, and dissolution of corporations. Corporations can be created only pursuant to the laws of the state of incorporation.

Landmark Law: Revised Model Business Corporation Act The Model Business Corporation Act (MBCA) was intended to provide a uniform law regulating the formation, operation, and termination of corporations. In 1984, the Committee on Corporate Laws of the American Bar Association completely revised the MBCA and issued the Revised Model Business Corporation Act (RMBCA). Most states have adopted all or part of the RMBCA. The Corporation as a Legal “Person” – A corporation is a separate legal entity (or legal person) for most purposes. Corporations are treated, in effect, as artificial persons created by the state that can sue or be sued in their own names, enter into and enforce contracts, hold title to and transfer property, and be found civilly and criminally liable for violations of law.

Characteristics of a Corporation – Some of the major characteristics of a corporation are: (1) Free transferability of shares; (2) Perpetual existence; and (3) Centralized management.

Classifications of Corporations – For-profit corporations, or profit corporations, are private corporations that are created to conduct a business for profit and can distribute profits to shareholders in the form of dividends. They are owned by private parties, not by the government.

Publicly held corporations are for-profit corporations that have many shareholders. A closely held corporation, or privately held corporation, is a for-profit corporation whose shares are usually owned by a few shareholders who are often family members, relatives, or friends.

A public benefit corporation (benefit corporation, B corporation, or PBC) is a for-profit corporation whose purpose is to create general or specific public benefits (for example, protecting the environment).

Limited Liability of Shareholders – As a general rule, shareholders are liable only to the extent of their capital contributions for the debts and obligations of their corporation and are not personally liable for the debts and obligations of the corporation.

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State Court Case Case 16.1 Shareholder’s Limited Liability: Menendez v. O’Niell Facts: A vehicle driven by Michael O’Niell crashed while traveling on Louisiana Highway 30.

Vanessa Savoy, a 19-year-old guest passenger in the vehicle, sustained severe injuries as a result of the collision. O’Niell, who was under the legal drinking age, had been drinking at Fred’s Bar and Grill prior to the accident. Fred’s Bar is owned by Triumvirate of Baton Rouge, Inc., a corporation. Marc Fraioli is the sole shareholder and president of Triumvirate. Savoy, through a legal representative, brought a lawsuit against O’Niell, O’Niell’s automobile insurance company, Triumvirate, and Fraioli seeking damages for her injuries. Fraioli filed a Motion for Summary Judgment asserting that as a shareholder of Triumvirate Corporation, he was not liable for the corporation’s debts. The trial court granted summary judgment to Fraioli and dismissed him as a defendant in the case. Savoy appealed.

Issue: Is Fraioli personally liable for the debts of Triumvirate, a corporation of which he is the sole shareholder?

Decision: The court of appeal affirmed the trial court’s grant of summary judgment dismissing Fraioli from the case.

Reason: As a general rule, a corporation is a distinct legal entity, separate from the individuals who comprise them, and individual shareholders are not liable for the debts of the corporation.

Mr. Fraioli met his burden of proving Triumvirate’s corporate existence. The involvement of a sole or majority shareholder in a corporation is not sufficient alone, as a matter of law, to establish a basis for disregarding the corporate entity.

Ethics Questions: One of the primary reasons to operate a business as a corporation, rather than as a sole proprietorship, is the “corporate shield.” The corporate form of business operation shields the owner from personal liability for corporate debt and other obligations. In contrast, in a sole proprietorship, there is no distinction between the liability of the business and the liability of the owner. The sole proprietor is personally responsible for the debts of the sole proprietorship.

Although Fraioli’s ethics may be in question for using the corporate shield to avoid liability (especially since he was the Triumvirate Corporation’s sole shareholder), he certainly has the legal right to do so.

Incorporation Procedure – The organizers of a corporation must comply with the state’s corporation code to form a corporation.

Selecting a State for Incorporating a Corporation – A corporation can be incorporated in only one state, even though it can do business in all other states in which it qualifies to do business.

A corporation is a domestic corporation in the state in which it is incorporated. It is a foreign corporation in all other states and jurisdictions. An alien corporation is a corporation that is incorporated in another country.

Promoters and Incorporators – A promoter is a person who organizes and starts a corporation.

The parties who sign the articles of incorporation are called incorporators.

Articles of Incorporation – The articles of incorporation, or corporate charter, form the basic governing document of a corporation. Under the RMBCA, the articles of incorporation must include: (1) The name of the corporation; (2) The number of shares the corporation is authorized to issue; (3) The address of the corporation’s initial registered office and the name of the initial registered agent (a registered agent is a person or corporation that is empowered to accept service of process on behalf of the corporation); and 179 .

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(4) The name and address of each incorporator.

Corporate Bylaws – Bylaws are a detailed set of rules adopted by the board of directors after a corporation is incorporated that contains provisions for managing the business and the affairs of the corporation. Either the incorporators or the initial directors can adopt the bylaws of the corporation. Bylaws do not have to be filed with any government official. Shareholders have the absolute right to amend the bylaws.

Organizational Meeting of the Board of Directors – An organizational meeting of the initial directors of a corporation must be held after the articles of incorporation are filed. At this meeting, the directors must adopt the bylaws, elect corporate officers, and transact such other business as may come before the meeting.

Business Environment: S Corporation Election for Federal Tax Purposes This section describes the basic parameters under which the “Subchapter S” rules of the Internal Revenue Code can be used to avoid double taxation by relatively small, closely-held corporations.

Financing the Corporation – A corporation needs to finance the operation of its business. The most common way to do this is by selling equity securities and debt securities. Equity securities (or stocks) represent ownership rights in the corporation. Equity securities can be common stock and preferred stock.

Common Stock – A type of equity security that represents the residual value of the corporation:  Common stock has no preferences  Common stock does not have a fixed maturity date  Corporations may issue different classes of common stock  Common shareholders have limited liability Preferred Stock – A type of equity security that is given certain preferences and rights over common stock.  Preferred stock can be issued in classes or series  One class of preferred stock can be given preference over another class of preferred stock  Preferred shareholders have limited liability Business Environment: Preferred Stock Preferences Preferred stock may have any or all of the following preferences: (1) Dividend preference (2) Liquidation preference (3) Cumulative dividend right (4) Right to participate in profits (5) Conversion right Redeemable Preferred Stock – Redeemable preferred stock, or “callable preferred stock,” permits a corporation to “redeem” (i.e., buy back) the preferred stock at some future date.

Authorized, Issued, and Outstanding Shares – The number of shares provided for in the article of incorporation is called authorized shares. Authorized shares that have been sold by the corporation are called issued shares. A corporation is permitted to repurchase its shares.

Repurchased shares are commonly called treasury shares. Shares that are in shareholder hands, whether originally issued or reissued treasury shares, are called outstanding shares.

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Debt Securities – Debt securities (also called fixed income securities) establish a debtor-creditor relationship in which the corporation borrows money from the investor to whom the debt security is issued. Three classifications of debt securities are: (1) Debenture—A long-term (often 30 years or more), unsecured debt instrument that is based on a corporation’s general credit standing; (2) Bond—A long-term debt security that is secured by some form of collateral; and (3) Note—A short-term debt security with a maturity of five years or less.

Indenture Agreement – An indenture agreement (indenture) is a contract between a corporation and a holder that contains the terms of a debt security.

Business Environment: Delaware Corporation Law The state of Delaware is the corporate haven in the United States. More than 50 percent of the publicly traded corporations in America, including 60 percent of the Fortune 500 companies, are incorporated in Delaware. On the legislative side, Delaware has enacted the Delaware General Corporation Law. This law is the most advanced corporation law in the country, and the statute is particularly written to be of benefit to large corporations. On the judicial side, Delaware has a special court—the court of chancery—that hears and decides business cases. The court is known for issuing decisions favorable to large corporations as the court applies Delaware corporation law to decide disputes.

Shareholders – Shareholders own the corporation. Nevertheless, they are not agents of the corporation (i.e., they cannot bind the corporation to contracts), and the only management duty they have is the right to vote on matters such as the election of directors and the approval of fundamental changes in the corporation.

Shareholders’ Meetings – Annual shareholders’ meetings are held to elect directors, choose independent auditors, and take other actions. Special shareholders’ meetings may be called by the board of directors, the holders of at least 10 percent of the voting shares of the corporation or any other person authorized to do so by the articles of the corporation or any other person authorized to do so by the articles of incorporation or the bylaws. Shareholders do not have to attend a shareholder’s meeting to vote. Shareholders may vote by proxy; that is, they can appoint another person (the proxy) as their agent to vote at a shareholder’s meeting.

Quorum and Vote Required – Unless otherwise provided in the articles of incorporation, if a majority of shares entitled to vote are represented at a meeting in person or by proxy, there is a quorum of the shareholders to hold the meeting. The affirmative vote of the majority of the voting shares represented at a shareholder’s’ meeting constitutes an act of the shareholders for actions other than for the election of directors.

Business Environment: Straight versus Cumulative Voting Unless otherwise required by a corporation’s articles of incorporation, or by corporate law, voting for the election of directors is by the straight voting (noncumulative voting) method. With straight voting, each shareholder votes the number of shares he or she owns on candidates for each of the positions open for election. Thus, a majority shareholder can elect the entire board of directors.

With cumulative voting, each shareholder is entitled to multiply the number of shares he or she owns by the number of directors to be elected and cast the accumulative number for a single candidate or distribute the product among two or more candidates. Cumulative voting gives a minority shareholder a better opportunity to elect someone to the board of directors.

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Supramajority Voting Requirement – This is a requirement that a greater than majority of shares constitutes a quorum of the vote of the shareholders.

Dividends – A dividend is a distribution of profits of the corporation to shareholders. Dividends are paid at the discretion of the board of directors.

Piercing the Corporate Veil – A doctrine that says if a shareholder dominates a corporation and uses it for improper purposes, a court of equity can disregard the corporate entity and hold the shareholder personally liable for the corporation’s debts and obligations. This is also referred to as the alter ego doctrine.

Critical Legal Thinking: Shareholder Resolutions At times, shareholders may wish to submit issues for a vote to other shareholders. The Securities Exchange Act of 1934 and SEC rules permit a shareholder to submit a resolution to be considered by other shareholders.

Board of Directors – The board of directors of a corporation is elected by the shareholders of the corporation. The board of directors is responsible for formulating policy decisions that affect the management, supervision, control, and operation of the corporation. Boards of directors are typically composed of inside and outside directors. An inside director is a person who is also an officer of the corporation. An outside director is a person who sits on the board of directors of a corporation but is not an officer of that corporation.

Meetings and Resolutions of the Board of Directors – Regular meetings of a board of directors are held at the times and places established in the bylaws. A board can call special meetings of the board of directors as provided in the bylaws. A simple majority of the number of directors established in the articles of incorporation or bylaws usually constitutes a quorum of the board of directors for transacting business. A resolution is a vote taken by the board of directors that authorizes certain actions to be taken on behalf of the corporation.

Information Technology: Corporate E-Communications Most state corporation codes have been amended to permit the use of corporate electronic communications (corporate e-communications) by corporations to communicate to shareholders, among directors, with regulatory agencies, and others.

Corporate Officers – Officers are employees of the corporation who are appointed by the board of directors to manage the day-to-day operations of the corporation. At a minimum, most corporations have the following officers: a president, one or more vice presidents, a secretary, and a treasurer.

Fiduciary Duties of Directors and Officers – Directors and officers of a corporation owe fiduciary duties of trust and competence to the corporation and its shareholders. The fiduciary duties of a corporate officers and directors include (1) the duty of loyalty, and (2) the duty of care.

Duty of Loyalty – This is a duty owed by directors and officers not to act adversely to the interests of the corporation and to subordinate their personal interest to those of the corporation and its shareholders.

Duty of Care – To meet this duty, corporate directors and officers must discharge their duties: (1) In good faith;

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(2) With the care that an ordinary prudent person in a like position would use under similar circumstances; and (3) In a manner they reasonably believe to be in the best interests of the corporation.

Critical Legal Thinking: Business Judgment Rule The determination of whether a corporate director or officer has met his or her duty of care is measured as of the time the decision is made; the benefit of hindsight is not a factor. Therefore, the directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment. This is called the business judgment rule.

Sarbanes-Oxley Act – This is a federal statute that establishes rules to improve corporate governance, prevent fraud, and add transparency to corporate operations.

Ethics: Sarbanes-Oxley Act Improves Corporate Governance Several major provisions of the Sarbanes-Oxley Act address corporate governance. These provisions include CEO and CFO certification of each annual and quarterly corporate report, reimbursement of bonuses and incentive pay due to material noncompliance with financial reporting requirements, a prohibition on personal loans to corporate directors or executive officers, penalties for tampering with evidence, and a prohibition on any person who has committed securities fraud from acting as an officer or a director of a public company. The Sarbanes-Oxley Act will likely reduce corporate fraudulent conduct and promote more ethical behavior from corporate officers and directors, since the penalties for violation of the Act (including non-compliance with the CEO and CFO certification requirement) are severe.

Mergers and Acquisitions – Corporations may agree to friendly acquisitions or combinations with one another. This may occur through merger, share exchange, or sale of assets. Corporations are also subject to unwanted takeovers, such as tender offers.

Merger – This is a transaction in which one corporation (the merged corporation) is absorbed into another corporation (the surviving corporation). After a merger, the merged corporation ceases to exist, and the surviving corporation gains all the rights, privileges, powers, duties, obligations, and liabilities of the merged corporation.

Share Exchange – This is a situation in which one corporation (the parent corporation) acquires all the shares of another corporation (the subsidiary corporation), and both corporations retain their separate legal existence.

Tender Offer – In a tender offer, the acquiring company, called the tender offeror, makes an offer directly to the shareholders of the target corporation to purchase their shares. The shareholders of the target corporation each make an individual decision about whether to sell their shares to the tender offeror. When a tender offer is made without the permission of the target company’s management, it is referred to as a hostile tender offer.

Global Law: Foreign Acquisitions of U.S. Companies The Exon-Florio Foreign Investment Provision, also referred to as the Exon-Florio Amendment, is a federal law mandating that the president of the United States suspend, prohibit, or dismantle the acquisition of U.S. businesses or investments by foreign investors if there is credible evidence that the foreign investor might take action that threatens to impair the “national security.”

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Dissolution of a Corporation – The life of a corporation may be dissolved voluntarily by the owners (voluntary dissolution) or involuntarily by the state (administrative dissolution) in certain circumstances.

Winding-up, Liquidation, and Termination – The process by which a dissolved corporation’s assets are collected, liquidated, and distributed to creditors, preferred shareholders, and common shareholders. Termination of a corporation occurs only after winding up the corporation’s affairs, liquidating its assets, and distributing the proceeds and property to claimants.

Multinational Corporations – A multinational corporation, also known as a transnational corporation, is a corporation that operates in more than one country. Multinational corporations operate in other countries through a variety of means, including the use of agents, branch offices, subsidiary corporations, business alliances, strategic partnerships, franchising, and other arrangements. Many multinational corporations conduct business in another country by using an international subsidiary corporation. The subsidiary corporation is organized under the laws of the foreign country. The parent corporation usually owns all of the majority of the subsidiary corporation.

Global Law: India’s Multinational Corporations India is the home of many large multinational corporations. The Tata Group, the largest private company in India, is a conglomerate that comprises more than 100 companies, exports goods and services to over 80 countries, has approximately 300,000 employees, and totals more than $100 billion in sales, with over half of that beyond India. It owns interests in communications, information technology, power, steel, automobiles, hotels, electricity, and other industries.

V. Key Terms and Concepts  Administrative dissolution—Involuntary dissolution of a corporation that is ordered by the secretary of state if the corporation has failed to comply with certain procedures required by law.  Alien corporation—A corporation that is incorporated in another country.  Annual shareholders’ meeting—Meeting of the shareholders of a corporation that must be held annually by the corporation to elect directors and to vote on other matters.  Arrearages—The amount of unpaid cumulative dividends.  Articles of dissolution—For a voluntary dissolution to be effective, articles of dissolution must be filed with the secretary of state of the state of incorporation.  Articles of incorporation (corporate charter)—The basic governing documents of a corporation. It must be filed with the secretary of state of the state of incorporation.  Authorized shares—The number of shares provided for in the articles of incorporation.  Board of directors—A panel of decision makers, the members of which are elected by the shareholders.  Bond—A long-term debt security that is secured by some form of collateral.  Business judgment rule—A rule that says directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment.  Bylaws—A detailed set of rules adopted by the board of directors after a corporation is incorporated that contains provisions for managing the business and the affairs of the corporation.  C corporation—A corporation with more than 100 shareholders or one that does not elect to become an S corporation. It is taxed at the corporate level and dividends distributed to shareholders are taxed on the personal income tax.

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CEO and CFO certification—The chief executive officer (CEO) and chief financial officer (CFO) of a public company must file a statement accompanying each annual and quarterly report called the CEO and CFO certification. This statement certifies that the signing officer has reviewed the report; that, based on the officer’s knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact that would make the statement misleading; and that the financial statement and disclosures fairly present, in all material aspects, the operation and financial condition of the company Centralized management—Corporate management consisting of a board of directors and officers.

Certificate of dissolution—In the case of administrative dissolution, the secretary of state issues a certificate of dissolution that dissolves the corporation.

Characteristics of a corporation—Free transferability of corporate shares, perpetual existence, and centralized management.

Closely held corporation (privately held corporation)—A corporation owned by one or a few shareholders.

Common stock—A type of equity security that represents the residual value of a corporation.

Common stock certificate—A document that represents the common shareholder’s investment in the corporation.

Common stockholder—A person who owns common stock.

Competing with the corporation—Directors and officers cannot engage in activities that compete with the corporation unless full disclosure is made and a majority of the disinterested directors or shareholders approve the activity.

Convertible preferred stock—Stock that permits the preferred stockholders to convert their shares into common stock.

Corporate electronic communications (corporate e-communications)—Use of electronic transfers and electronic networks by corporations to communicate to shareholders and among directors.

Corporate management—The directors and the officers form the corporate management.

Corporate officer—Employees of a corporation who are appointed by the board of directors to manage the day-to-day operations of the corporation.

Corporation—A fictitious legal entity that is created according to statutory requirements.

Corporation code—State statutes that regulate the formation, operation, and dissolution of corporations.

Court of chancery—A special court in Delaware that hears and decides business cases.

Cumulative preferred stock—Stock for which any missed dividend payments must be paid in the future to the preferred shareholders before the common shareholders can receive any dividends.

Cumulative voting—A system in which a shareholder can accumulate all of his or her votes and vote them all for one candidate or split them among several candidates.

Debenture—A long-term unsecured debt instrument that is based on the corporation’s general credit standing.

Debt securities (fixed income securities)—Securities that establish a debtor-creditor relationship in which the corporation borrows money from the investor to whom the debt security is issued.

Decree of dissolution—If a court dissolves a corporation, it enters a decree of dissolution that specifies the date of dissolution.

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Delaware General Corporation Law—This law is the most advanced corporation law in the country, and the statute is particularly written to be of benefit to large corporations.

Dividend—Distribution of profits of the corporation to shareholders.

Dividend preference—The right to receive a fixed dividend at stipulated periods during the year.

Domain name—The name of a website that a corporation uses to conduct business over the Internet.

Domestic corporation—A corporation in the state in which it was formed.

Double taxation—C corporations are taxed first at the corporate level and then the profits distributed by dividend payments are taxed as part of the personal income of the shareholders.

Duty of care of corporate officers and directors—A duty that corporate directors and officers have to use care and diligence when acting on behalf of the corporation.

Duty of loyalty of corporate officers and directors—A duty that directors and officers have not to act adversely to the interests of the corporation and to subordinate their personal interests to those of the corporation and its shareholders.

Equity securities (stocks)—Representation of ownership rights to a corporation.

Exon-Florio Foreign Investment Provision (Exon-Florio Amendment)—This is a federal law that mandates the president of the United States to suspend, prohibit, or dismantle the acquisition of U.S. businesses by foreign investors if there is credible evidence that the foreign investor might take action that threatens to impair the “national security.”

Fiduciary duties of corporate officers and directors—Duty of loyalty, honesty, integrity, trust, and confidence owed by directors and officers to their corporate employers.

Fixed dividend—A dividend preference is the right to receive a fixed dividend at set periods during the year.

For-profit corporation (profit corporation)—A corporation created to conduct a business for profit that can distribute profits to shareholders in the form of dividends.

Foreign corporation—A corporation in any state or jurisdiction other than the one in which it was formed.

Form 2553—An S corporation election is made by filing Form 2553 with the Internal Revenue Service (IRS).

Free transferability of shares—Generally, corporate shares are freely transferable by a shareholder by sale, assignment, pledge, or gift.

Hostile tender offer—When a tender offer (an offer that an acquirer makes directly to a target corporation’s shareholders in an effort to acquire the target corporation) is made without the permission of the target company’s management; it is referred to as a hostile tender offer.

Incorporating a corporation—The process of creating a corporation. In order to form a corporation, its organizers must comply with the state’s corporation code.

Incorporator—The parties who sign the corporation’s articles of incorporation.

Incorporators often become shareholders, directors, or officers of the corporation.

Indenture agreement (indenture)—A contract between the corporation and the holder that contains the terms of a debt security.

Inside director—A member of the board of directors who is also an officer of the corporation.

International subsidiary corporation—Many multinational corporations conduct business in another country by using an international subsidiary corporation. The subsidiary corporation is organized under the laws of the foreign country. The parent corporation usually owns all or the majority of the subsidiary corporation.

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Issued shares—Shares that have been sold by the corporation.

Judicial dissolution—Dissolution of a corporation through a court proceeding instituted by the state.

Legal entity (legal person)—A corporation is a separate legal entity (or legal person) for most purposes.

Limited liability of shareholders—Liability that shareholders have only to the extent of their capital contribution. Shareholders are generally not personally liable for debts and obligations of the corporation.

Liquidation preference—The right to be paid a stated dollar amount if a corporation is dissolved and liquidated.

Merger—A transaction in which one corporation is absorbed into another corporation and ceases to exist.

Merged corporation—In a merger, the corporation that is absorbed into another corporation and ceases to exist.

Minutes—Written records of a corporation’s board of directors’ meetings.

Model Business Corporation Act (MBCA)—A model act intended to provide a uniform law regulating the formation, operation, and termination of corporations.

Model Business Corporation Act (2016 revision)—In 2016, the Committee on Corporate Laws of the American Bar Association promulgated the Model Business Corporation Act (2016 revision). This new model act is a free-standing business corporation statute that will be considered for adoption by the states.

Multinational corporation (transnational corporation)—A corporation that operates in more than one country.

Negligence—Failure of a corporate director or officer to exercise the duty of care while conducting the corporation’s business.

Nonconvertible preferred stock—Preferred stock that does not have a conversion feature (i.e., the preferred stockholder cannot convert his or her shares into common stock).

Noncumulative preferred stock—With noncumulative preferred stock, there is no right of accumulation. In other words, the corporation does not have to pay any missed dividends.

Nonparticipating preferred stock—Does not give the holder a right to participate in the profits of the corporation beyond the fixed dividend rate.

Nonredeemable preferred stock—Preferred stock that is not redeemable (i.e., the issuing corporation is not permitted to buy back the preferred stock at some future date).

Not-for-profit corporation (nonprofit corporation)—Corporations that are formed for charitable, educational, religious, or scientific purposes. Although not-for-profit corporations may make a profit, they are prohibited by law from distributing this profit to their members, directors, or officers.

Note—A debt security with a maturity of five years or less.

Organizational meeting—A meeting that must be held by the initial directors of a corporation after the articles of incorporation are filed.

Outside director—A member of the board of directors who is not an officer of the corporation.

Outstanding shares—Shares of stock that are in shareholders’ hands.

Parent corporation—Many multinational corporations conduct business in another country by using an international subsidiary corporation. The subsidiary corporation is organized under the laws of the foreign country. The parent corporation usually owns all or the majority of the subsidiary corporation.

Participating preferred stock—Stock that allows the preferred stockholder to participate in the profits of the corporation along with the common stockholders.

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Perpetual existence—Corporations exist in perpetuity unless a specific duration is stated in a corporation’s articles of incorporation. The death, insanity, or bankruptcy of a shareholder, a director, or an officer of a corporation does not affect its existence.

Piercing the corporate veil (alter ego doctrine)—A doctrine that says if a shareholder dominates a corporation and uses it for improper purposes, a court of equity can disregard the corporate entity and hold the shareholder personally liable for the corporation’s debts and obligations.

Preferred stock—A type of equity security that is given certain preferences and rights over common stock.

Preferred stock certificate—Preferred shareholders are issued preferred stock certificates to show evidence of their ownership interest in the corporation. Electronic registration of preferred stockholder ownership interests is supplanting paper stock certificates.

Preferred stockholder—Person who owns preferred stock.

Promoter—A person who organizes and starts a corporation, negotiates and enters into contracts in advance of its formation, finds the initial investors to finance the corporation, etc.

Promoter’s contracts—A collective term for items such as leases, sales contracts, contracts to purchase property, and employment contracts entered into by promoters on behalf of the proposed corporation prior to its actual incorporation.

Promoter’s liability—Individual promoter liability for contracts entered into on behalf of the corporation.

Proxy (proxy card)—The written document that a shareholder signs authorizing another person to vote his or her shares at the shareholders’ meetings in the event of the shareholder’s absence.

Public benefit corporation (benefit corporation or B corporation or PBC)—A for-profit corporation with missions additional to those of the pure profit motive. Its purpose is to create general or specific public benefits, such as promoting social issues, protecting the environment, engaging in sustainability efforts, etc.

Publicly held corporation—A corporation that has many shareholders and whose securities are often traded on national stock exchanges.

Quorum of the board of directors—A simple majority of the number of directors established in the articles of incorporation or bylaws usually constitute a quorum of the board of directors for transacting business. However, the articles of incorporation and the bylaws may increase this number.

Quorum of the shareholders—Unless otherwise provided in the articles of incorporation, if a majority of shares entitled to vote are represented at a meeting in person or by proxy, there is a quorum of the shareholders to hold the meeting. Once a quorum is present, the withdrawal of shares does not affect the quorum of the meeting.

Redeemable preferred stock (callable preferred stock)—Stock that permits the corporation to buy back the preferred stock at some future date.

Registered agent—A person or corporation that is empowered to accept service of process on behalf of a corporation.

Regular meetings of a board of directors—Meetings held by the board of directors at the time and place established in the bylaws.

Resolution—A vote taken by the board of directors of a corporation that authorizes certain actions to be taken on behalf of the corporation.

Revised Model Business Corporation Act (RMBCA)—It arranges the provisions of the act more logically, revises the language of the act to be more consistent, and makes substantial changes in the provisions of the model act.

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S corporation—A corporate election designed to pass through taxation to the personal taxes of the shareholders, avoiding the double taxation of C corps.

Sarbanes-Oxley Act (SOX)—Requires public companies to establish and maintain adequate internal controls and procedures for financial reporting.

Secret profit—If a director or an officer breaches his or her duty of loyalty and makes a secret profit on a transaction, the corporation can sue the director or officer to recover the secret profit.

Self-dealing—If the directors or officers engage in purchasing, selling, or leasing of property with the corporation, the contract must be fair to the corporation, otherwise, it is voidable by the corporation. The contract or transaction is enforceable if it has been fully disclosed and approved.

Share exchange—A situation in which one corporation acquires all the shares of another corporation, and both corporations retain their separate legal existence.

Shareholder—An owner of a corporation who has the right to vote on matters such as the election of the board of directors and the approval of fundamental changes in the corporation.

Shareholder resolution—A resolution that a shareholder who meets certain ownership requirements may submit to other shareholders for a vote.

Special meetings of the board of directors—Meetings convened by the board of directors to discuss new shares, merger proposals, hostile takeover attempts, and so forth.

Special shareholders’ meeting—Meeting of shareholders that may be called to consider and vote on important or emergency issues, such as a proposed merger or amending the articles of incorporation.

Straight voting (noncumulative voting)—Each shareholder votes the number of shares he or she owns on candidates for each of the positions open.

Subchapter S corporation—If a corporation elects to be taxed as an S corporation, it pays no federal income tax at the corporate level; instead, the corporation’s income or loss flows to the shareholder’s individual income tax returns. Subchapter S election only affects the taxation of a corporation; it does not affect attributes of corporate form, including limited liability.

Subchapter S Revision Act—Congress enacted the Subchapter S Revision Act to allow the shareholders of some corporations to avoid double taxation by electing Subchapter S corporation status.

Subsidiary corporation—After a share exchange, one corporation (the parent corporation) owns all the shares of the other corporation (the subsidiary corporation).

Supramajority voting requirement (supermajority voting requirement)—A requirement that a greater than majority of shares constitutes a quorum of the vote of the shareholders.

Surviving corporation—In a merger, the corporation that absorbs the merged corporation and continues to exist.

Target corporation—The corporation that is proposed to be acquired in a tender offer situation.

Tender offer—An offer that an acquirer makes directly to a target corporation’s shareholders in an effort to acquire the target corporation.

Tender offeror—The party that makes a tender offer.

Termination of a corporation—The ending of a corporation that occurs only after the winding up of the corporation’s affairs, the liquidation of its assets, and the distribution of the proceeds to the claimants.

Treasury shares—Shares of stock repurchased by the company itself.

Unissued shares—Authorized shares that have not been sold by the corporation.

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Usurping an opportunity—A director or officer steals a corporate opportunity for him- or herself.

Voluntary dissolution—A corporation that has begun business or issued shares can be dissolved upon recommendation of the board of directors and a majority vote of the shares entitled to vote.

Winding up and liquidation—The process by which a dissolved corporation’s assets are collected, liquidated, and distributed to creditors, preferred shareholders, and common shareholders.

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Chapter 17 Securities Law and Investor Protection

Why is insider trading wrong?

I. Teacher to Teacher Dialogue One of the most unfortunate aspects of our overly litigious society is the notion that the government must somehow “cover” every loss. Witness the current costs of the so-called S & L bailout, which has already achieved the dubious distinction of being one of this country’s most costly financial debacles. That’s not to say that we should allow every innocent depositor to suffer the losses incurred by the managers of these institutions. Nor can we afford to allow our financial institutions to lose their foundations of reliance and trust. The government does have a proper role and duty to support this financial infrastructure. But should the rules remain the same for stock investors as opposed to depositors? Many commentators argue that when investment choices are made, these choices should bring a higher degree of awareness and risk.

It is risk that must be fully emphasized at the outset of these materials. No government, no agency, no set of statutory protections can immunize a stock investor from the basic economic reality of stock investment—risk of loss. This risk was there before the Great Depression, and will be there no matter how many SECs, CFTCs, and the like we create.

Assume a sporting event were to be contested under the following conditions: a. All the players were well trained. b. The rules of the game were fully explained to the players. c. Those rules are fairly and evenhandedly applied to the players. d. An even playing field is used as a site for the contest.

With all these suppositions in place, can you rest assured your team will win? Or you can hope that, win or lose, your team was engaged in a fair contest?

In the broadest sense, the buying and selling of securities is similar to an athletic event. Each participant goes into the game with his or her own self-interest in mind. And all the fair rules in the world will not change one essential truth of these or any other contests—there will be winners and there will be losers. That reality must always be kept in mind from the outset by anyone seeking to make his or her fortune through the sale or purchase of securities. Risk is inherent in the nature of this activity, and anyone who fails to appreciate that simple fact should not be there in the first place.

It is most difficult for professionals to master the ins and outs of the financial markets, let alone the casual investor. Yet the lure of playing this game is so strong that every year millions of people invest hard-earned money with nothing more than high hopes and a prayer. Securities law was designed to at least give some substance to those hopes and prayers. That substance is public information upon which investment choices can be rationally made. These laws are not designed to assure a win in this high-risk game, but rather to provide a more even playing field.

The great financial stock market crash of 1929 and the ensuing Depression brought on by that calamity brought to the forefront the need to create a greater governmental role in securities markets. Prior to that period, the sale of stocks in corporations remained essentially unregulated except for the common law doctrines of fraud and the like. Manipulative and unscrupulous trading practices coupled with a lot of hopes and prayers all pointed to a need for a better set of ground rules by which this game could be played.

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The basic rules of the game go back to the Securities Act of 1933 and the Securities Exchange Act of 1934 that created the Securities and Exchange Commission. Over the years, the Commission’s role has greatly increased with the advent of new technologies like programmed trading and the need to expand its regulatory framework into the financial services arena. Because of recent scandals in this sector of the economy, a number of new white-collar crimes have been added to the government’s arsenal for dealing with abuses. All in all, it has made the specialized practice of securities law or SEC accounting more difficult, yet more challenging, than ever.

II. Chapter Objectives 1. List and describe major federal securities laws.

2. Define a security.

3. Describe initial public offerings and how securities are registered with the Securities and Exchange Commission (SEC).

4. Define an emerging growth company and describe the requirements for issuing securities as such.

5. Describe the requirement for issuing securities pursuant to SEC Regulation A+.

6. Describe the requirements that must be met to issue securities using a small company offering registration.

7. Define a well-known seasoned investor and describe how securities can be issued pursuant to a shelf registration.

8. Define crowdfunding and describe how capital is raised using crowdfunding.

9. List and describe the securities that are exempt from registration.

10. List and describe offerings exempt from registration such as the nonissuer, intrastate, private placement, and small offering exemptions from registration.

11. Describe civil and criminal penalties for violating the Securities Act of 1933.

12. Describe how trading in securities is regulated by federal securities laws.

13. Define insider trading and describe the liability for engaging in insider trading.

14. Describe short-swing profit transactions that violate securities laws.

15. Describe how state laws regulate securities transactions.

III. Key Question Checklist  What are the key elements of the Securities Act of 1933?  What are the key elements of the Securities Act of 1934?  What other related statutes may apply?

IV. Chapter Outline Introduction to Securities Law and Investor Protection – The U.S. Congress enacted federal securities statutes to regulate the securities markets in response to lack of regulation. The federal securities statutes were designed to require disclosure of information to investors, provide for the regulation of securities issues and trading, and prevent fraud.

Securities Law – The federal and state governments have enacted statutes that regulate the issuance and trading of securities. These are referred to collectively as securities laws.

Landmark Law: Federal Securities Laws Congress has enacted a series of laws that regulate the issuance and trading of securities. These include the Securities Act of 1933, which regulates the issuance of securities, and the Securities Exchange Act of 1934, which was enacted to prevent fraud in the subsequent trading of 192 .

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securities. The Jumpstart Our Business Startups Act (JOBS Act) is designed to make it easier for start-up companies to raise capital through initial public offerings. The JOBS Act mandates that the Securities and Exchange Commission (SEC) adopt rules that would allow small businesses to use crowdfunding to raise capital using online equity marketplaces.

Securities and Exchange Commission – The Securities and Exchange Commission (SEC) is a federal administrative agency that is empowered to administer federal securities law. The major responsibilities of the SEC include: (1) Adopting rules and regulations that further the purpose of the federal securities statutes; (2) Investigating alleged securities violations and bringing enforcement actions against suspected violators; (3) Bringing a civil action to recover monetary damages from violators of securities laws; and (4) Regulating the activities of securities brokers and advisors.

The SEC requires both foreign and domestic companies to file registration statements, periodic reports, forms, and other filings using EDGAR, the SEC’s electronic data and records system.

Securities Exchanges – The New York Stock Exchange (NYSE) lists the stocks and securities of approximately 3,000 of the world’s largest companies for trading. The National Association of Securities Dealers automated Quotation System (NASDAQ) is an electronic stock market.

NASDAQ has the largest trading volume of any securities exchange in the world. More than 3,000 U.S. and foreign companies are traded on NASDAQ. E-Securities Transactions – Electronic securities transactions, or e-securities transactions, are common in issuing stocks and other securities to the public, trading in securities, filing information with the SEC, and disseminating information to investors.

Definition of Security – A security is (1) an interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant; (2) an interest or instrument that is expressly mentioned in securities acts; or (3) an investment contract. According to the Howey test, an arrangement is an investment contract if there is an investment of money by an investor in a common enterprise and the investor expects to make profits based on the sole or substantial efforts of the promoter or others.

Initial Public Offering (IPO) – Section 5 of the Securities Act of 1933 requires securities offered to the public through the use of the mail, internet, or any facility of interstate commerce to be registered with the SEC by means of a registration statement and an accompanying prospectus.

A business or party selling securities to the public is called an issuer. An issuer may be a new company that is selling securities to the public for the first time. This is referred to as going public. Or the issuer may be an established company that sells a new security to the public. This issuance of new securities by an issuer is called an initial public offering (IPO).

Registration Statement – Issuers must file a registration statement with the SEC containing descriptions of the security being offered, the registrant’s business, management information, pending litigation, how the proceeds will be used, government regulations that affect the issued security, the degree of competition in the industry, and any special risk factors. Registration statements become effective 20 days after filing, unless the SEC requires additional information.

A new 20-day period starts with every amendment, although the registrant can request an acceleration of the effective date.

Prospectus – A prospectus is a written disclosure document that helps investors evaluate the financial risk involved in an investment.

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Initial Public Offerings – Examples of companies that have gone public in recent years include LinkedIn Corporation, a social networking site for people in professional occupations; Twitter, Inc., an online social networking and microblogging service; and Alibaba Group Holdings Limited, an online sales and electronic payment service.

E-Public Offerings – Companies are now issuing sales of stock over the internet. This includes companies that are making electronic initial public offerings, or e-initial public offerings (eIPOs), by selling stock to the public for the first time. E-securities offerings provide an efficient way to distribute securities to the public.

Sale of Unregistered Securities – Sale of securities that should have been registered but were not violates the Securities Act of 1933. Investors may rescind the purchase and recover damages for securities that should have been registered and were not. The U.S. government can impose criminal penalties on any person who willfully violates the Securities Act of 1933.

Emerging Growth Company – An emerging growth company is a class of public company created by the Jumpstart Our Business Startups Act (JOBS Act) that may issue securities pursuant to less restrictive rules than a traditional initial public offering. EGC status is often referred to as the IPO on-ramp.

Regulation A+ Securities Offering – This is a regulation that permits an issuer to sell securities to the public pursuant to a simplified registration process. Regulation A+ is divided into two tiers.

Tier 1 permits an issuer to sell up to $20 million of securities within a 12-month period. Tier 2 permits an issuer to sell up to $50 million of securities within a 12-month period.

Small Company Offering Registration – The Small Company Offering Registration (SCOR) is a method for small companies to sell up to $1 million of securities during a 12-month period to the public by using a question-and-answer disclosure form called Form U-7.

Well-Known Seasoned Issuer – A well-known seasoned issuer is a large company that, if it meets certain requirements, may file a registration statement with the Securities and Exchange Commission (SEC) that, when it becomes effective, is a shelf registration that permits the company to issue securities to the public during a three-year period without filing a new registration statement for each offering.

Crowdfunding – This is a process that allows small companies to raise capital up to $1,070,000 during a 12-month period from many small-dollar investors through a public offering using public solicitation including social media and the internet.

Information Technology: Regulation Crowdfunding The Securities and Exchange Commission (SEC) has adopted SEC Regulation Crowdfunding that sets forth the rules for a crowdfunding offering. Crowdfunding requires securities of an issuer to be sold to the public exclusively using an intermediary’s internet-based funding portal or web platform. Funding portals must register with the SEC. Many crowdfunding portals have launched to fill this role, including Kickstarter, Indiegogo, CircleUP, EquityNet, RocketHub, Crowdfunder, and others.

Exempt Securities – Exempt securities include those issued by any government within the United States, short-term notes and drafts with a maturity date of nine months or less, securities issued by nonprofits, those issued by financial institutions that are regulated by the appropriate 194 .

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banking authorities, insurance and annuity contracts, stock dividends and splits, and securities issued in a corporate reorganization in which one security is exchanged for another security. Once securities are exempt, they are always exempt.

Exempt Transactions – Certain transactions where securities are sold are exempt from registration with the SEC if they meet specified requirements. These are called exempt transactions.

Nonissuer Exemption – Average investors do not have to file a registration statement prior to reselling securities.

Intrastate Offering Exemptions – These are exemptions from registration that permit local businesses to raise capital from local investors without the need to register with the Securities and Exchange Commission (SEC). There are two intrastate offering exemptions, one provided under SEC Rule 147 and another under SEC Rule 147A. Private Placement Exemptions – These are exemptions from registration with the Securities and Exchange Commission (SEC) of an issue of securities that does not involve a public offering.

There are two private placement exemptions, one provided under SEC Rule 506(b) and another under SEC Rule 506(c).

Small Offering Exemption – This is an exemption from registration that permits the sale of securities not exceeding $5 million during a 12-month period.

Information Technology: Initial Coin Offering (ICO) Some start-up companies that wish to raise capital are doing so through an initial coin offering (ICO). The start-up accepts payment from investors in Bitcoin or other cryptocurrency, or in money, and then issues its own crypto coins or tokes to the investors. Purchasers of the digital coins are not issued stock in the company and have no equity interest or voting rights.

Liability For Violations of The Securities Act of 1933 – Various provisions of the Securities Act of 1933 impose civil and criminal penalties on parties who violate the act.

Civil Liability: Section 11 of the Securities Act of 1933 – This is a provision of the Securities Act of 1933 that imposes civil liability on persons who intentionally defraud investors by making misrepresentations or omissions of material facts in the registration statement or who are negligent for not discovering the fraud.

Civil Liability: Section 12 of the Securities Act of 1933 – This a provision of the Securities Act of 1933 that imposes civil liability on any person who violates the provisions of Section 5 of the act. Violations include selling securities pursuant to an unwarranted exemption and making misrepresentations concerning the offer or sale of securities. The purchaser’s remedy for a violation of Section 12 is either to rescind the purchase or to sue for damages.

Business Environment: Government Actions for Violations of the Securities Act of 1933 The U.S. government may bring actions against those who violate the provisions of the Securities Act of 1933. These actions include:  SEC Actions—The SEC may (1) issue a consent decree whereby a defendant agrees not to violate securities laws in the future but does not admit to having violated securities laws in the past; (2) bring an action in U.S. district court to obtain an injunction to stop

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challenged conduct; and (3) request the court to grant ancillary relief, such as disgorgement of profits by the defendant.

Criminal Liability—Section 24 of the Securities Act of 1933 imposes criminal liability on any person who willfully violates the act. A violator may be fined, imprisoned, or both.

Trading in Securities – Unlike the Securities Act of 1933, which regulates the original issuance of securities, the Securities Exchange Act of 1934 regulates primarily subsequent trading.

Section 10(b) and Rule 10b-5 – Section 10(b) of the Securities Exchange Act of 1934 prohibits the use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations promulgated by the SEC. SEC Rule 10b-5 addresses the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities.

Civil Liability: Section 10(b) of the Securities Exchange Act of 1934 – A private plaintiff may bring a civil action and seek rescission of the securities contract or recover damages.

Business Environment: Government Actions for Violations of the Securities Exchange Act of 1934 The U.S. government may bring actions against those who violate the provisions of the Securities Exchange Act of 1934. These actions include:  SEC Actions—The SEC may enter into consent decrees with defendants, seek injunctions in U.S. district court, and seek court orders requiring defendants to disgorge illegally gained profits. Pursuant to the Insider Trading Sanctions Act, the SEC may obtain a civil penalty of up to three times the illegal profits gained or losses avoided on insider trading.  Section 32 of the Securities Exchange Act of 1934 makes it a criminal offense to violate willfully the provisions of the act. Under the Sarbanes-Oxley Act, a person who willfully violates the Securities Exchange Act of 1934 can be fined, imprisoned, or both. A corporation or another entity may be fined.

Insider Trading – When company employees or advisors use material nonpublic information to profit, it is considered insider trading and illegal. Insiders are defined as officers, directors, and employees of the company; lawyers, accountants, consultants, and other agents; and others who owe a fiduciary duty to the organization.

Tipper-Tippee Liability – The person who discloses information to the tippee is the tipper, and is liable for the profits made by the tippee, who is liable for acting on information that is not public.

United States Supreme Court Case Case 17.1 Tippee Trading: Salman v. United States Facts: Maher Kara was an investment banker at Citigroup. Maher began sharing inside information with his brother, Michael. Maher knew that Michael was trading in securities based on the inside information. Without Maher’s knowledge, Michael fed the inside information to Bassam Yacoub Salman, Michael’s friend and Maher’s brother-in-law.

Salman was indicted on four counts of securities fraud and one count of conspiracy to commit securities fraud in violation of Section 10(b) and Rule 10b-5. At trial, Salman argued that he could not be held liable for tippee trading because the tipper (Maher, his brother-in-law) did not personally receive money or property from Salman in exchange for the tips and thus did not personally benefit from Salman’s trades. After a jury trial in U.S. district court, Salman was 196 .

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convicted on all counts. The U.S. court of appeals affirmed Salman’s conviction, and Salman appealed to the U.S. Supreme Court.

Issue: Can a tippee be held liable for violating Section 10(b) and Rule 10b-5 if the tipper did not personally receive money or property from the tippee in exchange for the tips and did not personally benefit from the tippee’s trading?

Decision: The U.S. Supreme Court held that a tippee is liable for violating Section 10(b) and Rule 10b-5 even if the tipper did not personally receive money or property from the tippee in exchange for the tips and did not personally benefit from the tippee’s trading.

Reason: The tippee acquires the tipper’s duty to abstain from trading if the tippee knows the information was disclosed in breach of the tipper’s duty, and the tippee may commit securities fraud by trading in disregard of that knowledge. Accordingly, a gift of inside information to a friend, a family member, or anyone else would support the inference that the tipper exploited the trading value of inside information for personal purposes and thus personally benefited from the disclosure.

Ethics Questions: Here, by disclosing confidential information as a gift to his brother with the expectation that he would trade on it, Maher breached his duty of trust and confidence to Citigroup and its clients—a duty Salman acquired, and breached himself, by trading on the information with the full knowledge that it had been improperly disclosed.

Misappropriation Theory – This is a rule that imposes liability under Section 10(b) and Rule 10b5-1 on an outsider who misappropriates information about a company, in violation of his or her fiduciary duty, and then trades in the securities of that company.

Aiders and Abettors – These are parties who knowingly assist principal actors in the commission of securities fraud.

Ethics: Stop Trading on Congressional Knowledge Act In 2012, the U.S. Congress enacted the Stop Trading on Congressional Knowledge (STOCK) Act. This federal statute prohibits members and employees of Congress, the president and all employees of the executive branch, and judges and employees of the judicial branch from using any nonpublic information derived from the individual’s position or gained from performance of the individual’s duties for personal benefit. The act also prohibits them from receiving special access to initial public offerings.

Short-Swing Profits – These are profits that are made by statutory insiders on trades involving equity securities of their corporation that occur within 6 months of each other.

Section 16(b) – Section 16(b) of the Securities Exchange Act of 1934 requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation.

Section 16 Rules – The SEC has adopted the following rules concerning Section 16:  It defines officer to include only executive officers who perform policy-making functions.  It relieves insiders of liability for transactions that occur within 6 months before becoming an insider.  It states that insiders are liable for transactions that occur within 6 months of the last transaction engaged in while an insider.

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State “Blue-Sky” Laws –These are state laws that regulate the issuance and trading of securities.

State securities laws are often referred to as “blue-sky” laws because they help prevent investors from purchasing a piece of the “blue sky.”

V. Key Terms and Concepts  Accredited investor—A person, a corporation, a company, an institution, or an organization that meets the net worth, income, asset, position, and other requirements established by the SEC to qualify as an accredited investor.  Aiders and abettors—Parties who knowingly assist principal actors in the commission of securities fraud.  Civil action—Private parties who have been injured by certain registration statement violations by an issuer or others may bring a civil action against the violator under Section 11 of the Securities Act of 1933.  Civil penalty—A financial penalty imposed against a defendant in civil court.  Commercial paper—Short-term notes and drafts that have a maturity date that does not exceed nine months.  Common securities—Interests or instruments that are commonly known as securities are common securities.  Confidential draft registration statement—An emerging growth company may submit a confidential draft registration statement with the Securities and Exchange Commission (SEC) for review by SEC staff. This confidential filing allows companies, if they choose to do so, to withdraw a proposed IPO without having to disclose confidential business information.  Consent decree—The SEC may issue a consent decree whereby a defendant agrees not to violate securities laws in the future but does not admit to having violated securities laws in the past.  Crowdfunding—The Jumpstart Our Business Startups (JOBS) Act created a new funding mechanism called crowdfunding for entrepreneurs and small businesses to raise small amounts of capital from public investors using online portals. Crowdfunding can be used by small companies that do not want to meet the requirements and expense of issuing securities pursuant to a registered offering and do not qualify for or do not wish to comply with the restrictions of any of the exemptions from registration.  Cryptocurrency—A digital currency that works as a medium of exchange and serves as virtual cash.  Due diligence defense—A defense to a Section 11 action that, if proven, makes the defendant not liable.  EDGAR—The electronic data and record system of the Securities and Exchange Commission (SEC).  Effective date—The date a securities registration becomes effective.  Electronic initial public offering (e-initial public offering, e-IPO)—Selling stock to the public for the first time over the internet.  Electronic securities transactions (e-securities transactions)—Electronic securities transactions, or e-securities transactions, are becoming commonplace in disseminating information to investors, trading in securities, and issuing stocks and other securities to the public.  Emerging growth company (EGC)—The Jumpstart Our Business Startups (JOBS) Act created a new category of issuer under federal securities laws called the emerging growth company (EGC). EGC status is often referred to as the initial public offering (IPO) “onramp.” By qualifying as an EGC, the company is exempt from a broad range of requirements typically imposed on companies pursuing an IPO.  Exempt securities—Securities that are exempt from registration with the SEC. 198 .

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Exempt transactions—Certain transactions where securities are sold are exempt from registration with the SEC if they meet specified requirements. These are called exempt transactions.

Federal securities statutes—Federal laws designed to require disclosure to investors and prevent securities fraud. The two primary securities statutes enacted by the federal government are the Securities Act of 1933 and the Securities Exchange Act of 1934.

Final prospectus—A written disclosure document submitted by a securities issuer which includes the final price of the securities.

Form C—With regard to crowdfunding, the form that must be filed electronically with the Securities and Exchange Commission (SEC) before fundraising can begin.

Form D—A company conducting a security offering under SEC Rule 504 must file a notice with the SEC on this form within 15 days after the first sale of securities.

Form S-1—The general form for registering securities with the Securities and Exchange Commission (SEC).

Funding portal (web platform)—The Jumpstart Our Business Startups (JOBS) Act permits securities of an entrepreneur or a small business issuer to be sold to the public using an intermediary’s funding portal, which is an Internet website. The funding portal must register with the SEC. Going public—An issuer may be a new company that is selling securities to the public for the first time. This is referred to as going public.

Howey test—A test which states that an arrangement is an investment contract if there is an investment of money by an investor in a common enterprise and the investor expects to make profits based on the sole or substantial efforts of the promoter or others.

Initial coin offering (ICO)—The issuance of a cryptocurrency by an issuer to investors. Some start-up companies that wish to raise capital are doing so through an ICO. Initial public offering (IPO)—The sale of securities by an issuer to the public.

Injunction—The SEC may bring an action in U.S. district court to obtain an injunction to stop challenged conduct.

Insider trading—When an insider makes a profit by personally purchasing shares of the corporation prior to public release of favorable information or by selling shares of the corporation prior to the public disclosure of unfavorable information.

Insider Trading Sanctions Act—A federal statute that permits the SEC to obtain a civil penalty of up to three times the illegal benefits received from insider trading.

Intrastate offering exemptions—Exemptions from registration that permit local businesses to raise capital from local investors to be used in the local economy without the need to register with the SEC. Investment banker—Many issuers of securities employ investment bankers, which are independent securities companies, to sell their securities to the public.

Investment contract—A flexible standard for defining a security.

IPO on-ramp—The first opportunity to engage in an initial public offering (IPO).

Issuer—A business or party selling securities to the public is called an issuer.

Jumpstart Our Business Startups Act (JOBS Act)—A federal law designed to make it easier for startup companies to raise capital through initial public offerings (IPOs).

Matter of Cady, Roberts & Company—In the Matter of Cady, Roberts & Company, the SEC announced that the duty of an insider who possesses material nonpublic information is to either (1) abstain from trading in the securities of the company, or (2) disclose the information to the person on the other side of the transaction before the insider purchases the securities from or sells the securities to him or her.

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Misappropriation theory—A rule that imposes liability under Section 10(b) and Rule 10b-5 on an outsider who misappropriates information about a company, in violation of his or her fiduciary duty, and then trades in the securities of that company.

Mutual fund—Mutual funds sell shares to the public, make investments in stocks and bonds for the long-term, and are restricted from investing in risky investments.

National Association of Securities Dealers Automated Quotation System (NASDAQ)—The world’s largest electronic securities exchange. It lists more than 3,000 U.S. and global companies and corporations.

New York Stock Exchange (NYSE)—Lists the stocks and securities of approximately 3,000 of the world’s largest companies for trading.

Non-accredited investor—An investor who does not meet the qualifications to be an accredited investor.

Nonissuer exemption—An exemption from registration which states that securities transactions not made by an issuer, an underwriter, or a dealer do not have to be registered with the SEC. NYSE Euronext—The New York Stock Exchange (NYSE) is operated by NYSE Euronext, which was formed when the NYSE merged with the fully electronic stock exchange Euronext.

Offering circular—Securities issuers must provide investors with an offering circular prior to the purchase of securities.

Officer—According to SEC Section 16, an officer includes only executive officers who perform policy-making functions.

Preliminary prospectus—A written disclosure document that must be submitted to the SEC along with the registration statement and given to the prospective purchasers of the securities.

Private placement exemptions (SEC Rule 506)—Exemptions from registration that permit issuers to raise capital from an unlimited number of accredited investors and no more than 35 non-accredited investors without having to register the offering with the SEC. Registered—Section 5 of the Securities Act of 1933 requires securities offered to the public through the use of the mails or any facility of interstate commerce to be registered with the SEC by means of a registration statement and an accompanying prospectus.

Registration statement—Document that an issuer of securities files with the SEC that contains required information about the issuer, the securities to be issued, and other relevant information.

Reporting companies—A company conducting a security offering under SEC Rule 504 must file a notice with the SEC on this form within 15 days after the first sale of securities.

Companies that are already SEC reporting companies cannot use this exemption.

Rules and regulations—Adopting restrictions that further the purpose of the federal securities statutes is a responsibility of the SEC. Scienter—Intentional conduct. Scienter is required for there to be a violation of Section 10(b) and Rule 10b-5.

SCOR form (Form U-7)—The SEC has adopted the Small Company Offering Registration (SCOR) for corporations and limited liability companies proposing to raise $1 million or less in any 12-month period from a public offering of securities. The SEC requires that a SCOR form (Form U-7) be completed by the company and be made available to potential investors.

Form U-7 is a question-and-answer disclosure form that small businesses can complete and file without the services of an expensive securities lawyer. Form U-7 doubles as a prospectus.

SEC Regulation A+—A regulation that permits an issuer to sell securities to the public pursuant to a simplified registration process.

SEC Regulation Crowdfunding—Sets forth the SEC rules for a crowdfunding offering.

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intermediary’s internet-based funding portal or web platform. Funding portals must register with the SEC. SEC Rule 10(b)-5—A rule adopted by the SEC to clarify the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities.

SEC Rule 10(b)5-1—An SEC rule that prohibits the trading in the security of any issuer on the basis of material nonpublic information obtained in a breach of duty of trust or confidence owed to the person who is the source of the information.

SEC Rule 147—Stipulates that an intrastate offering can be made only in the one state in which established requirements are met.

SEC Rule 147A—Permits an offeror to sell securities to purchasers who are residents of the state in which the issuer has its principal place of business and is doing business. The offeror does not have to be a resident of the state, and may use general solicitation and advertising including by electronic communications. Sales may not be made to out-of-state residents.

SEC Rule 504—Provides a small offering exemption that exempts from SEC registration the sale of securities not exceeding $5 million during a 12-month period.

SEC Rule 506(b)—Allows issuers to raise capital from an unlimited number of accredited investors and no more than 35 unaccredited investors without having to register the offering with the SEC. SEC Rule 506(c)—An exemption from registration that permits issuers to raise any amount of capital from an unlimited number of accredited investors without having to register the offering with the SEC. General solicitations and advertising of the offering to the public, including using the internet, is permitted.

Section 5 of the Securities Act of 1933—A section that requires an issuer to register its securities with the SEC prior to selling them to the public.

Section 10(b) of the Securities Exchange Act of 1934—A provision of the Securities Exchange Act of 1934 that prohibits the use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations prescribed by the SEC. Section 10(b) insider—(1) Officers, directors, and employees at all levels of a company; (2) lawyers, accountants, consultants, and agents and representatives who are hired by the company on a temporary and nonemployee basis to provide services or work to the company; and (3) others who owe a fiduciary duty to the company.

Section 11 of the Securities Act of 1933—A provision of the Securities Act of 1933 that imposes civil liability on persons who intentionally defraud investors by making misrepresentations or omissions of material facts in the registration statement or who are negligent for not discovering the fraud.

Section 12 of the Securities Act of 1933—A provision of the Securities Act of 1933 that imposes civil liability on any person who violates the provisions of Section 5 of the act.

Section 16 statutory insider—Section 16(a) of the Securities Exchange Act of 1934 defines any person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company as a statutory insider who is subject to the rules of Section 16. Statutory insiders must file reports with the SEC to disclose their ownership and trading in the company’s securities.

Section 16(a) of the Securities Exchange Act of 1934—A section of the Securities Exchange Act of 1934 that defines any person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company as a statutory insider for Section 16 purposes.

Section 16(b) of the Securities Exchange Act of 1934—A section of the Securities Exchange Act of 1934 that requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation.

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Section 24 of the Securities Act of 1933—A provision of the Securities Act of 1933 that imposes criminal liability on any person who willfully violates the 1933 act or the rules or regulations adopted thereunder.

Section 32 of the Securities Exchange Act of 1934—A provision of the Securities Exchange Act of 1934 that imposes criminal liability on any person who willfully violates the 1934 act or the rules or regulations adopted thereunder.

Securities Act of 1933—A federal statute that primarily regulates the issuance of securities by corporations, partnerships, associations, and individuals.

Securities and Exchange Commission (SEC)—A federal administrative agency that is empowered to administer federal securities laws. The SEC can adopt rules and regulations to interpret and implement federal securities laws.

Securities Exchange Act of 1934—A federal statute that primarily regulates the trading in securities.

Securities law—The federal and state governments have enacted statutes that regulate the issuance and trading of securities. These are referred to collectively as securities law. The primary purpose of securities law is to promote full disclosure to investors and to prevent fraud in the issuance and trading of securities.

Security—(1) An interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant, (2) an interest or instrument that is expressly mentioned in securities acts, and (3) an investment contract.

Shelf registration—For the well-known seasoned investor (WKSI), the SEC permits a shelf registration or shelf offering or shelf prospectus. A WKSI files the documents for a shelf registration with the SEC and is then permitted in the future to take securities “off the shelf” and sell the securities to the public using multiple offerings over a three-year period without filing a separate prospectus for each offering. A shelf registration allows an issuer to quickly issue securities when needed or when market conditions are optimal without waiting for the SEC to review a newly filed registration statement.

Short-swing profits—Profits that are made by statutory insiders on trades involving equity securities of their corporation that occur within six months of each other.

Small Company Offering Registration (SCOR)—A method for small companies to sell up to $1 million of securities to the public by using a question-and- answer disclosure form called Form U-7.

Small offering exemption—SEC Rule 504 provides a small offering exemption that exempts from SEC registration the sale of securities not exceeding $5 million during a 12-month period.

State securities laws (“blue-sky” laws)—State laws that regulate the issuance and trading of securities.

Statutorily defined securities—Interests or instruments that are expressly mentioned in securities acts are statutorily defined securities.

Stop Trading on Congressional Knowledge Act (STOCK Act)—This federal statute prohibits members and employees of the U.S. Congress, the U.S. president, and all employees of the executive branch, and judges and employees of the judicial branch from using any nonpublic information derived from the individual’s position or gained from the performance of the individual’s duties for personal benefit. This act also prohibits them from receiving special access to initial public offerings.

Test the waters—In the context of an emerging growth company (EGC) initial public offering (IPO), an EGC may communicate with institutional accredited investors to test the waters to see if there is enough interest in its IPO before proceeding with it.

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Tier 1—SEC Regulation A+ is divided into two tiers. Tier 1 permits the securities issuer to raise up to $20 million in a 12-month period, and there is no limit on the amount of securities that any person can purchase of the issue.

Tier 2—SEC Regulation A+ is divided into two tiers. Tier 2 permits the securities issuer to raise up to $50 million in a 12-month period. There is no limit on the amount of securities that an accredited investor can purchase, but a non-accredited investor (sometimes referred to as a “main street” investor) can only purchase securities up to 10 percent of his or her annual income or net worth per year, whichever is greater.

Tippee—The person who receives material nonpublic information from a tipper.

Tipper—A person who discloses material nonpublic information to another person.

Tipper-tippee liability—The tipper is liable for the profits made by the tippee.

Uniform Securities Act—The Uniform Securities Act has been adopted by many states. This act coordinates state securities laws with federal securities laws.

Unregistered securities—The sale of securities that should have been registered with the SEC but were not is a violation of the Securities Act of 1933. Investors who purchased such unregistered securities can rescind their purchases and recover damages, and the U.S. government can impose criminal penalties on any person who willfully violates the Securities Act of 1933.

Well-known seasoned investor (WKSI)—A large company that meets certain qualifications and is thus granted substantial flexibility of communication with prospective investors and may immediately issue securities upon filing a registration statement with the SEC. Whistle-blower bounty program—Allows a person who provides information that leads to a successful SEC action in which more than $1 million is recovered to receive 10 to 30 percent of the money collected.

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Chapter 18 Agency Law Who is responsible?

I. Teacher to Teacher Dialogue Agency law is very important in a basic undergraduate law course in that it represents a synergy of two otherwise distinctive bodies of law: contracts and torts. It is useful to remind students of the interplay between these two areas of law. For example, go through the creation of the agency relationship (which highlights contract elements), involve a third party (by way of torts), and decide whether any defenses may apply (possibilities from both the law of contracts and torts). Invariably, certain patterns of behavior can be identified that can be used to help students ask key questions about agency-based issues.

Agency is defined by Section 1 of the Restatement (Second) of Agency as a fiduciary relationship “which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act.”

Agency is a legally recognized relationship that allows an attribution of one person’s behavior to another. This carryover process is two-sided in that both benefit and burden inure to the parties involved in the agency relationship.

Under the basic doctrine of agency, the principal is allowed to reap the beneficial harvest of the agent’s actions made on his or her behalf. For example, assume an agent has agreed to be paid a set salary of $100 for selling certain kinds of goods. The principal gets to keep the net profits from that agent’s selling activities, be they $100 or $1,000,000. This net gain is what allows the use of agency theory to maximize one’s efficiency through the actions of others.

There, are, however, some limits on the ability to designate others to act on one’s behalf based on the uniqueness of personal services or on public policy grounds that forbid the use of agents, such as voting or serving a criminal sentence. As a practical matter, business as we know it today simply could not be conducted on any scale beyond sole proprietorship without extensive use of agency relationships.

The benefits of agency are not without counterbalancing problems. The Latin maxim respondeat superior may be familiar to your students. In certain instances, a principal is liable to third parties for the acts of his or her agent. Just as the benefits of agency can be great, so can the burdens. One of the fastest growing areas of management specialization in today’s business environment is risk management. This area generally concerns business financial responsibility for exposures to specified contingencies or perils. Included in these perils are the acts of the agents for which the principal may be liable. The ironic aspect of all this is that the very same people who helped a business grow can lead that same enterprise to financial ruin.

Every agency liability question having an involvement with third parties has three subquestions that must be answered in order to come to a final resolution of the issues at hand.

They are: 1. What are the responsibilities of the principal and agent vis-à-vis each other?

2. What are the responsibilities of the agent vis-à-vis the third party?

3. What are the responsibilities of the principal vis-à-vis the third party?

Invariably a certain fact pattern emerges. First there is some sort of principal/agent relationship established. This relationship may be based on actual, implied, apparent, or ratified authority. In all events, once that authority line has been drawn, the question of the legal consequences to the

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principal and agent vis-à-vis each other must be answered. These consequences include their respective rights and duties to each other.

Once the first subquestion is resolved, the rights, duties, and obligations of the agent and principal, respectively, must then be examined vis-à-vis the third party. Often there will be some sort of wrongful and unauthorized act committed by the agent. That act will result in probable liability for both the agent and the principal to the third party who was harmed by the act. Think of the three subquestions as a loop that must be closed in order for the whole case to be resolved.

An agency issue starts with the establishment of the agency relationship. It goes through the rights and duties of third parties. It terminates where it began, with a determination of the ultimate responsibilities of the principal and agent vis-à-vis each other.

II. Chapter Objectives 1. Define agency and describe the principal-agent relationship, the employer-employee relationship, and the principal-independent contractor relationship.

2. Describe how express and implied agencies are created.

3. Define apparent agency.

4. List and describe the duties of a principal.

5. List and describe the duties of an agent.

6. Describe the tort liability of principals and agents to third parties.

7. Describe the liability of agents and principals for intentional torts.

8. Describe the principal’s and agent’s liability on third-party contracts.

9. Define independent contractor and describe the liability of independent contractors.

10. Describe how an agency is terminated.

III. Key Question Checklist  How is an agency relationship created?  What definition best fits the agency relationship?  If there is not an agency, is there a principal/independent contractor relationship?  What are the principal and agent’s duties to each other?  What are the principal and agent’s duties to the third party?  How can an agency be terminated?

IV. Chapter Outline Introduction to Agency Formation and Termination – If businesspeople had to personally conduct all of their business, the scope of their activities would be severely curtailed. The use of agents (or agency), which allows one person to act on behalf of another, solves this problem.

Employment and Agency Relationships – Agency relationships are fiduciary relationships formed by mutual agreement between the principal and an agent. The principal employs the agent to act on his or her behalf.

Principal-Agent Relationship – The principal hires an employee and gives him or her the authority to act and enter into contracts on the principal’s behalf. The authority is limited to any express agreement between the parties or implied by the circumstances surrounding the agency.

Employer-Employee Relationship – An employer–employee relationship exists when an employer hires an employee to perform some type of physical service. An employee is not an agent unless he or she is specifically empowered to enter into contracts on the principal employer’s behalf.

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Principle-Independent Contractor Relationship – This is the relationship between a principal and an independent contractor who is not an employee of the principal but has been employed by the principal to perform a certain task on behalf of the principal.

Formation of an Agency – An agency can arise in any of the following ways: (1) express agency; (2) implied agency, (3) apparent agency; or (4) agency by ratification.

Express Agency – The most common form of agency is an express agency, where the agent contracts with the principal to act on the principal’s behalf. The contract may be oral or written, but is bound by the Statute of Frauds. If a principal and an agent enter into an exclusive agency contract, the principal cannot employ any agent other than the exclusive agent. The exclusive agency terminates upon completion of the contracted services. Breach by the principal will allow the agent to recover damages. In the absence of an exclusive agency, the principal may employ multiple agents, and the services of all agents are terminated when any one of the agents accomplish the stated purpose.

Contemporary Environment: Power of Attorney This express agency agreement gives an agent the power to sign legal documents. There are two types: (1) a general power of attorney, which confers broad powers; and (2) a special power of attorney, which limits the powers of the agent.

Implied Agency – In many situations, a principal and an agent do not expressly create an agency.

Instead, the agency is implied from the conduct of the parties. This type of agency is referred to as an implied agency. The extent of the agent’s authority is determined from the facts and circumstances of the particular situation.

Agency by Ratification – Agency by ratification occurs when (1) a person misrepresents himself or herself as another’s agent when in fact he or she is not, and (2) the purported principal ratifies (accepts) the unauthorized act. In such cases, the principal is bound to perform, and the agent is relieved of any liability for misrepresentation.

State Court Case Case 18.1 Independent Contractor: Smith v. Delta Tau Delta, Inc. Facts: Delta Tau Delta, Inc., a national fraternity, granted a charter to the Beta Psi local fraternity at Wabash College. The national fraternity does not control the operation of the local fraternity or its members. The national fraternity disapproves of hazing and underage drinking, and can suspend local fraternity charters where hazing and underage drinking occur. During a hazing incident at the Beta Psi local fraternity, Johnny Dupree Smith, a freshman, died from acute alcohol ingestion in a hazing incident. Smith’s parents brought a wrongful death action against the local fraternity Beta Psi, the national fraternity Delta Tau Delta, and Wabash College. The plaintiffs reached a settlement with Wabash College. The plaintiffs alleged that the local fraternity chapter was negligent, that it and its members were the agents of the national fraternity, and that the national fraternity was vicariously liable for their negligence. The national fraternity made a motion for summary judgment, arguing that the local fraternity and its members were not its agents. The trial court granted the national fraternity’s motion for summary judgment and the court of appeals affirmed the trial court decision. The Smiths appealed.

Issue: Is there an agency relationship between the local fraternity and its members and the national fraternity?

Decision: The Supreme Court of Indiana concluded that an agency relationship did not exist between the national fraternity and the local fraternity and its members.

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Reasoning: The local fraternity’s everyday management and supervision of activities and conduct of its resident members is not undertaken at the direction and control of the national fraternity.

Ethics Questions: This is a tragic case, and it is easy to feel sympathy for the parents for the loss of their son. However, the case involves a straightforward application of the doctrine of vicarious liability, and based on the facts presented in the case, the local fraternity and its members were not acting on behalf of the national fraternity and were not subject to its control.

State Court Case Case 18.2 Agency: Eco-Clean, Inc. v. Brown Facts: Nicholas Brown was a student at Georgia Tech University and a member of the Ramblin’ Reck spirit club. Georgia Tech owns a Model A automobile called the Ramblin’ Reck, which is the university’s mascot. Members of the spirit club are responsible for driving the car at university events. Eco-Clean, Inc. installed new wood handles on the vehicle. One day, Brown was standing on the Model A’s passenger side running board and grasping the wooden door handle while the vehicle was being operated by a fellow Georgia Tech student. The handle snapped off and Brown fell to the pavement, suffering severe injuries. Eyewitnesses testified that the car accelerated through a red light and that the car was turning at an unusually high rate of speed at the time of the accident. Brown sued the university and Eco-Clean for negligence. The jury found that Eco-Clean was negligent for installing the door handle with short wooden screws rather than stronger bolts. It also found that the student driver was an agent of the university and that the university was vicariously liable for the driver’s negligence. The university appealed the decision, alleging that the driver of the Model T was not its agent.

Issue: Was the driver of the car an agent of Georgia Tech University?

Decision: The court of appeals held that the student driver was an agent of Georgia Tech University and upheld the trial court’s award of damages to Brown.

Reason: Because some evidence introduced at trial authorized the jury to determine that the board of regents was liable under an agency theory for the negligence of the driver, the trial court did not err in denying the board of regents’ motion for a directed verdict of liability.

Ethics Questions: Arguably, Georgia Tech did not act ethically in denying liability, since the vehicle was being operated by a Georgia Tech student at the time of the accident. This appears to be a clear case of vicarious liability.

Apparent Agency – Apparent agency, or agency by estoppel, arises when the principal creates the appearance of an agency that does not exist. Where an apparent agency is established, the principal is estopped from denying the relationship and is bound by any contracts that the agent has entered into.

State Court Case Case 18.3 Agency Relationship: Bosse v. Brinker Restaurant Corporation, d.b.a. Chili’s Grill and Bar Facts: Four teenagers ate a meal at a Chili’s restaurant in Dedham, Massachusetts and left without paying. A patron of the restaurant saw them leave without paying, and he followed them in his vehicle. A high-speed chase ensued. The patron used his cell phone to call the Chili’s manager. The manager called 911 and reported the incident and the location of the car chase. The teenager’s car collided with a cement wall, and two of the teenagers, Brendan Bosse and Michael Griffin, were seriously injured. The Chili’s patron drove past the crash scene and was never identified. Bosse and Griffin sued Chili’s for compensatory damages for their injuries. The plaintiffs argued that the patron was an agent of Chili’s and therefore that Chili’s was liable to the plaintiffs based on the doctrine of respondeat superior, which holds a principal liable for the acts

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of its agents. Chili’s filed a motion for summary judgment, arguing that the patron was not its agent.

Issue: Is the restaurant patron who engaged in the high-speed car chase an agent of Chili’s?

Decision: The superior court held that the restaurant patron who engaged in the high-speed chase in which the plaintiffs were injured was not an agent of Chili’s restaurant. The superior court granted summary judgment to Chili’s. The appeals court of Massachusetts affirmed the decision.

Reasoning: The evidence was insufficient to create a genuine issue whether Chili’s appointed or authorized the patron to act as a “posse” to conduct the chase. No information indicates that Chili’s had any effective control over the patron.

Ethics Questions: Giving the fact that the teenagers did not pay for their meals, it is difficult to feel sympathy for them in this case. However, sympathy (or the lack thereof) did not likely influence the court’s decision. The facts demonstrate that no agency relationship was created between Chili’s and the unidentified patron, since he was not under the restaurant’s direction or control. Summary judgement for the moving party is proper when (1) there is no significant issue of material fact, and (2) the moving party is entitled to judgment as a matter of law.

Principal’s Duties – The principal owes the following duties to an agent: (1) Duty to compensate—A principal owes a duty to compensate the agent for performance of services, either the amount stated in the contract or, if there was no agreement, whatever the customary fee paid in the industry is due.

(2) Duty to reimburse—In carrying out an agency, an agent may spend his or her own money on the principal’s behalf. Unless otherwise agreed, the principal owes a duty to reimburse the agent for all such expenses if they were (a) authorized by the principal, (b) within the scope of the agency, and (c) necessary to discharge the agent’s duties in carrying out the agency.

(3) Duty to indemnify—A principal owes a duty to indemnify the agent for any losses the agent suffers because of the principal’s conduct. This duty usually arises where an agent is held liable for the principal’s misconduct.

(4) Duty to cooperate—Unless otherwise agreed, the principal owes a duty to cooperate with and assist the agent in the performance of the agent’s duties and the accomplishment of the agency.

Contingency Fee – Under this type of arrangement, the principal owes a duty to pay the agent an agreed-upon fee only if the objective of the agency is obtained. Real estate brokers, lawyers, and salespersons often work on a contingency-fee basis.

Agent’s Duties – The agent owes the following duties to a principal: (1) Duty to Perform—The agent must perform the lawful duties as stated in the contract and must meet the standards of reasonable skill, care, and diligence implicit in all contracts.

(2) Duty to Notify—The agent must notify the principal of any information that would be important to the principal. Information learned by an agent in the course of an agency is imputed to the principal.

(3) Duty to Account—The agent owes a duty to accurately account for all transactions that he undertakes on behalf of the principal, to maintain a separate account for the principal, and to use the principal’s property in an authorized manner. The principal has a right to demand an accounting from the agent at any time, and the agent owes a legal duty to make the accounting.

Ethics: Agent’s Duty of Loyalty An agent owes the principal a duty of loyalty and a fiduciary duty. The most common types of breaches of loyalty by an agent are as follows: (1) Self-dealing—Agents are generally prohibited from undisclosed self-dealing with the principal.

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(2) Usurping an opportunity—A third-party offer to an agent must be conveyed to the principal.

The agent cannot appropriate the opportunity for herself unless the principal rejects it after due consideration.

(3) Competing with the principal—Agents are prohibited from competing with the principal during the course of an agency unless the principal agrees.

(4) Misuse of confidential information—In the course of an agency, the agent often acquires confidential information about the principal’s affairs. The agent is under a legal duty not to disclose or misuse confidential information either during or after the course of the agency.

(5) Dual agency—This occurs when an agent acts for two or more different principals in the same transaction. This practice is generally prohibited unless all the parties involved in the transaction agree to it.

Tort Liability of Principals and Agents – Both principal and agent are liable for their own tortious conduct. The principal is liable for the tortious conduct of an agent who is acting within the scope of their authority. An agent is liable for tortious acts of a principal only if they aid or abet the conduct.

Negligence – Principals are liable for acts performed by agents acting within the scope of their authority under the common law doctrine of respondent superior, which is based on the legal theory of vicarious liability.

State Court Case Case 18.4 Scope of Employment: Matthews v. Food Lion, LLC Facts: Brigitte Hall was a part-time cashier at Food Lion. When Hall’s shift was over, she “punched out” and headed to the bathroom before leaving the store. Hall entered the bathroom at a brisk pace, and when she opened the door, the door struck Diamond Matthews, injuring her.

Matthews sued Hall and Food Lion to recover damages for negligence and respondeat superior.

The trial court granted summary judgment for Food Lion, based on the conclusion that Hall was not acting within the scope of her employment at the time of the incident. Matthews appealed.

Issue: Was Hall acting within the scope of her employment at the time of the accident?

Decision: The court of appeals held that Hall was not acting within the scope of her employment at the time of the accident. The court of appeals affirmed the trial courts’ grant of summary judgment for Food Lion.

Reason: The evidence establishes that Food Lion has no control over the actions of its employees once they have “clocked out” of work. Hall was not acting within the scope of her employment at the time of the incident and Hall had completely departed from the course of business of her employer.

Ethics Questions: Arguably, Food Lion should have denied liability in this case, since this was a “close case” to decide in terms of whether Hall was acting within the scope of her employment at the time of the accident. In support of Food Lion’s position, Hall was “punched out” at the time the incident involving Matthews occurred. The facts do not appear to indicate that any of the parties involved acted unethically in this case.

Frolic and Detour – Agents sometimes do things during the course of their employment that furthers their personal interests, such as running personal errands. This is referred to as frolic and detour. Negligence actions stemming from frolic and detour are examined on a case-by-case basis. Agents are always personally liable for their tortious conduct in such situations.

Contemporary Environment: Coming and Going Rule Under this rule, principals are generally not held liable for injuries caused by agents or employees on their way to and from work, even if the principal supplies the transportation.

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Dual-Purpose Mission – A situation that occurs when a principal requests an employee or agent to run an errand or do another act for the principal while the agent is on his or her own personal business is known as dual-purpose mission.

Liability for Intentional Torts – A principal is not liable for the intentional torts of agents and employees that are committed outside the principal’s scope of business. However, a principal is liable under the doctrine of vicarious liability for intentional torts of agents and employees committed within the agent’s scope of employment. The motivation test and the work-related test are two tests applied by courts to determine whether an agent’s intentional torts were committed within the agent’s scope of employment.

Misrepresentation – Principals are liable for both the intentional and innocent misrepresentations made by an agent acting within the scope of employment. Intentional misrepresentation occurs when the agent makes statements that he knows are false. Innocent misrepresentations occur when the agent negligently makes a misrepresentation to a third party.

The third party may rescind the contract and recover any consideration paid or affirm the contract and recover damages.

Contract Liability of Principals and Agents – Principals that authorize agents to enter into contracts with a third party will be liable on the contract. The agent can also be held liable on the contract in certain circumstances.

Fully Disclosed Agency – This is the result of the third party knowing that the agent is acting as such for an identified principal. In a fully disclosed agency, the contract is between the principal and the third party. The agent has no liability under the contract unless they have guaranteed the performance of the principal.

Partially Disclosed Agency – This occurs when the agent discloses their agency status but not the identity of the principal to the third party. In this event, both the principal and the agent are liable on third party contracts, because the third party must rely on the agent’s reputation or credit when entering into the agreement. If the agent is made to pay the contract, the agent can sue the principal for indemnification. The third party and the agent can agree to relieve the agent’s liability.

Undisclosed Agency – This is when the third party is unaware of both the existence of the agency or of the principal. Both the principal and the agent are liable on the contract. The agent becomes the principal to the contract, but they are indemnified by the principal, and can recover for any losses.

Independent Contractor – Outsiders who are employed by principals to perform certain tasks on their behalf are called independent contractors. The party that employs an independent contractor is called the principal.

Factors for Determining Independent Contractor Status – The key point for determining whether someone is an independent contractor is the degree of control that the principal has over that party. Critical factors in determining independent contractor status include: (1) Whether the worker is engaged in a distinct occupation or an independently established business; (2) The length of time the agent has been employed by the principal; (3) The amount of time that the agent works for the principal; (4) Whether the principal supplies the tools and equipment used in the work; 210 .

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(5) The method of payment, whether by time or by the job; (6) The degree of skill necessary to complete the task; (7) Whether the worker hires employees to assist him or her; and (8) Whether the employer has the right to control the manner and means of accomplishing the desired result.

Critical Legal Thinking: Are FedEx Drivers Independent Contractors?

In this case, FedEx considered the drivers it hired to be independent contractors and not employees, and FedEx’s contract with the drivers identified them as independent contractors.

FedEx required its drivers to provide their own vehicles, which must be approved by the company.

More than 300 FedEx drivers in Oregon filed a class action lawsuit against FedEx in U.S. district court, alleging that they were employees of FedEx and not independent contractors. They sought to recover unpaid wages and overtime pay, recover damages for being forced to incur business expenses, recover payment of benefits owed to employees by law, rescind the FedEx contracts, and obtain an injunction against FedEx from enforcing independent contractor status on the drivers. The district court held that the drivers were independent contractors and granted summary judgment to FedEx. The U.S. court of appeals held that FedEx drivers were employees of FedEx and not independent contractors. The court of appeals stated, “Direct evidence of the right to control is the most important factor under Oregon law. We can find no difference at all between FedEx drivers’ actual situation in so far as control is concerned and the situation of one hired to drive a delivery truck owned and operated by FedEx. Slayman v. FedEx Ground Package System, Inc., 765 F.3d 1033, 2014 U.S. App. Lexis 16623 (United States Court of Appeals for the Ninth Circuit, 2014) Liability for an Independent Contractor’s Torts – The principal is not liable for the torts of their independent contractors, since they do not control the means by which the results are accomplished.

Liability for an Independent Contractor’s Contracts – Principals are bound by the authorized contracts of their independent contractors, but not those entered into by the independent contractors without the express or implied authority of the principals.

Termination of an Agency – An agency contract can be terminated by: (1) An act of the parties; (2) An unusual change of circumstances, (3) Impossibility of performance; or (4) Operation of law.

Termination of an Agency by an Act of the Parties – The parties may terminate an agency relationship by either agreement or their actions. The parties may end their relationship by mutual consent, relieving each other of any further rights and duties. Agency agreements often are written for a specific time period, and the agency automatically lapses when the period passes.

The agency relationship will terminate upon the successful completion of the assigned duty. An agency agreement may also specify that the relationship will terminate upon the occurrence of a specified event. The termination of an agency extinguishes an agent’s actual authority to act on the principal’s behalf. However, if the principal fails to give the proper notice of termination to a third party, the agent still has apparent authority to bind the principal to contracts with these third parties.

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Termination of an Agency by an Unusual Change in Circumstances – An agency terminates when there is an unusual change in circumstances that would lead the agent to believe that the principal’s original instructions should no longer be valid.

Contemporary Environment: Impossibility of Performance An agency relationship terminates if a situation arises that makes its fulfillment impossible. The loss or destruction of the subject matter of the agency, the loss of a required qualification, or a change in the law can lead to termination by impossibility of performance.

Termination of an Agency by Operation of Law – Agency contracts may be terminated by operation of law by the death of either the principal or the agent, the insanity of either party, bankruptcy of the principal, or by the outbreak of a war between the principal’s country and the agent’s country.

Wrongful Termination – The termination of an agency extinguishes the power of the agent to act on behalf of the principal. If the principal’s or agent’s termination of an agency contract breaches the contract, the other party can sue to recover damages for wrongful termination.

V. Key Terms and Concepts  Agency—The principal-agent relationship: the fiduciary relationship “which results from the manifestation of consent by one person to another that the other shall act in his behalf and subject to his control, and consent by the other so to act.”  Agency by ratification—An agency that occurs when (1) a person misrepresents him- or herself as another’s agent when in fact he or she is not, and (2) the purported principal ratifies the unauthorized act.  Agency law—The large body of common law that governs agency; a mixture of contract law and tort law.  Agent—The party who agrees to act on behalf of another.  Agent’s signature—The agent’s signature on a contract entered into on the principal’s behalf can establish the agent’s status and therefore his or her liability.  Apparent agency (agency by estoppel)—Agency that arises when a principal creates the appearance of an agency that in actuality does not exist.  Attorney-in-fact—An agent who has been granted the power of attorney.  Coming and going rule (going and coming rule)—A rule that says a principal is generally not liable for injuries caused by its agents and employees while they are on their way to or from work.  Competing with the principal—Agents are prohibited from competing with the principal during the course of an agency unless the principal agrees.  Constructive notice—Notice of the termination of an agency that is printed in a newspaper that serves the vicinity of the parties is constructive notice.  Contingency fee—A fee arrangement between a lawyer and client whereby the lawyer is paid a percentage of damages won through trial judgment or by settlement.  Contract liability—Agency law imposes contract liability on principals and agents, depending on the circumstances.  Degree of control—The crucial factor in determining whether someone is an independent contractor or an employee is the degree of control that the principal has over that party.  Direct notice—At the time of termination of an agency, the principal can give direct notice of termination to all persons with whom the agent dealt.  Dual agency—Occurs when an agent acts for two or more different principals in the same transaction.

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Dual-purpose mission—A situation that occurs when a principal requests an employee or agent to run an errand or do another act for the principal while the agent is on his or her own personal business. Most jurisdictions hold both the principal and the agent liable if the agent injures someone while on such a mission.

Durable power of attorney—A durable power of attorney remains effective even though the principal is incapacitated.

Duty of loyalty of agents—A fiduciary duty owed by an agent not to act adversely to the interests of the principal.

Duty to account (duty of accountability)—A duty that an agent owes to maintain an accurate accounting of all transactions undertaken on the principal’s behalf.

Duty to compensate—A duty that a principal owes to pay an agreed-upon amount to the agent, either upon the completion of the agency or at some other mutually agreeable time.

Duty to cooperate—Unless otherwise agreed, the principal owes a duty to cooperate with and assist the agent in the performance of the agent’s duties and the accomplishment of the agency.

Duty to indemnify—A principal owes a duty to indemnify the agent for any losses the agent suffers because of the principal’s conduct.

Duty to notify—An agent owes a duty to notify the principal of important information concerning the agency.

Duty to perform—An agent’s duty to a principal that includes (1) performing the lawful duties expressed in the contract, and (2) meeting the standards of reasonable care, skill, and diligence implicit in all contracts.

Duty to reimburse—Unless otherwise agreed, the principal owes a duty to reimburse the agent for expenses incurred by the agent if the expenses were (1) authorized by the principal, (2) within the scope of the agency, and (3) necessary to discharge the agent’s duties in carrying out the agency.

Employer-employee relationship—A relationship that results when an employer hires an employee to perform some form of physical service.

Estopped—In the context of an apparent agency, the principal is estopped (stopped) from denying the agency relationship and is bound to contracts entered into by the apparent agent while acting within the scope of the apparent agency.

Exclusive agency contract—A contract a principal and agent enter into that says the principal cannot employ any agent other than the exclusive agent.

Express agency—An agency that occurs when a principal and an agent expressly agree to enter into an agency agreement with each other.

Frolic and detour—When an agent does something during the course of his employment to further his own interests rather than the principal’s.

Fully disclosed agency—An agency in which a contracting third party knows (1) that the agent is acting for a principal, and (2) the identity of the principal.

Fully disclosed principal—A fully disclosed principal is liable on the contract but the agent is not.

General power of attorney—Confers broad powers on the agent to act in any matters on the principal’s behalf.

Implied agency—An agency that occurs when a principal and an agent do not expressly create an agency, but it is inferred from the conduct of the parties.

Imputed knowledge—Information that is learned by an agent that is attributed to the principal.

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Independent contractor—“A person who contracts with another to do something for him who is not controlled by the other nor subject to the other’s right to control with respect to his physical conduct in the performance of the undertaking” [Restatement (Second) of Agency].

Inherently dangerous activity—Principals cannot avoid liability for inherently dangerous activities that they assign to independent contractors.

Innocent misrepresentation—Occurs when an agent makes an untrue statement that he or she honestly and reasonably believes to be true.

Intentional misrepresentation (fraud or deceit)—Occurs when an agent makes an untrue statement that he or she knows is not true.

Intentional tort—Occurs when a person has intentionally committed a wrong against (1) another person or his or her character, or (2) another person’s property.

Misuse confidential information—The agent is under a legal duty not to disclose or misuse confidential information either during or after the course of the agency.

Motivation test—A test to determine the liability of the principal; if the agent’s motivation in committing the intentional tort is to promote the principal’s business, then the principal is liable for any injury caused by the tort.

Negligence—The doctrine of negligence rests on the principle that if someone (i.e., the principal) expects to derive certain benefits from acting through others (i.e., an agent), that person should also bear the liability for injuries caused to third persons by the negligent conduct of an agent who is acting within their scope of employment.

Notice of termination of an agency—The termination of an agency extinguishes an agent’s actual authority to act on the principal’s behalf. However, if the principal fails to give the proper notice of termination to a third party, the agent still has apparent authority to bind the principal to contracts with these third parties.

Partially disclosed agency—An agency in which a contracting third party knows that the agent is acting for a principal but does not know the identity of the principal.

Partially disclosed principal—If an agent discloses his or her agency status but does not reveal the principal’s identity, then the principal is known as a partially disclosed principal.

Power of attorney—An express agency agreement that is often used to give an agent the power to sign legal documents on behalf of the principal.

Principal—The party who employs another person to act on his or her behalf.

Principal-agent relationship—An employer hires an employee and gives that employee authority to act and enter into contracts on his or her behalf.

Principal–independent contractor relationship—Principals often employ outsiders—that is, persons and businesses that are not employees—to perform certain tasks on their behalf.

Respondeat superior—A rule that says an employer is liable for the tortious conduct of its employees or agents while they are acting within the scope of his or her authority.

Restatement (Second) of Agency—The reference source for the rules of agency.

Scope of employment—Principals are liable for the negligent conduct of agents acting within the scope of their employment.

Self-dealing—Agents are generally prohibited from undisclosed self-dealing with the principal.

Special power of attorney (limited power of attorney)—A power of attorney where a principal confers powers on an agent to act in specified matters on the principal’s behalf.

Termination of an agency by act of the parties—An agency may be terminated by the following acts of the parties: (1) mutual agreement, (2) lapse of time, (3) purpose achieved, and (4) occurrence of a specified event.

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Termination of an agency by an unusual change in circumstances—An agency terminates when there is an unusual change in circumstances that would lead the agent to believe that the principal’s original instructions should no longer be valid.

Termination of an agency by impossibility of performance—An agency relationship terminates if a situation arises that makes its fulfillment impossible.

Termination of an agency by operation of law—An agency is terminated by operation of law, including: (1) death of the principal or agent, (2) insanity of the principal or agent, (3) bankruptcy of the principal, (4) impossibility of performance, (5) changed circumstances, and (6) war between the principal’s and agent’s countries.

Tort liability—Three main sources of tort liability for principals and agents are negligence, intentional torts, and misrepresentation.

Tortious conduct—A principal and an agent are each personally liable for their own tortious conduct.

Undisclosed agency—An agency in which a contracting third party does not know of either the existence of the agency or the principal’s identity.

Undisclosed principal—The principal in an undisclosed agency.

Usurping an opportunity—An agent cannot personally usurp an opportunity that belongs to the principal.

Vicarious liability—Liability without fault.

Work-related test—A test to determine the liability of a principal; if an agent commits an intentional tort within a work-related time or space, the principal is liable for any injury caused by the agent’s intentional tort.

Wrongful termination—The termination of an agency contract in violation of the terms of the agency contract. The non-breaching party may recover damages from the breaching party.

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Chapter 19 Equal Opportunity in Employment

Why is discrimination wrong?

I. Teacher to Teacher Dialogue Discrimination and equal opportunity are hard materials to present to students. As instructors, we need to be careful to first clearly define the terms illustrated by the two sides of the word “discrimination.” Second, be sure to present both sides of every argument. This is especially important in the most controversial areas such as affirmative action. After all arguments have been listed, be sure to have students engage in open debate, allowing all sides to be heard, not just the politically correct ones. If the class as a whole wants to take only one side, we owe it to fair inquiry and academic freedom to put forward opposite views, even if we personally do not support those views. Teaching these materials is never easy, but remains always exciting. As the Reverend Martin Luther King, Jr. once said, “It may be true that the law cannot make a man love me. But it can keep him from lynching me, and I think that’s pretty important.”

Few American legal issues are inflamed with more controversy than discrimination in the workplace. The genesis of our nation’s heritage is rooted in a diversity of peoples who immigrated to the New World in order to flee the royalist, class, or caste systems that so often predestined their opportunities for social and economic advancement. The U.S. Declaration of Independence, and the government founded on it, became the first major system of selfgovernance premised on the assumption that all persons are born equal and should be treated equally in the eyes of the law. As we all know, that equality has often been a hope rather than a reality for many. For all of the rhetoric in the early days of the United States, freedom and equality meant equality only for free or freed men, not women, and slavery still existed in many of the states.

The same diversity that has been a source of national pride has also been the basis of disparate treatment of persons in the workplace for many years. The term “discriminate” has within it two distinct and opposite meanings. On the positive side, discrimination is simply a fact of life. We are not all equal in all ways. We have different talents, strengths, levels of training, and abilities. Employers, in turn, should be allowed and expected to seek utilization of these divergent talents and strengths in their own best interests. To discriminate in the positive sense is to reward ability and merit on its face. The positive aspect of discrimination really says that uniqueness should be discerned, differentiated, distinguished, and rewarded in the workplace. In the end, economic marketplace factors are blind to any other factors but job performance. Like it or not, positive discrimination is a simple economic necessity that is no different than the laws of nature and cannot be ignored. For example, you cannot expect the average person on the street to play golf as well as Tiger Woods. He, in turn, is amply rewarded for his talent.

The negative side of discrimination is found in wrongful selection processes. For a society founded on a premise of equality, we have certainly had more than our share of unequal treatment in the workplace. The negative side of discrimination is inequality of treatment based on wrongful motive, justifications, or rationalizations. Each choice not based on talent, ability, and merit is a step away from the inherent basis of equality before the law. Wrongful discrimination is like cancer. Sooner or later, once it is allowed to grow unchecked, it will kill. None of us can afford to look the other way and say: “It’s not my problem.” Wrongful discrimination against any

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group is a wrong upon society at large. Almost everyone appreciates that fact intuitively, if not intellectually.

One element that provides hope for positive change is goodwill. Where people of goodwill cling to the basic rightness of equity before the law, that equity will eventually result in a changed culture. Until then, law and our courts will continue to be the testing grounds for this monumental change in the social order. It may sound corny, but we all must do our part to live and let live.

I like to point out to my students that within the near future, Caucasians will become a minority as the Latin population continues to soar. Shifts in the work force as more women achieve degrees and seek employment will further affect the employment demographic.

II. Chapter Objectives 1. Describe the functions of the Equal Employment Opportunity Commission.

2. Describe the scope of coverage of Title VII of the Civil Rights Act of 1964.

3. Identify race and color discrimination that violate Title VII. 4. Identify national origin discrimination that violates Title VII. 5. Define gender discrimination and describe the scope of protection against gender discrimination.

6. Describe how members of the LGBTQ community are protected from job discrimination.

7. Describe racial, sexual, and other forms of harassment.

8. Describe an employer’s duty to make reasonable accommodations for employees’ religions.

9. List and describe defenses that may be raised by an employer against a charge of violating Title VII. 10. Describe the scope of coverage of the Equal Pay Act. 11. Describe the scope of coverage of the Age Discrimination in Employment Act. 12. Describe the protections afforded by the Americans with Disabilities Act. 13. Define genetic information discrimination.

14. Explain the protections afforded employees from employer retaliation.

15. Describe employment protections for veterans and military personnel.

16. Define affirmative action in employment.

III. Key Question Checklist  What type of discrimination is being alleged?  What statutory remedies are available?  Which remedy is most suitable for your case?

IV. Chapter Outline Introduction to Equal Opportunity in Employment – Starting in the 1960s, the U.S. Congress began enacting a comprehensive set of federal laws that eliminated major forms of employment discrimination. These laws, which were passed to guarantee equal opportunity in employment to all employees and job applicants, have been broadly interpreted by the federal courts, particularly the U.S. Supreme Court. States have also enacted antidiscrimination laws.

Equal Employment Opportunity Commission –The Equal Employment Opportunity Commission (EEOC) is the federal administrative agency responsible for enforcing most of the federal antidiscrimination laws.

Complaint Process – A complainant must first file a complaint with the EEOC. Based on whether a violation is found or not, it will decide whether to sue the employer. If a state has a Fair

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Employment Practices Agency (FEPA), the complainant may file his or her claim with the FEPA instead of the EEOC. Lilly Ledbetter Fair Pay Act of 2009 – The act provides that each discriminatory pay decision restarts the statutory 180-day clock. The act provides that a court can award back pay for up to two years preceding the filing of the claim if similar violations occurred during the prior two-year time period.

Title VII of the Civil Rights Act of 1964 – In the 1960s, Congress enacted several major federal statutes that outlawed employment discrimination against members of certain classes. One of the main statutes is Title VII of the Civil Rights Act of 1964.

Landmark Law: Title VII of the Civil Rights Act of 1964 Title VII of the Civil Rights Act of 1964 prohibits job discrimination based on the following five protected classes: race, color, religion, sex, and national origin.

Scope of Coverage of Title VII – Title VII applies to employers of 15 or more employees, all employment agencies, labor unions with 15 or more members, state and local governments, and most federal government employment. Title VII prohibits two major forms of employment discrimination: disparate-treatment discrimination and disparate-impact discrimination.

Disparate-Treatment Discrimination – This is a form of discrimination that occurs when an employer discriminates against a specific individual because of his or her race, color, national origin, sex, or religion. In these situations, complainants must prove that: (1) They are a member of a Title VII protected class; (2) They applied for and were qualified for the employment position; (3) They were rejected despite this; and (4) The employer kept the position open and sought applicants from persons with the complainant’s qualifications.

Disparate-Impact Discrimination – This is a form of discrimination that occurs when an employer discriminates against an entire protected class. This type of discrimination is often proven through statistical data about an employer’s employment practices. The plaintiff must demonstrate a causal link between the challenged practice and the statistical imbalance.

Remedies for Violations of Title VII – A successful plaintiff may recover back pay, reasonable attorneys’ fees, and equitable remedies. The court can award punitive damages if the employer shows malice or reckless indifference. The sum of compensatory and punitive damages is capped at different amounts of money, depending on the size of the employer.

Race and Color Discrimination – Title VII of the Civil Rights Act of 1964 was enacted primarily to prohibit employment discrimination based on a person’s race and color.

Race Discrimination – The EEOC recognizes the following racial classifications: African American, Asian, Caucasian, Native American, and Pacific Islander. Race discrimination in employment violates Title VII. Federal Court Case Case 19.1 Race Discrimination: Bennett v. Nucor Corporation Facts: The plaintiffs, six African-Americans, brought a lawsuit in U.S. district court against their employer, Nucor, alleging that the company had engaged in racial discrimination and harassment 218 .

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against them in violation of Title VII of the Civil Rights Act of 1964. The plaintiffs presented evidence at trial of racial epithets and other acts of discrimination against African-Americans in the workplace and that Nucor, after proper notice, did not address those problems. A prior complaint filed against Nucor by the Equal Employment Opportunity Commission (EEOC) for racial discrimination against other parties was also introduced as evidence at trial. The jury found the defendant liable for violating Title VII and awarded each of the plaintiffs $200,000 in damages. Nucor appealed.

Issue: Is Nucor liable for racial harassment?

Decision: The U.S. court of appeals affirmed the U.S. district court’s finding of racial harassment and the award of damages to the plaintiffs.

Reason: The district court did not abuse its discretion by concluding that any time we have a racially hostile environment claim and there is a background of the EEOC being involved, that it is relevant to whether there is continued race discrimination or a racially hostile work environment.

Ethics Questions: Employees do not act ethically when they use racial epithets and engage in racial harassment. Nucor should have acted promptly to address such behavior, both in terms of legal and ethical compliance.

Color Discrimination – This is employment discrimination against a person because of his or her color; for example, a light-skinned person of a race discriminates against a dark-skinned person of the same race.

Landmark Law: Civil Rights Act of 1866 The Civil Rights Act of 1866 was enacted after the Civil War. Section 1981 of the act states that all persons “have the same right…to make and enforce contracts…as is enjoyed by white persons.” This law was enacted to give African Americans the same right to contract as whites.

Section 1981 expressly prohibits racial discrimination; it has also been held to forbid discrimination based on national origin. Employment decisions are covered by Section 1981 because the employment relationship is contractual.

National Origin Discrimination – This is employment discrimination against a person because of his or her heritage, cultural characteristics, or the country of the person’s ancestors.

Business Environment: English-Only Rules in the Workplace The Equal Employment Opportunity Commission (EEOC) states that an English-only rule that is justified by “business necessity” is lawful. Thus, an English-only rule that is limited to the work area is usually lawful. That is, employees are free to speak a language other than English during breaks, lunchtime, and before and after work while still on the premises.

Gender Discrimination – Title VII of the Civil Rights Act of 1964 prohibits job discrimination based on gender.

Gender Discrimination – Also known as sex discrimination, this is applied equally to both men and women. But the overwhelming majority of Title VII sex discrimination cases are brought by women.

Landmark Law: Pregnancy Discrimination Act In 1978, the Pregnancy Discrimination Act was enacted as an amendment to Title VII. The act forbids employment discrimination against a female job applicant or employee because of her pregnancy, childbirth, or a medical condition related to pregnancy or childbirth.

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Sexual Orientation and Gender Identity Discrimination – The term LGBTQ generally refers to an individual’s sexual orientation or gender identity. The initialism LGBTQ+ is sometimes used to ensure inclusion of all spectrums of sexuality and gender. The Equal Employment Opportunity Commission (EEOC) interprets the prohibition in Title VII against sex discrimination to include members of the LGBTQ community. The EEOC rules prohibit employment discrimination against LGBTQ job applicants and employees.

Critical Legal Thinking: Sexual Orientation Protected by Title VII Kimberly Hively began teaching as a part-time adjunct professor at Ivy Tech Community College in Indiana. She applied for 6 full-time positions at the college during a five-year position but was rejected for each position. Finally, her part-time contract was not renewed. Hively is openly lesbian. After receiving a right-to-sue letter from the Equal Employment Opportunity Commission (EEOC), Hively sued Ivy Tech in U.S. district court alleging that she had been discriminated against because of her sexual orientation in violation of Title VII. The district court dismissed the case, and a three-judge panel of the U.S. Court of Appeals for the Seventh Circuit affirmed. The en banc court of appeals decided to hear the case. The en banc court concluded that employment discrimination based on sexual orientation is a form of sex discrimination prohibited

by Title VII. Hively v. Ivy Tech Community College, 853 F.3d 339, 2017 U.S. App. Lexis 5839 (United States Court of Appeals for the Seventh Circuit, 2017) Harassment – Sometimes supervisors and/or coworkers engage in conduct that is offensive because it is sexually, racially, ethnically, or religiously charged. Such conduct is referred to as harassment. The U.S. Supreme Court has held that harassment that is so severe or frequent that it creates a hostile work environment violates Title VII. Affirmative Defense – In some situations, an employer is not liable for harassment if it can prove an affirmative defense. An employer can prove an affirmative defense if the following is established: (1) The employer exercised reasonable care to prevent, and promptly correct, any sexual harassing behavior; and (2) The plaintiff-employee unreasonably failed to take advantage of any preventative or corrective opportunities provided by the employer or to otherwise avoid harm.

Classification of a Harasser – Determining the liability of an employer for a harassing conduct of an employee involves different liability rules depending on whether the harassing employee is a coworker or supervisor. If an employee who harasses another employee is a coworker, then the employer is liable if it was negligent in controlling the working situation. In this situation, an employer may not invoke an affirmative defense. If a supervisor harasses an employee by causing a tangible employment action, such as the victim being terminated, demoted, or denied employment benefits, then the employer is strictly liable for the harassing supervisor’s conduct. If a supervisor harasses an employee but no tangible employment action is taken, the employer is vicariously liable unless it can prove an affirmative defense.

Racial and National Origin Harassment – It is unlawful to harass a person because of his or her race, color, or national origin if it is so severe that it creates a hostile work environment.

Harassment based on race or color is referred to as racial harassment. Harassment based on national origin is referred to as national origin harassment.

Critical Legal Thinking: Sexual Harassment Sometimes supervisors and coworkers engage in conduct that is offensive because it is sexually charged. Such conduct is referred to as gender harassment or sexual harassment. The victim and 220 .

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the harasser can be either a man or a woman, but females make up the majority of sexual harassment victims. In determining whether sexual harassment has occurred to a female, the EEOC and courts apply a reasonable woman standard which allows cases to be analyzed from the perspective of the complainant and not of the defendant. The victim of sexual harassment and the harasser can be of the same sex. Thus, same-gender harassment, also called same-sex harassment, violates Title VII. Federal Court Case Case 19.2 Sexual Harassment: Waldo v. Consumers Energy Company Facts: Teresa Waldo was a female electrical line worker employed by Consumers Energy Company of Michigan (Consumers). She was routinely subjected to sexual harassment by her male coworkers, and she reported the harassment to her supervisor and to the human resources department of the company. The company did not investigate or curb the harassment. Waldo sued Consumers in U.S. district court for sexual harassment in violation of Title VII of the Civil Rights Act of 1964, and the jury returned a verdict in her favor. Consumers appealed.

Issue: Is Consumers liable for sexual harassment?

Decision: The U.S. court of appeals affirmed the U.S. district court’s finding of sexual harassment and the award of damages, attorney’s fees, and costs.

Reason: The district court did not abuse its discretion in finding that the clear weight of the evidence demonstrated that Waldo’s working environment at Consumers was filled with discrimination sufficient to create a hostile work environment. Also, it was not an abuse of discretion for the district court to find that Consumers’ response to the complaints of harassment was inadequate.

Ethics Questions: Clearly, Waldo’s male coworkers did not act ethically in this case. Consumers should have responded promptly when it received Waldo’s complaint, investigating the allegations of sexual harassment, and taking action to eliminate the abusive behavior of her coworkers.

Other Types of Harassment – Harassment based on age (40 and older), pregnancy, disability, sexual preference, and genetic information also violate Title VII. Information Technology: Offensive Electronic Communications Constitute Sexual and Racial Harassment Electronic communications (emailing, texting, etc.) have increased the exposure of employees to sexual and racial harassment and therefore employers to lawsuits. In order to address this risk, employers must adopt policies pertaining to the use of electronic communications and make their employees aware that certain electronic messages constitute harassment and violate the law.

Employers should make periodic inspections and audits of stored electronic communications to ensure that employees are complying with company anti-harassment policies.

Religious Discrimination – Although religious discrimination is prohibited under Title VII, the right of an employee to practice his religion is not absolute. An employer must make a reasonable accommodation for a religious observance, practice, or belief unless such an accommodation would represent an undue hardship for the employer.

U.S. Supreme Court Case Case 19.3 Religious Accommodation: Equal Employment Opportunity Commission v.

Abercrombie & Fitch Stores, Inc. Facts: Abercrombie & Fitch operates clothing stores. The company imposes a Look Policy that governs its employees’ dress. The Look Policy prohibits caps from being worn in the workplace, declaring them as too informal for Abercrombie’s desired image. Samantha Elauf is a practicing 221 .

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Muslim who, consistent with her religion, wears a headscarf. Abercrombie’s district manager stated that Elauf’s headscarf would violate the Look Policy and refused to hire her. The Equal Employment Opportunity Commission (EEOC) sued Abercrombie on Elauf’s behalf, claiming that its refusal to hire her violated Title VII. The U.S. district court granted the EEOC summary judgment and awarded $20,000 in damages. The U.S. court of appeals reversed and awarded Abercrombie summary judgment. The EEOC appealed to the U.S. Supreme Court.

Issue: Does Title VII apply only when an applicant has informed an employer of her need for an accommodation?

Decision: The U.S. Supreme Court held that Title VII applies even when an applicant has not informed the employer of the need for an accommodation. The Supreme Court reversed the U.S. court of appeals’ grant of summary judgment to Abercrombie and remanded the case for further proceedings.

Reasoning: Title VII requires otherwise-neutral policies to give way to the need for an accommodation.

Ethics Questions: This case emphasizes the mandate of Title VII as it relates to employee religious practices. Title VII requires an employer to make a reasonable accommodation of an employee’s religious observances, practices, or beliefs unless such an accommodation would represent an undue hardship for the employer.

Defenses to a Title VII Action – Employers can refute claims of discrimination by proving that they selected or promoted employees based on merit or seniority.

Bona Fide Occupational Qualification – A bona fide occupational qualification (BFOQ) is a true job qualification. Employment discrimination based on a protected class other than race or color is lawful if it is job-related and a business necessity.

Equal Pay Act –The Equal Pay Act protects both sexes from pay discrimination based on sex, covering all private, state, and local employees, but not federal employees. Pay disparity is not allowed if the jobs require equal skill, effort, responsibility, and similar working conditions.

Criteria That Justify a Differential in Wages – It is allowed in payment systems based on seniority, merit, quantity or quality of product, and shift differentials. The employer bears the burden of proving these defenses.

Age Discrimination – The Age Discrimination in Employment Act (ADEA) prohibits age discrimination against employees who are age 40 or older. The ADEA prohibits age discrimination in all employment decision, including hiring, promotions, payment of compensation, and other terms and conditions of employment. The Older Workers Benefit Protection Act (OWBPA) extends this protection to employee benefits.

The ADEA is administered by the EEOC. Private plaintiffs can also sure under the ADEA. A successful plaintiff in an ADEA action can recover back wages, attorney’s fees, and equitable relief, including hiring, reinstatement, and promotion.

Discrimination Against Individuals with Disabilities – The Americans with Disabilities Act (ADA), which was signed into law on July 26, 1990, is the most comprehensive piece of civil rights legislation since the Civil Rights Act of 1964.

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and corporations wholly owned by the United States are exempt from Title I coverage. Title I of the ADA is administered by the EEOC. In 2008, Congress passed the Americans with Disabilities Act Amendments Act (ADAAA). The primary purposes of the ADAAA were to expand the definition of disability, require that the definition of disability be broadly construed, and require common sense assessments in applying the provisions of the ADA and ADAAA. Qualified Individual with a Disability – Any person who, with or without reasonable accommodation, can perform the essential functions of a job, is considered to be a qualified individual with a disability. To be disabled, one must have an impairment that substantially limits a major life activity, have a record of the impairment, and be regarded as being impaired.

Limits on Employer Questions – Title I of the ADA restricts an employer from asking about the disability, but may query the applicant’s ability to perform job-related functions. Medical examinations may be given only after an offer has been extended, but may be a condition of starting work, provided all employees are subject to the same test.

Reasonable Accommodation – Under Title I, an employer is under an obligation to make a reasonable accommodation for a disability of an employee if such accommodation does not cause an undue hardship on the employer.

Undue Hardship – Employers are not obligated to provide accommodations that would impose an undue hardship. An undue hardship is an action that would require significant difficulty or expense. In determining what constitutes an undue hardship, the EEOC and courts consider factors such as the nature and cost of accommodation, the overall financial resources of the employer, and the employer’s type of operation.

Uncovered Conditions – Temporary or nonchronic impairments of short duration with little or no residual effects usually are not considered disabilities.

Genetic Information Discrimination – This is discrimination based on information from which it is possible to determine a person’s propensity to be stricken by diseases.

Genetic Information Nondiscrimination Act – The Genetic Information Nondiscrimination Act (GINA) is a federal statute that makes it illegal for an employer to discriminate against job applicants and employees based on genetic information.

Protection from Retaliation – Federal antidiscrimination laws prohibit employers from engaging in retaliation against an employee for filing a charge of discrimination or participating in a discrimination proceeding.

Veterans and Military Personnel – The Uniformed Services Employment and Reemployment Rights Act (USERRA) of 1994, as amended by the Veteran’s Benefits Act of 2010, protects and grants employment benefits to persons who serve or have served in the U.S. military services, or who is or has been a member of the Reserves or National Guard. The USERRA (1) prohibits employers from engaging in employment and wage discrimination against persons because of their past military service or their current or future military obligations, (2) requires employers to rehire returning service members who had previously been its employees at a job—with comparable status, pay, benefits, and seniority—that the person would have attained had they not been absent for military service, and (3) requires employers to rehire persons with serviceconnected disabilities if the disability can be reasonably accommodated.

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Affirmative Action – Affirmative action is a policy that provides that certain job preferences will be given to minority or other protected-class applicants when an employer makes an employment decision. The U.S. Supreme Court upheld the use of affirmative action to make up for egregious past discrimination, particularly based on race.

Affirmative Action Plan – An affirmative action plan provides that certain job preferences will be given to members of minority racial and ethnic groups, females, and other protected-class applicants when making employment decisions. To be lawful, an affirmative action plan must be narrowly tailored to achieve some compelling interest. Employment quotas based on a specified number or percentage of minority applicants or employees are unlawful. If a person’s minority status is only one factor of many factors considered in an employment decision, that decision will usually be considered lawful.

Reverse Discrimination – The courts have held that if an affirmative action plan is based on preestablished numbers or percentage quotas for hiring or promoting minority applicants, then it causes illegal reverse discrimination.

V. Key Terms and Concepts  Affirmative action—Policy that provides that certain job preferences will be given to minority or other protected class applicants when an employer makes an employment decision.  Affirmative action plan—Employers often adopt an affirmative action plan, which provides that certain job preferences will be given to members of minority racial and ethnic groups, females, and other protected-class applicants when making employment decisions.  Affirmative defense—An employer may raise an affirmative defense against liability by proving that the employer exercised reasonable care to prevent, and promptly correct, any sexual harassing behavior, and that the plaintiff-employee unreasonably failed to take advantage of any preventive or corrective opportunities provided by the employer or to otherwise avoid harm.  Age discrimination—Employment discrimination based on age. Federal law protects employees who are 40 and older from job discrimination based on their age.  Age Discrimination in Employment Act (ADEA)—A federal statute that prohibits age discrimination practices against employees who are 40 years and older.  Americans with Disabilities Act (ADA)—Imposes obligations on employers and providers of public transportation, telecommunications, and public accommodations to accommodate individuals with disabilities.  Americans with Disabilities Act Amendments Act (ADAAA) of 2008—A federal act that amends the ADA by expanding the definition of disability, requiring that the definition of disability be broadly construed, and requiring common sense assessments in applying certain provisions of the ADA.  Bona fide occupation qualification (BFOQ)—Employment discrimination based on a protected class (other than race or color) is lawful if it is job related and a business necessity.

This exception is narrowly interpreted by the courts.  Civil Rights Act of 1866—This law was enacted to give African Americans, just freed from slavery, the same right to contract as whites.  Civil Rights Act of 1964—A federal statute that prohibits discrimination based on race, color, national origin, gender, and religion in public accommodations, by state and municipal government public facilities, by government agencies that receive federal funds, and in employment.

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Color discrimination—Employment discrimination against a person because of his or her color, for example, where a light-skinned person of a race discriminates against dark-skinned person of the same race.

Coworker—An individual who works with another.

Discrimination—The EEOC has jurisdiction to investigate charges of discrimination based on race, color, national origin, gender, religion, age, disability, and genetic information.

Disparate-impact discrimination—Occurs when an employer discriminates against an entire protected class. An example would be where a facially neutral employment practice or rule causes an adverse impact on a protected class.

Disparate-treatment discrimination—Occurs when an employer discriminates against a specific individual because of his or her race, color, national origin, sex, or religion.

Employment discrimination—Any employment act in violation of federal and/or state nondiscrimination laws. For example, refusing to hire someone on the basis of that person’s gender.

Equal Employment Opportunity Commission (EEOC)—The federal administrative agency responsible for enforcing most federal antidiscrimination laws.

Equal opportunity in employment—The right of all employees and job applicants (1) to be treated without discrimination, and (2) to be able to sue employers if they are discriminated against.

Equal Pay Act—Protects both sexes from pay discrimination based on sex extends to jobs that require equal skill, equal effort, equal responsibility, and similar working conditions.

Fair Employment Practices Agency (FEPA)—If a state has a Fair Employment Practices Agency (FEPA), the complainant may file his or her claim with the FEPA instead of the EEOC. Gender discrimination (sex discrimination)—Discrimination against a person because of his or her gender.

Gender harassment (sexual harassment)—Sometimes supervisors and/or coworkers engage in conduct that is offensive because it is sexually charged. Such conduct is referred to as gender harassment or sexual harassment.

Gender identity—Refers to an individual’s personal experience of one’s own gender, which could correlate with an assigned sex at birth or can differ from it.

Gender identity discrimination—Discrimination against an individual because that person is transgender. This is sex discrimination that violates Title VII of the Civil Rights Act of 1964.

Genetic information discrimination—Discrimination based on information from which it is possible to determine a person’s propensity to be stricken by diseases.

Genetic Information Nondiscrimination Act (GINA)—A federal statute that makes it illegal for an employer to discriminate against job applicants and employees based on genetic information.

Harassment—Sometimes supervisors and coworkers engage in conduct that is offensive because it is sexually, racially, ethnically, or religiously charged. Such conduct is referred to as harassment.

Hostile work environment—The U.S. Supreme Court has held that sexual harassment that creates a hostile work environment violates Title VII. LGBTQ (lesbian, gay, bisexual, transgender, and queer)—An initialism that refers to an individual’s sexual orientation or gender identity. The initialism LGBTQ+ is sometimes used to insure inclusion of all spectrums of sexuality and gender.

Lilly Ledbetter Fair Pay Act of 2009—A federal statute that permits a complainant to file an employment discrimination claim against an employer within 180 days of the most recent

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paycheck violation and to recover back pay for up to two years preceding the filing of the claim if similar violations occurred during the two-year period.

Mental or psychological disorders—Impairment also includes mental or psychological disorders, such as intellectual disability (e.g., mental retardation), organic brain syndrome, emotional or mental illness, and specific learning disabilities.

National origin discrimination—Employment discrimination against a person because of his or her heritage, cultural characteristics, or the country of the person’s ancestors.

National origin harassment—Offensive or derogatory remarks about a person’s national origin, offensive name calling, or the display of offensive symbols impinging a person’s national origin.

Older Workers Benefit Protection Act (OWBPA)—A federal statute that prohibits age discrimination regarding employee benefits.

Physiological impairments—A physiological impairment includes any physical disorder or condition, cosmetic disfigurement, or anatomical loss affecting one or more of the following body systems: neurological, musculoskeletal, special sense organs, respiratory, cardiovascular, reproductive, digestive, genitourinary, hemic and lymphatic, skin, and endocrine.

Pregnancy Discrimination Act—Amendment to Title VII that forbids employment discrimination because of “pregnancy, childbirth, or related medical conditions.”

Punitive damages—A court can award punitive damages against an employer in a case involving an employer’s malice or reckless indifference to federally protected rights.

Qualified individual with a disability—A person who (1) has a physical or mental impairment that substantially limits one or more of his or her major life activities, (2) has a record of such impairment, or (3) is regarded as having such impairment.

Quid pro quo sex discrimination—Title VII also prohibits any form of gender discrimination where sexual favors are requested in order to obtain a job or be promoted. This is called quid pro quo sex discrimination.

Race discrimination—Employment discrimination against a person because of his or her race.

Racial harassment—Racial slurs, offensive or derogatory remarks about a person’s race, offensive name calling, or the display of racially offensive symbols.

Reasonable accommodation for a disability—Under Title I of the ADA, an employer’s duty to reasonably accommodate an individual’s disability if doing so does not cause an undue hardship on the employer.

Reasonable accommodation for a religion—Under Title VII, an employer’s duty to reasonably accommodate the religious observances, practices, or beliefs of its employees if doing so does not cause an undue hardship on the employer.

Reasonable woman standard—In determining whether sexual harassment has occurred to a female, the Equal Employment Opportunity Commission (EEOC) and courts apply a reasonable woman standard which allows cases to be analyzed from the perspective of the complainant and not that of the defendant.

Religious discrimination—Discrimination against a person solely because of his or her religion or religious practices.

Retaliation—Acts of retaliation include dismissing, demoting, harassing, or other methods of reprisal.

Reverse discrimination—Discrimination against a group that is usually thought of as a majority.

Right to sue letter—A letter that is issued by the EEOC if it chooses not to bring an action against an employer that authorizes a complainant to sue the employer for employment discrimination.

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Same-gender harassment (same-sex harassment)—The Supreme Court held that an employee who has been harassed by members of his or her own sex can sue for sexual harassment.

Section 1981 of the Civil Rights Act of 1866—Section 1981 of this act states that all persons “have the same right . . . to make and enforce contracts . . . as is enjoyed by white persons.”

Sex discrimination (gender discrimination)—Discrimination against a person because of his or her gender.

Sex-plus discrimination—In this form of discrimination, an employer does not discriminate against a class as a whole but treats a subset of the class differently.

Sexual harassment (gender harassment)—Lewd remarks, touching, intimidation, posting pinups, and other verbal or physical conduct of a sexual nature that occur on the job.

Sexual orientation—Also referred to as sexual identity, this refers to an individual’s romantic or sexual attraction to persons of the opposite sex or gender, the same sex or gender, both sexes or more than one gender, or lack of sexual attraction to others.

Sexual orientation discrimination—Employment discrimination based on a person’s sexual orientation.

Supervisor—One who is superior to a worker in the organizational hierarchy.

Title I of the Americans with Disabilities Act (ADA)—A title of a federal statute that prohibits employment discrimination against qualified individuals with disabilities in regard to job application procedures, hiring, compensation, training, promotion, and termination.

Title II of the Genetic Information Nondiscrimination Act (GINA)—Title II of GINA makes it illegal for an employer to discriminate against job applicants and employees based on genetic information.

Title VII of the Civil Rights Act of 1964—A federal statute intended to eliminate job discrimination based on five protected classes: race, color, religion, sex, or national origin.

Title IX of the Education Amendments of 1972 (Patsy Mink Equal Opportunity in Education Act)—This is a federal law that prohibits gender discrimination at colleges, universities, secondary, schools, and elementary schools that receive federal government financial assistance. Title IX requires equal treatment based on sex regarding every aspect of education, including sports, financial assistance, housing, student health services, counseling, employment, etc.

Undue hardship of Title I of the Americans with Disabilities Act—Employers are not obligated to provide accommodations that would impose an undue hardship—that is, actions that would require significant difficulty or expense. In determining what constitutes an undue hardship, the Equal Employment Opportunity Commission (EEOC) and the courts consider factors such as the nature and cost of accommodation, the overall financial resources of the employer, and the employer’s type of operation.

Undue hardship of Title VII of the Civil Rights Act of 1964—Under Title VII, an employer is under a duty to reasonably accommodate the religious observances, practices, or beliefs of its employees if doing so does not cause an undue hardship on the employer.

Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA)— Protects and grants employment benefits to persons who serve or have served in the U.S. military services, or who is or has been a member of the Reserves or National Guard. The USERRA (1) prohibits employers from engaging in employment and wage discrimination against persons because of their past military service or their current or future military obligations, (2) requires employers to rehire returning service members who had previously been its employees at a job—with comparable status, pay, benefits, and seniority—that the person would have attained had they not been absent for military service, and (3) requires employers to rehire persons with service-connected disabilities if the disability can be reasonably accommodated.

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Veterans’ Benefits Act of 2010—An amendment to the Uniformed Services Employment and Reemployment Rights Act (USERRA) of 1994.

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Chapter 20 Employment Law and Worker Protection

How do we protect employment?

I. Teacher to Teacher Dialogue This chapter reviews the major legislative enactments that have been superimposed upon the employer/employee relationship. In many ways, government is a silent third party whose presence is pervasive at the bargaining table. It sets the rules not only of how the bargain is to be struck, but it also has had a much more active involvement in the ongoing employment relationship after the initial bargain is struck. This three-part marriage of employer, employee, and Uncle Sam is not always a happy one.

A phrase commonly used in the area of pension and employee benefits law is “golden ball and chain.” This description is meant to illustrate the two-sided nature of the prerequisites associated with the employment relationship. On one side, the gold comes from the financial security afforded by a steady income and the various employment-related insurance protections designed to protect one from the vicissitudes of life. The ball and chain aspect comes from the price paid for those perks. This cost not only includes the obvious time and energy commitments involved in doing one’s job, but also the lost opportunity costs associated with having chosen one employer over others. For many, the employment relationship becomes one of love-hate or at least a standoff based on economic necessity.

In the past, the dominant contractual form this relationship has taken has been found in the employment at will doctrine. This doctrine assumes that given equal bargaining power, and absent express or implied agreement to the contrary, either the employee or employer may end the relationship. This termination can come about at any time, for any reason, bilaterally or unilaterally. The doctrine has long been under fire as being myopic on two main scores: It presumes equality of bargaining power between the employer and employee and that the employment relationship is totally a private contractual matter between the contracting parties.

Recent cases and legislative enactments have greatly eroded the doctrine. On the legislative front, a number of states have decided that public policy interests in favor of certain kinds of activities must take precedent over the employer/employee relationship. Examples would include retirement fund laws, protecting jobs of employees that need to take time off for medical emergencies for themselves or their immediate family, setting minimum pay rates, and employee health and safety protections. In addition, a number of courts have seen fit to interpret employer handbooks, written and oral job policies, and other acts as indicia of an implied contract between the employer and employee. What may have appeared originally to be the employee’s economic ball and chain has also become the employer’s.

The simple truth is that there is a growing involvement of government at every step of the employer-employee relationship. It sets the ground rules for hiring, working conditions, paying for harm, termination, and ultimate payment of pensions and or death benefits. It all has come a long way from the simplistic and archaic notion that the employment contract is only the business of the immediate parties involved.

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II. Chapter Objectives 1. Define term employee and at-will employee.

2. Describe workers’ compensation programs and the benefits available.

3. Describe employers’ duty to provide safe working conditions under the Occupational Safety and Health Act. 4. Describe the minimum wage, overtime pay, and other rules of the Fair Labor Standards Act. 5. Describe the protections afforded by the Family and Medical Leave Act. 6. Describe the protections afforded by the Consolidated Omnibus Budget Reconciliation Act. 7. Describe the protections afforded by the Employee Retirement Income Security Act. 8. Describe unemployment compensation and how persons qualify for benefits.

9. Describe Social Security and how persons qualify for benefits.

III. Key Question Checklist  Define the employer-employee relationship.  What restrictions are placed on that relationship?  What government rules apply to the employer-employee relationship?  What employees are covered under FMLA?  What are the current requirements for employers under IRCA?  What are the ERISA rules affecting private pensions?

IV. Chapter Outline Introduction to Employment Law and Worker Protection – Generally, the employeremployee relationship is subject to the common law of contracts and agency law. This relationship is also highly regulated by federal and state governments that have enacted numerous laws that protect workers.

Term Employment and Employment at Will – The term of a worker’s employment depends on whether the worker has been hired as a term employee or an at-will employee.

Term Employment – Term employment occurs where an employer and employee enter a contract for a specified time. An employee who is employed under a term contract is called a term employee. An employer who terminates a term employee without cause during the stated period is liable for wrongful discharge and owes damages to the employee. Where there is an employment contract for stated terms, an employer may terminate an employee for cause without being liable for damages.

Contemporary Environment: At-Will Employment Most employees, including most managers, are at-will employees. This is because they do not have term contracts with their employer. An at-will employee can be terminated without cause at any time by the employer. The employee has no redress to recover damages from the employer.

At-will employees may also be terminated for cause, but a showing of cause is not necessary for the employer to terminate the employee.

Exceptions – The following are certain exceptions where employees, including at-will employees, cannot be legally terminated: (1) Labor union exception—This is a rule that restricts an employer’s ability to discharge an atwill employee who is a member of a labor union. Certain procedures must be followed to seek the discharge of a union represented employee;

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(2) Public policy exception—Under this exception, employees, including at-will employees, cannot be discharged by an employer if such discharge violates public policy. For example, refusing to do an act in violation of the law violates public policy; and (3) Statutory exception—This is a law that prohibits employers from refusing to hire, not promoting, or discharging at-will or term employees in violation of federal and state statutes. For example, employees cannot be discharged because of their race, national origin, color, gender, religion, age, disabilities, or being members of other protected classes as specified in federal and state antidiscrimination laws.

State Court Case Case 20.1 At-Will Employment: Dore v. Arnold Worldwide, Inc. Facts: Brook Dore applied for a management supervisor position at AWI. He was offered the job, and he accepted it. AWI sent Dore a letter that stated the terms of employment. In the letter, AWI indicated that Dore was an at-will employee. Dore read, signed, and returned the letter.

After two years of employment, AWI terminated Dore. Dore sued AWI, alleging breach of contract, breach of the implied covenant of good faith and fair dealing, intentional infliction of emotional distress, and fraud. Dore alleged that because the agreement did not state whether termination would be with or without cause, it was therefore ambiguous and the at-will clause could not be enforced. Dore also alleged that through various oral representations and conduct, there was an implied-in-fact contract between himself and AWI that he would not be discharged except for cause. The trial court held that Dore was an at-will employee who had been properly terminated by AWI. The trial court granted summary judgment to AWI. The court of appeals reversed and remanded the case for trial. Dore appealed to the Supreme Court of California.

Issue: Was Dore an at-will employee who could be terminated without cause?

Decision: The Supreme Court of California agreed with the trial court that Dore was an at-will employee who had been properly terminated by AWI. The supreme court reversed the decision of the court of appeals.

Reasoning: The language of the parties’ written agreement was unambiguous, stating that Dore’s employment with AWI was at-will.

Ethics Questions: This case should impress upon employees the importance of reading and understanding the terms of an employment agreement before signing it. In the overwhelming majority of circumstances, courts will rely upon the clear, unambiguous language of an employment contract to understand the rights and liabilities of employers and their employees, particularly when the contract complies with both federal and state law.

Workers’ Compensation – Workers’ compensation acts were enacted by the states in order to respond to the problems caused by the common law practice, which required employees to sue employers if they were injured on the job. Common law subjected the employee to a lengthy litigation process with uncertain results. Workers’ compensation acts create an administrative procedure for workers to receive workers’ compensation for injuries that occur on the job.

Workers’ Compensation Insurance – Employers are required to purchase insurance or to be self-insured in order to cover workers’ compensation claims for employees.

Employment-Related Injury – For an injury to be compensable under workers’ compensation, the claimant must prove that he or she was harmed by an employment-related injury. Thus, injuries that arise out of and in the course of employment are compensable.

Exclusive Remedy – Workers’ compensation is an exclusive remedy. Thus, workers cannot both receive workers’ compensation and sue their employers in court for damages. Workers’ compensation acts do not bar injured workers from suing responsible third parties to recover 231 .

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damages. If an employer intentionally injures a worker, the worker can collect workers’ compensation benefits and also sue the employer.

State Court Case Case 20.2 Workers’ Compensation: Wal-Mart Stores v. Henle Facts: Julie Henle was a manual laborer at Wal-Mart whose work included unloading delivery trucks, climbing ladders to stock shelves, and driving forklifts. Henle was injured when a 60pound stack of plastic totes fell 15 feet, striking her on the head and left shoulder, and knocking her to the floor. The injury caused Henle to suffer chronic headaches and dizziness. She had trouble concentrating, and was diagnosed with mood disorders. One year after the injury, a doctor performing an independent medical evaluation determined Henle suffered 40 percent impairment of the whole person. At that time, Henle was 55 years old.

In arbitration, the Worker’s Compensation Commissioner concluded that Henle was permanently and totally disabled from competitive employment. Wal-Mart appealed. The district court found the commissioner’s award of permanent and total disability was supported by the evidence. WalMart again appealed.

Issue: Was the award of permanent total disability warranted in this case?

Decision: The court of appeals upheld the finding of permanent total disability and the award of workers’ compensation benefits.

Reasoning: The court disagreed with Wal-Mart’s contention that an employee must suffer from one-hundred percent impairment to qualify for total disability. According to the court, industrial disability does not require a state of absolute helplessness; instead, the pertinent question is whether jobs exist in the community for which the injured employee can realistically compete.

The court concluded that the types of accommodations needed for Henle to work were not available in the general labor market.

Ethics Questions: The court’s reasoning in this case is persuasive: If an injury and its necessary accommodations makes it impossible for the worker to realistically compete in the general labor market, the worker is effectively permanently and totally disabled.

State Court Case Case 20.3 Workers’ Compensation: Kelley v. Coca-Cola Enterprises, Inc. Facts: Kelley, who was treated for a herniated disc and a cervical dorsal strain after a teambuilding event organized by Coca-Cola, filed a claim for workers’ compensation. Coca-Cola opposed the claim, asserting that because Kelley was involved in employee horseplay, he was not entitled to workers’ compensation benefits. The trial court returned a verdict in favor of Kelley, entitling him to participate in workers’ compensation benefits. Coca-Cola appealed.

Issue: Is Kelley entitled to workers’ compensation benefits?

Decision: The court of appeals affirmed the trial court’s judgment.

Reason: An exception to the general rule prohibiting one from participating in workers’ compensation benefits applies where the employee is injured by horseplay commonly carried on by the employees with the knowledge and consent or acquiescence of the employer.

Ethics Questions: Student answers may vary. But the opposition displayed by Coca-Cola asserting that because Kelley was involved in employee horseplay, he was not entitled to workers’ compensation benefits, does not seem too ethical. The public policy underlying workers’ compensation laws is the belief that industry should be required to address the effects of its own “wreckage,” especially employees who sustain work-related injuries.

Occupational Safety – The Occupational Safety and Health Act was enacted in 1970, establishing the Occupational Safety and Health Administration (OSHA) and imposing recordkeeping and reporting requirements on employers. OSHA is empowered to inspect places of

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employment for health hazards and safety violations. If a violation is found, OSHA can issue a written citation that requires the employer to abate or correct the situation.

Specific Duty Standards – These OSHA standards set specific safety rules for designated equipment, procedures, types of work, individual industries, unique work conditions, etc.

Federal Court Case Case 20.4 Specific Duty Standard: R. Williams Construction Company v. Occupational Safety and Health Review Commission Facts: R. Williams Construction Company (Williams) was constructing a sewer project at a building site. Two Williams employees, Jose Aguiniga and Adam Palomar, were responsible for cleaning the pumps and did so throughout each working day, as needed. On the day of the accident, Aguiniga and Palomar entered the unshored trench to clean the pumps and remained there for about fifteen minutes. As the two men were exiting the trench, the north end wall collapsed, burying Aguiniga completely and Palomar almost completely. Aguiniga died and Palomar was severely injured. The Occupational Safety and Health Administration (OSHA), conducted an investigation and cited Williams for violating the following OSHA trench safety standards:  Failing to instruct its employees in the recognition and avoidance of unsafe conditions and in the regulations applicable to their work environment, as required by 29 C.F.R. Section 1926.21(b)(2).  Failing to ensure that no worker would have to travel more than 25 feet to reach a safe point of egress, as required by 29 C.F.R. Section 1926.651(c)(2).  Failing to ensure that a “competent person” (i.e., one with specific training in soil analysis and protective systems and capable of identifying dangerous conditions) performed daily inspections of excavations for evidence of hazardous conditions, as required by 29 C.F.R. Sections 1926.651(k)(1).  Failing to ensure that the walls of the excavation were either sloped or supported, as required by 29 C.F.R. Section 1926.652(a)(1).

Issue: Has Williams violated the OSHA trench safety standards?

Decision: The U.S. Court of Appeals held that Williams had violated the OSHA trench safety standards, and upheld the citations issued against Williams and the imposition of the $22,000 penalty.

Reason: The ALJ’s findings, based upon the witnesses’ testimony regarding Williams’ lack of attention to safety standards, is supported by substantial evidence. Williams violated 29 C.F.R. Section 1926.21(b)(2) for failing to instruct each employee in the recognition and avoidance of unsafe conditions and for failing to eliminate other hazards: Williams provided no training in trenching hazards to at least the two employees working in the trench; moreover, no Williams supervisor was familiar with OSHA regulations.

Ethics Questions: Although student answers may vary, Williams arguably acted unethically in this case as it ignored important safety standards and did not properly supervise the work being done. Although it is debatable whether businesses would take substantial safety precautions without the imposition of OSHA safety standards, pre-OSHA “horror stories” would seem to indicate that companies would be tempted to take such precautions due to their expense and administrative burden without the existence of safety compliance law and the involvement of a federal regulatory authority.

General Duty Standard – The Occupational Safety and Health Act also imposes a general duty standard. The general duty standard requires an employer to provide a work environment free from recognized hazards that are causing or are likely to cause death or serious physical harm to

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employees. This requirement is a catch-all provision that applies even if no specific workplace safety regulation addresses the situation.

Federal Court Case Case 20.5 General Duty Standard: SeaWorld of Florida, LLC v. Perez, Secretary, United States Department of Labor Facts: SeaWorld operates a theme park designed to entertain and educate paying customers by displaying and studying marine animals. Dawn Brancheau, a veteran trainer at SeaWorld, was interacting with Tilikum, a killer whale, when the whale grabbed her and refused to release her.

Brancheau suffered traumatic injuries and drowned. Brancheau’s death was the third fatality associated with Tilikum during a 30-year period.

There are no specific duty standards regulating how trainers work with killer whales. The Secretary of Labor issued citations to SeaWorld for violating the general duty clause by exposing animal trainers to the recognized hazard of injury or drowning when working with killer whales during performances and training. The Secretary determined that SeaWorld had violated the general duty standard, held that trainers should not be allowed any contact with killer whales unless they are protected by physical barriers or decking systems, and imposed a $12,000 fine.

SeaWorld petitioned for review.

Issue: Did SeaWorld violate the general duty clause?

Decision: The U.S. court of appeals denied SeaWorld’s petition for review.

Reasoning: According to the U.S. court of appeals, the remedy imposed for SeaWorld’s violations does not change the essential nature of its business. There will still be human interactions and performances with killer whales; the remedy will simply require that they continue with increased safety measures. With distance and physical barriers between Tilikum and trainers, Tilikum can still perform almost the same behaviors performed when no barriers were present.

Ethics Questions: The general duty standard is an Occupational Safety and Health Act (OSHA) standard that requires an employer to provide a work environment free from recognized hazards that are causing or are likely to cause death or serious physical harm to employees. Inherent in the term “killer whale” is the distinct possibility that such an animal can cause death or serious physical injury. When also taking into consideration Tilikum’s history (Brancheau’s death was the third fatality associated with Tilikum during a 30-year period), the Secretary of Labor’s conclusion that SeaWorld violated the general duty standard is supported by the evidence.

Fair Labor Standards Act – In 1938, Congress enacted the Fair Labor Standards Act (FLSA) to protect workers. The FLSA prohibits child labor and spells out minimum wage and overtime pay requirements. The U.S. Department of Labor is empowered to enforce the FLSA, and private civil actions are also permitted to enforce is provisions.

Child Labor – The FLSA regulates child labor by restricting the types of occupations and jobs that children under the age of 18 may engage in. The FLSA forbids the use of oppressive child labor and makes it unlawful to ship goods produced by businesses that use oppressive child labor.

The Secretary of Labor may conduct workplace inspections and investigations to determine whether oppressive child labor is employed.

Minimum Wage – The FLSA establishes minimum wage and overtime pay requirements for hourly employees. The federal minimum wage is set by Congress and can be changed. As of 2018, the federal minimum wage was set at $7.25 per hour. An employee who earns tips can be paid $2.13 per hour by an employer if that amount plus the tips received equals at least the minimum wage. If an employee’s tips and direct employer payment does not equal the minimum wage, the employer must make up the difference.

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More than half of the states have enacted minimum wage laws that set minimum wages at a rate higher than the federal rate.

Living Wage – Some cities have enacted minimum wage requirements, usually called living wage laws, which establish minimum wage rates that are higher than the federal or state levels.

Examples of cities with living wage laws are San Francisco, Chicago, New York City, Seattle, Los Angeles, and Minneapolis.

Overtime Pay – Under the Fair Labor Standards Act (FLSA), an employer cannot require nonexempt employees to work more than 40 hours per week unless they are paid overtime pay of one and a half times their regular pay for each hour worked more than 40 hours that week. Each week is treated separately.

Critical Legal Thinking: Payment of Overtime Pay to Workers IBP, Inc. produces fresh beef, pork, and related meat products. At its plant in Pasco, Washington, it employed approximately 178 workers in its slaughter division and 800 line workers. All workers must wear gear such as outer garments, hardhats, earplugs, gloves, aprons, leggings, and boots. IBP requires employees to store their equipment and tools in company locker rooms, where the workers don and doff their equipment and protective gear.

The pay of production workers is based on time spent cutting and bagging meat. Pay begins with the first piece of meat and ends with the last piece of meat. IBP employees filed a class action lawsuit against IBP to recover compensation for the time spent walking between the locker room and the production floor before and after their assigned shifts. The employees alleged that IBP was in violation of the Fair Labor Standards Act (FLSA).

The U.S. Supreme Court held that the time spent by employees walking between the locker room and the production areas of the plant was compensable under the Fair Labor Standards Act. IBP, Inc. v. Alvarez, 546 U.S. 21, 126 S.Ct. 514, 2005 U.S. Lexis 8373 (Supreme Court of the United States, 2005) Exemptions from Minimum Wage and Overtime Pay Requirements – Not all employees qualify to be paid overtime pay benefits. The Fair Labor Standards Act (FLSA) exempts the following categories of employers from federal overtime pay requirements as long as they receive above a certain amount of compensation: (1) Highly compensated employees; (2) Executive employees; (3) Administrative employees; (4) Learned professionals; (5) Creative professionals; (6) Computer employees; (7) Teachers; and (8) Outside sales representatives Family and Medical Leave Act – This act guarantees workers unpaid time off from work for family and medical emergencies and other specified situations. The act, which applies to companies with 50 or more workers as well as federal, state, and local governments, covers about half of the nation’s workforce. To be covered by the act, an employee must have worked for the employer for at least one year and must have performed more than 1,250 hours of service during the previous twelve-month period.

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offered the opportunity to continue his group health insurance at the group rate plus administration fees.

Employee Retirement Income Security Act – If employers offer pension plans, the Employee Retirement Income Security Act (ERISA) establishes the record-keeping, disclosure, and other requirements that will apply to them. It also establishes how and when an employee will become vested in the plan.

Unemployment Compensation – Employers are required to pay unemployment contributions to assist employees that are temporarily unemployed under the Federal Unemployment Tax Act (FUTA) and various state laws. State governments administer unemployment compensation programs under general guidelines set by the federal government.

Social Security – The Social Security system provides limited retirement and death benefits to certain employees and their beneficiaries. The Federal Insurance Contributions Act (FICA) requires that both employers and employees make contributions into the Social Security fund, just as the Self-Employment Contributions Act requires that self-employed individuals make similar contributions.

V. Key Terms and Concepts  Administrative employee exemption—The administrative employee exemption applies to employees who are compensated on a salary or fee basis, whose primary duty is the performance of office or nonmanual work, and whose work includes the exercise of discretion and independent judgment with respect to matters of significance.  At-will employee—An at-will employee can be terminated without cause at any time by the employer. The employee has no redress to recover damages from the employer. At-will employees may also be terminated for cause, but a showing of cause is not necessary for the employer to terminate the employee. Most employees are at-will employees.  Child labor—The Fair Labor Standards Act (FLSA) forbids the use of oppressive child labor and makes it unlawful to ship goods produced by businesses that use oppressive child labor.  Computer employee exemption—The computer employee exemption applies to employees who are compensated either on a salary or fee basis; who are employed as computer systems analysts, computer programmers, software engineers, or other similarly skilled workers in the computer field; and who are engaged in the design, development, documentation, analysis, creation, testing, or modification of computer systems or programs.  Consolidated Omnibus Budget Reconciliation Act (COBRA)—Federal law that permits employees and their beneficiaries to continue their group health insurance after an employee’s employment has ended.  Creative professional employee exemption—The Fair Labor Standards Act (FLSA) has established certain exemptions from overtime pay benefits. The creative professional employee exemption applies to employees compensated on a salary or fee basis who perform work that requires invention, imagination, originality, or talent to a recognized field of artistic or creative endeavor.  Employee Retirement Income Security Act (ERISA)—A federal act designed to prevent fraud and other abuses associated with private pension funds.  Employment-related injury—An injury to an employee that arises out of and in the course of employment.  Exclusive remedy—Workers cannot both receive workers’ compensation and sue their employers in court for damages.

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Executive employee exemption—The executive exemption applies to executives who are compensated on a salary basis, who engage in management, who have authority to hire employees, and who regularly direct two or more employees.

Exemptions from overtime pay requirements—The Fair Labor Standards Act (FLSA) establishes categories of employees who are exempt from federal overtime pay requirements if they perform certain job duties and receive above a certain amount of compensation for their work.

Fair Labor Standards Act (FLSA)—A federal act enacted in 1938 to protect workers. It prohibits child labor and spells out minimum wage and overtime pay requirements.

Family and Medical Leave Act (FMLA)—A federal act that guarantees workers up to twelve weeks of unpaid leave in a twelve-month period to attend to family and medical emergencies and other specified situations.

Federal Insurance Contributions Act (FICA)—A federal act that says employees and employers must make contributions into the Social Security fund.

Federal Unemployment Tax Act (FUTA)—A federal act that requires employers to pay unemployment taxes; unemployment compensation is paid to workers who are temporarily unemployed.

General duty standard—A duty that an employer has to provide a work environment “free from recognized hazards that are causing or are likely to cause death or serious physical harm to his employees.”

Highly compensated employee exemption—The highly compensated employee exemption applies to employees who are compensated on a salary basis, perform office or nonmanual work, and regularly perform at least one of the duties of an exempt executive, administrative, or professional employee.

Labor union exception—There are certain exceptions where employees, including at-will employees, cannot be legally terminated. The labor union exception is a rule that restricts an employer’s ability to discharge an at-will employee who is a member of a labor union.

Certain procedures must be followed to seek the discharge of a union represented employee.

Learned professional employee exemption—The learned professional exemption applies to employees compensated on a salary or fee basis that perform work that is predominantly intellectual in character, who possess advanced knowledge in a field of science or learning, and whose advanced knowledge was acquired through a prolonged course of specialized intellectual instruction.

Living wage laws—Some cities have enacted minimum wage requirements, usually called living wage laws, which establish higher minimum wage rates than the federal level.

Minimum wage—The federal minimum wage is set by Congress and can be changed. As of 2018, the federal minimum wage was set at $7.25 per hour.

Occupational Safety and Health Act—A federal act enacted in 1970 that promotes safety in the workplace.

Occupational Safety and Health Administration (OSHA)—A federal administrative agency that is empowered to enforce the Occupational Safety and Health Act. Outside sales representative exemption—The outside sales representative exemption applies to employees who will be paid by the client or customer, whose primary duty is making sales or obtaining orders or contracts for services, and who are customarily and regularly engaged away from the employer’s place of business.

Overtime pay—Under the Fair Labor Standards Act (FLSA), an employer cannot require nonexempt employees to work more than 40 hours per week unless they are paid overtime pay of one-and-a-half times their regular pay for each hour worked in excess of 40 hours that week.

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Public policy exception—There are certain exceptions where employees, including at-will employees, cannot be legally terminated. The public policy exception is a law stating that employees cannot be discharged by an employer if such discharge violates public policy.

Discharging an employee for refusing to do an act in violation of the law violates public policy.

Self-Employment Contributions Act—A federal act that says self-employed persons must pay Social Security taxes equal to the combined employer-employee amount.

Social Security—Federal system that provides limited retirement and death benefits to covered employees and their dependents.

Social Security Administration—The Social Security system is administered by the Social Security Administration.

Specific duty standards—An OSHA standard that addresses a safety problem of a specific duty nature (e.g., requirement for a safety guard on a particular type of equipment).

Statutory exception—There are certain exceptions where employees, including at-will employees, cannot be legally terminated. The statutory exception is a law that prohibits employers from refusing to hire, not promoting, or discharging at-will or term employees in violation of federal and state statutes. For example, employees cannot be discharged because of their race, national origin, color, gender, religion, age, disabilities, or being members of other protected classes as specified in federal and state antidiscrimination laws.

Teacher professional employee exemption—The Fair Labor Standards Act (FLSA) establishes categories of employees who are exempt from federal overtime pay requirements if they perform certain job duties and receive above a certain amount of compensation for their work. The teacher professional employee exemption applies to employees who have a primary duty of teaching, tutoring, instructing, or lecturing in an activity of imparting knowledge, and who do so in an educational establishment.

Term employee—A term employee has an employment contract with an employer for a stated time.

Unemployment compensation—Compensation that is paid to workers who are temporarily unemployed.

U.S. Department of Labor—The U.S. Department of Labor is empowered to enforce the Fair Labor Standards Act (FLSA).

Vesting—Vesting occurs when an employee has a nonforfeitable right to receive pension benefits.

Workers’ compensation—Compensation paid to workers and their families when workers are injured in connection with their jobs.

Workers’ compensation acts—Acts that compensate workers and their families if workers are injured in connection with their jobs.

Workers’ compensation board (workers’ compensation commission)—Under worker’s compensation, an injured worker files a claim with the appropriate state government agency (often called the workers’ compensation board or workers’ compensation commission). The workers’ compensation board determines the legitimacy of the claim. If the worker disagrees with the agency’s findings, he or she may appeal the decision through the state court system.

Worker’s compensation insurance—Insurance that employers obtain and pay for from private insurance companies or from government-sponsored programs.

Wrongful discharge—An employer who terminates a term employee without cause during the stated period is liable for wrongful discharge and owes damages to the employee.

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Chapter 21 Labor Law and Immigration Law Why are Unions Necessary?

I. Teacher to Teacher Dialogue This chapter is designed to introduce the student to our nation’s sometimes-controversial history with regard to the development of public policies towards organized labor. Organized labor has suffered from a long and steady decline in membership, power, and influence over the past forty years. In spite of this, consider the working conditions that existed before unions. It is a hallmark of advanced industrialized economies that the work force is highly organized and has a strong bargaining power over its affairs. The immediate post-Civil War era of industrialization saw the possibilities for abuse of the work force not only become reality, but also a tragedy, when it came to workers’ safety. Most modern social legislation, however, ranging from the minimum wage, to child labor laws, to workplace and antidiscrimination statutes are traceable to hard fought collective bargaining agreements aimed at solving the problems.

The basic employer/employee relationship is a contractual one. As with any contract, both parties are expected to enter into the relationship with their own best interests at heart. Each side of the labor/management relationship still looks out for itself. But in looking out for “number one,” both must appreciate their mutual interdependence on each other. Labor must realize that it cannot sustain its own survival on the backs of failed companies brought down by union-imposed inefficiencies. Labor must adjust to the situation and make concessions to both the technological and economic realities of trying to compete in a global economy. Management, in turn, must do the same. This chapter describes how the law can help in this process.

II. Chapter Objectives 1. List and describe federal labor law statutes.

2. Describe how a union is organized.

3. Describe the process of collective bargaining.

4. Describe employees’ right to strike and when strikes are illegal.

5. Describe employees’ right to picket and when picketing is illegal.

6. Explain how labor’s bill of rights affects internal union affairs.

7. Describe immigration laws and foreign worker visas.

III. Key Question Checklist  How is a union organized?  What are the consequences of an employer’s illegal interference with a union election?  How does the process of collective bargaining work?  What is the right to strike?  What is the right to picket?  What is labor’s bill of rights?  What are the main features of immigration law?

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IV. Chapter Outline Introduction to Labor Law and Immigration Law – Prior to the Industrial Revolution, employees and employers had somewhat equal bargaining power. Beginning in the 1930s, federal legislation was enacted that gave employees the right to form and join labor unions. Through collective bargaining with employers, labor unions obtained better working conditions, higher wages, and greater benefits for their members. Labor unions have the right to strike and to engage in picketing in support of their positions. Today, many high technology and other businesses rely on employees who are foreign nationals. U.S. immigration laws provide that visas may be issued by the federal government for a specified number of foreign nationals to work in the United States.

Labor Law – Today, about 11 percent of American workers in both the private and public sectors are represented by unions. One of the largest international unions is the AFL-CIO, formed from the 1955 merger of the American Federation of Labor and the Congress of Industrial Organizations.

Landmark Law: Federal Labor Law Statutes Prior to the Great Depression, labor laws were typically pro-management, but later swung towards the union before settling somewhere near middle, like a pendulum. For example, the Sherman Antitrust laws were used to break up fledgling unions in early years. A number of statutes have been enacted giving workers protection and the right to collectively bargain. These laws included the Norris-LaGuardia Act (1932), which made it legal for workers to organize, and the National Labor Relations Act of 1935, which established the right of workers to organize and bargain collectively. Power again swung when the U.S. Congress enacted the Taft-Hartley Act (Labor-Management Relations Act) in 1947, which expanded the activities that unions could employ, while protecting employers’ rights to engage in free speech during union elections. Even more important, it gave the president the right to intercede and seek an injunction if a strike would threaten national security. In 1959, due to corruption and graft that seemed to overwhelm some unions, Congress enacted the Labor-Management Reporting and Disclosure Act (LandrumGriffin Act), known as the union “Bill of Rights.” This established the rights of union members and required significant reporting of union affairs to the federal government, requiring them to file a copy of their books each year. The Railway Labor Act of 1926, amended in 1934, covers employees of railroad and airline carriers.

National Labor Relations Board – This administrative body oversees union elections and prevents both unions and employers from engaging in unfair labor practices.

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Organizing a Union – Section 7 of the NLRA gives employees the right to join together as an appropriate bargaining unit and form a union. Managers and professional employees may not join unions formed by the employees whom they supervise. Once a bargaining unit is defined, the union may petition the NLRB to hold an election.

Types of Union Elections – If 30 percent of the employees comprising a bargaining unit are interested in joining a union, the union can petition the NLRB to set an election date. An election contested by the employer must be supervised by the NLRB. A simple majority vote at the election will win the election. If management does not contest the union, a consent vote may be held without NLRB oversight. Finally, if employees no longer wish to be represented by the union, a decertification election will be supervised by the NLRB. Union Solicitation on Company Property – Employers may restrict union activities on the organization’s property to employees’ free time and to nonworking areas, even barring off-duty employees and nonemployees. Violation of these rules is grounds for termination. The only exception to this is if the inaccessibility exception applies, where the location of the business and living space of the employees place them beyond the reach of reasonable union effort.

Ethics: Illegal Interference with an Election Section 8(a) of the National Labor Relations Act (NLRA) makes it an unfair labor practice for an employer to interfere with, coerce, or restrain employees from exercising their statutory right to form and join unions. Threats of loss of benefits for joining the union, statements such as “I’ll close this plant if a union comes in here,” and the like are unfair labor practices.

Section 8(b) of the NLRA prohibits unions from engaging in unfair labor practices that interfere with a union election. Coercion, physical threats, etc. are unfair labor practices.

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Federal Court Case Case 21.1 Unfair Labor Practice: National Labor Relations Board v. Starbucks Corporation Facts: The Industrial Workers of the World (IWW) attempted to unionize four Starbucks coffee shops in Manhattan. In response, Starbucks mounted an anti-union campaign. Starbucks instituted a dress code rule that employees could wear only one pro-union button of a reasonable size to work. The National Labor Relations Board issued an order that Starbucks’s anti-union efforts constituted an unfair labor practice in violation of Section 8(a) of the National Labor Relations Act. The Board filed a petition for enforcement of its order. Starbucks accepted the Board’s determination, except for alleging on appeal that its one-button dress policy was not an unfair labor practice.

Issue: Is Starbucks’s one-button policy an unfair labor practice?

Decision: The U.S. court of appeals concluded that Starbucks’s enforcement of its one-button dress code is not an unfair labor practice.

Reason: The company adequately maintains the opportunity to display pro-union sentiment by permitting one, but only one, union button on workplace clothing.

Ethics Questions: Starbucks fought the unionization of its employees for the reason any employer would engage in anti-union activities—concern that unionization of its employees would increase its labor costs. It is debatable whether Starbucks acted unethically in this case; the formulation of an opinion regarding this issue most likely depends on an individual’s view of unions and unionization of the labor force.

Collective Bargaining – Collective bargaining occurs when employees elect a group to negotiate labor contracts on their behalf. Wages, hours, and employee benefits like health plans, retirement plans, and fringe benefits are compulsory subjects that must be included in the negotiations. The size and composition of the supervisory force, location of plants, and corporate reorganization may be included as permissive subjects. Topics like closed shops and discrimination are illegal subjects, and cannot be included.

Union Security Agreements – The two types of security agreements are the union shop, which requires an employee to join a union within a certain time period from their hire date, and an agency shop, where employees pay an agency fee to the union to cover the expenses of collective bargaining, but do not have to join the union. Under a closed shop agreement, an employer agrees to hire only employees who are already members of a union. The employer cannot hire employees who are not members of a union. A closed shop agreement is illegal in the United States.

Critical Legal Thinking: State Right-to-Work Laws Consistent with the Taft-Hartley Act, states can enact right-to-work laws that outlaw union and agency shops. If a state enacts a right-to-work law, individual employees cannot be forced to join a union or pay union dues and fees, even though a labor union has been elected by other employees. Many state governments and businesses support right-to work laws to attract new businesses to a nonunion environment. Unions vehemently oppose the enactment of right-to-work laws because they substantially erode union power.

The following states have enacted right to work laws: Alabama, Arizona, Arkansas, Florida, Georgia, Idaho, Indiana, Iowa, Kansas, Kentucky, Louisiana, Michigan, Mississippi, Missouri, Nebraska, Nevada, North Carolina, North Dakota, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, West Virginia, Wisconsin, and Wyoming.

Strikes – The National Labor Relations Act (NLRA) gives union management the right to recommend that a union call a strike if a collective bargaining agreement cannot be reached. In a

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strike, union members refuse to work. Strikes are permitted by federal labor law. Before there can be a strike, a majority of the union’s members must vote in favor of the action.

Cooling-Off Period – Before a strike, a union must give 60-day notice to the employer that the union intends to strike. It is illegal for a strike to begin during the mandatory 60-day cooling-off period. The 60-day period is designed to give the employer and the union enough time to negotiate a settlement of the union grievances and avoid a strike.

No-Strike Clause – It is illegal for a strike to take place in violation of a negotiated no-strike clause, and an employer may dismiss union members who strike in violation of a no-strike clause.

Business Environment: Illegal Strikes Illegal strikes include violent strikes, sit-down strikes because the strikers continue to occupy the employer’s premises, partial or intermittent strikes because they interfere with an employer’s right to operate at full power, and wildcat strikes because they are unauthorized by the union.

Crossover and Replacement Workers – Union members that choose not to strike or return to work after striking for a time are crossover workers. Replacement workers are those hired by management to replace striking workers. Permanent hire replacement workers cannot be dismissed if the strike is settled.

Employer Lockout – If an employer reasonably anticipates a strike by some of its employees, it may prevent those employees from entering the plant or premises. This is called an employer lockout.

Picketing – This is the action of strikers walking in front of an employer’s premises, carrying signs announcing their strike. Picketing in support of a strike is legal unless it is accompanied by violence, or if it obstructs customers, deliveries and pickups, or non-striking employees from entering or leaving the employer’s place of business.

Federal Court Case Case 21.2 Union Picketing: Ahern, National Labor Relations Board v. International Longshore and Warehouse Union Facts: In this case, the union’s picketing and trespassing resulted in the destruction of EGT’s property and the harassment of its employees and contractors. EGT filed charges with the National Labor Relations Board (NLRB). The NLRB petitioned the U.S. district court, which issued a temporary restraining order and then an injunction prohibiting the union from engaging in picket line violence, threats and property damage, mass picketing and blocking of ingress and egress at the EGT facility, and from restraining or coercing employees of EGT or any other person doing business in relation to the EGT facility. The district court found the union in contempt and ordered the union to pay damages to EGT and the NLRB. The union appealed.

Issue: Did the union engage in unfair labor practices?

Decision: The U.S. court of appeals upheld the district court’s injunctions and award of damages.

Reasoning: Civil contempt proceedings serve two purposes: (1) coercing compliance with a court order, and (2) compensating the prevailing party. EGT therefore is entitled to compensation for its actual damages. The district court’s awards sought to coerce the union and its members to comply with the court’s injunctions and to compensate injured parties for actual losses caused by the union’s and its members’ contumacious conduct.

Ethics Questions: The interests of justice dictate that a defendant: (1) comply with a court order; and (2) compensate the plaintiff for damages the plaintiff has demonstrably sustained due to the

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fault of the defendant. Furtherance of these interests support the U.S. court of appeals’ decision to uphold the district court’s injunctions and award of damages.

Secondary Boycott Picketing – This is a type of picketing in which a union tries to bring pressure against an employer by picketing the employer’s suppliers or customers. Secondary boycott picketing is legal only if the picketing is against the struck employer’s product, and not against a neutral employer.

Ethics: Labor Union Picketing and the First Amendment This case involved a union that staged a mock funeral in front of a work site (a hospital construction project). The National Labor Relations Board (NLRB) filed a petition for a temporary injunction against the union’s mock funeral. On appeal, the U.S. court of appeals held that the mock funeral was not coercive, threatening, restraining, or intimidating and therefore was not illegal secondary boycott picketing. Secondary boycott picketing is a type of picketing in which a union tries to bring pressure against an employer by picketing the employer’s suppliers or customers. According to the U.S. court of appeals, the union’s mock funeral was not secondary boycott picketing. The court stated, “Their (the union’s) message may have been unsettling or even offensive to someone visiting a dying relative, but unsettling and even offensive speech is not without the protection of the First Amendment (to the U.S. Constitution).” Sheet Metal Workers’ International Association, Local 15, AFL-CIO v. National Labor Relations Board, 491 F.3d 429, 2007 U.S. App. Lexis 14361 (United States Court of Appeals for the District of Columbia Circuit, 2007)

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Internal Union Affairs Title I of the Landrum-Griffin Act, often referred to as labor’s “bill of rights,” gives each union member equal rights and voting power. It also granted members the right to sue or to initiate actions through government agencies.

Business Environment: Worker Adjustment and Retraining Notification Act In 1988, Congress passed the Worker Adjustment and Retraining Notification Act (also called the Warn Act or Plant Closing Act), which covers employers of 100 or more employees, and requires employers to notify workers or their union 60 days before a plant closing that would result in the loss of 50 or more employees within a 30-day period or if there will be a mass reduction of 33 percent of their workers, unless the closing or layoff is caused strictly by unforeseeable business circumstances. The WARN Act is designed to give employees notice before an intended closing, perhaps preventing some of the devastating effects of the same.

Immigration Law and Employment – U.S. Citizenship and Immigration Services (USCIS), part of the U.S. Department of Homeland Security, currently administers the Immigration Reform and Control Act of 1986, the Immigration Act of 1990, and other U.S. immigration laws.

Foreign nationals who qualify and have met the requirements to do so may become citizens of the United States. During the swearing-in ceremony, they must swear the Oath of Citizenship.

Business Environment: Employment Eligibility Verification The law requires employers to employ only individuals who may legally work in the United States—either U.S. citizens, or foreign citizens who have the necessary authorization. The Immigration Reform and Control Act of 1986 requires employers to attest to their employees’ immigration status and makes it illegal for employers to knowingly recruit illegal immigrants.

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Employers are required to have prospective employees complete a portion of Form I-9, Employment Eligibility Verification, and must obtain a completed Form I-9 before the employee accepts a job offer. Employers can use the federal government U.S. Citizenship and Immigration Services (USCIS) E-Verify internet-based system to verify the employment eligibility of their employers after hire.

Temporary Visitors – Foreign persons may be permitted to enter the United States for temporary visits. A B-1 visa can be issued to persons seeking temporary entry to the United States for business purposes. A B-2 visa can be granted to persons seeking temporary entry to the United States for tourism or non-business reasons, such as visiting family in the United States. B-1 and B-2 are nonimmigrant visas. The maximum period of stay for a B-1 or B-2 visa is 6 months, although the United States may restrict an applicant’s stay to less than 6 months.

A Visa Waiver Program (VWP) allows citizens or nationals of designated countries to come to the United States for business or travel without a B visa for stays of not more than 90 days.

Student Visa – Students from foreign countries who wish to study at colleges and universities or English language programs in the United States must obtain an acceptance letter from the sponsoring U.S. academic institution. Spouses and unmarried children under the age of 21 of an F-1 student qualify for an F-2 visa and may stay in the United States as long as the F-1 holder retains a legal status.

Optional practical training (OPT) is a program that allows F-1 visa holders to temporarily work in the United States to get practical training after graduation or completion of at least 9 months of an academic program.

H-1 B Foreign Guest Worker Visa – This is a visa that allows U.S. employers to employ foreign nationals in the United States who are skilled in specialty occupations. These workers are called foreign guest workers.

EB-1 Extraordinary Ability Visa – This is a visa that allows U.S. employers to employ foreign nationals in the United States who possess exceptional qualifications for certain types of employment.

EB-5 Investor Visa – This is a visa that permits persons who invest a required amount of money in a commercial enterprise located in the United States, and who meet other established requirements, to immigrate to the United States.

V. Key Terms and Concepts  AFL-CIO—The 1955 combination of the AFL and the CIO.  Agency shop—A workplace in which an employee does not have to join the union but must pay an agency fee to the union.  American Federation of Labor (AFL)—The American Federation of Labor (AFL) was formed in 1886, under the leadership of Samuel Gompers.  Appropriate bargaining unit (bargaining unit)—The group that a union seeks to represent.  B-1 visa—A visa issued to persons seeking temporary entry to the United States for business purposes.  B-2 visa—A visa issued to persons temporary entry to the United States for tourism and nonbusiness purposes.  Closed shop—Under a closed shop agreement, an employer agrees to hire only employees who are already members of a union.

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                      

Collective bargaining—The act of negotiating contract terms between an employer and the members of a union.

Collective bargaining agreement—The resulting contract from a collective bargaining procedure.

Compulsory subjects—Wages, hours, and other terms and conditions of employment.

Congress of Industrial Organizations (CIO)—Permitted semiskilled and unskilled workers to become members.

Consent election—If management does not contest an election, a consent election may be held without NLRB supervision.

Contested election—An election for a union that an employer’s management contests.

Cooling-off period—Requires a union to give an employer at least 60 days’ notice before a strike can commence.

Crossover worker—A person who does not honor a strike who either (1) chooses not to strike, or (2) returns to work after joining the strikers for a time.

Decertification election—If employees no longer want to be represented by a union, a decertification election will be held.

Dues checkoff—Upon proper notification by the union, union and agency shop employers are required to deduct union dues and agency fees from employees’ wages and forward these dues to the union.

EB-1 Extraordinary Ability visa (EB-1 visa)—A visa that allows U.S. employers to employ, in the United States, foreign nationals who possess exceptional qualifications for certain types of employment.

EB-5 Investor visa (EB-5 visa)—A visa that permits persons who invest a required amount of money in a commercial enterprise located in the United States, and who meet other established requirements, to immigrate to the United States.

Employer lockout—Act of the employer to prevent employees from entering the work premises when the employer reasonably anticipates a strike.

E-Verify—Employers can use the federal government’s U.S. Citizenship and Immigration Services (USCIS) E-Verify internet-based system to verify the employment eligibility of their employees after hire.

F-1 visa—A visa issued to foreign nationals to study at colleges and universities and English language programs in the United States.

F-2 visa—Spouses and unmarried children under the age of 21 of an F-1 student qualify for an F-2 visa and may stay in the United States as long as the F-1 holder retains a legal status.

Foreign guest worker—A foreign guest worker must be sponsored by a U.S. employer.

Form I-9 Employment Eligibility Verification—Employers are required to have prospective employees complete Form I-9 Employment Eligibility Verification.

H-1B Foreign Guest Worker Visa (H-1B visa)—A visa that allows U.S. employers to employ in the United States, foreign nationals who are skilled in specialty occupations.

H-4 visa—H-1B visa holders are allowed to bring their immediate family members (i.e., spouse and children under 21) to the United States under the H-4 visa category as dependents.

Illegal strike—The majority of strikes are lawful strikes. However, several types of strikes have been held to be illegal and are not protected by federal labor law.

Illegal subjects—Certain topics are illegal subjects of collective bargaining and therefore cannot be subjects of negotiation or agreement.

Immigration Act of 1990—This law, along with the Immigration Reform and Control Act of 1986, other federal statutes, presidential executive orders, and government regulations regulate immigration, the employment of immigrants in the United States, and naturalization and citizenship.

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    

              

Immigration Reform and Control Act of 1986—A federal statute that makes it unlawful for employers to hire illegal immigrants.

Inaccessibility exception—A rule that permits employees and union officials to engage in union solicitation on company property if the employees are beyond reach of reasonable union efforts to communicate with them.

Internal union rules—A union may adopt internal union rules to regulate the operation of the union, acquire and maintain union membership, and the like.

Labor law—The major federal statutes that regulate the labor-management relationship, the rules and regulations adopted pursuant to these statutes, and court decisions interpreting and applying the statutes and rules and regulations are collectively referred to as labor law.

Labor Management Relations Act (Taft-Hartley Act)—This act (1) expands the activities that labor unions can engage in, (2) gives employers the right to engage in free-speech efforts against unions prior to a union election, and (3) gives the President of the United States the right to seek an injunction (for up to eighty days) against a strike that would create a national emergency.

Labor Management Reporting and Disclosure Act (Landrum-Griffin Act)—This act regulates internal union affairs and establishes the rights of union members.

Mass layoff—A mass layoff is a reduction of 33 percent of the employees or at least fifty employees during any thirty-day period.

National Labor Relations Act (NLRA) (Wagner Act)—A federal statute enacted in 1935 that establishes the right of employees to form and join labor organizations.

National Labor Relations Board (NLRB)—A federal administrative agency that oversees union elections, prevents employers and unions from engaging in illegal and unfair labor practices, and enforces and interprets certain federal labor laws.

No-strike clause—A clause in a collective bargaining agreement whereby a union agrees it will not strike during an agreed-upon period of time.

Norris-LaGuardia Act—Enacted in 1932, the Norris-LaGuardia Act stipulates that it is legal for employees to organize.

Oath of Citizenship—Foreign nationals who qualify and have met the requirements to do so may become citizens of the United States. During their swearing-in ceremony, they must swear the Oath of Citizenship.

Optional Practical Training (OPT)—A program that allows F-1 visa holders to temporarily work in the United States to get practical training after graduation or completion of at least 9 months of an academic program.

Partial (intermittent) strike—In partial strikes, or intermittent strikes, employees strike part of the day or workweek and work the other part.

Permissive subjects—Subjects that are not compulsory or illegal are permissive subjects of collective bargaining.

Picketing—The action of strikers walking in front of the employer’s premises carrying signs announcing their strike.

Plant closing—A plant closing is a permanent or temporary shutdown of a single site that results in a loss of employment for fifty or more employees during any thirty-day period.

Railway Labor Act—The Railway Labor Act of 1926, as amended in 1934, covers employees of railroad and airline carriers.

Replacement worker—Workers who are hired to take the place of striking workers. They can be hired on either a temporary or permanent basis.

Right-to-work laws—Right-to-work laws are often enacted by states to attract new businesses to a nonunion and low-wage environment.

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              

Secondary boycott picketing—A type of picketing where unions try to bring pressure against an employer by picketing his or her suppliers or customers.

Section 7 of the NLRA—A law that gives employees the right to join together and form a union.

Section 8(a) of the NLRA—A law that makes it an unfair labor practice for an employer to interfere with, coerce, or restrain employees from exercising their statutory right to form and join unions.

Section 8(b) of the NLRA—A law that prohibits unions from engaging in unfair labor practices that interfere with a union election.

Sit-down strike—In sit-down strikes, striking employees continue to occupy the employer’s premises.

Strike—A cessation of work by union members in order to obtain economic benefits or correct an unfair labor practice.

Title 1 of the Landrum-Griffin Act (labor’s “bill of rights”)—Gives each union member equal rights and privileges to nominate candidates for union office, vote in elections, and participate in membership meetings.

Unfair labor practice—Section 8(a) of the NLRA makes it an unfair labor practice for an employer to interfere with, coerce, or restrain employees from exercising their statutory right to form and join unions.

Union security agreement—To obtain the greatest power possible, elected unions sometimes try to install a union security agreement.

Union shop—A workplace in which an employee must join the union within a certain number of days after being hired.

U.S. Citizenship and Immigration Services (USCIS)—A federal agency empowered to enforce U.S. immigration laws.

Violent strike—In violent strikes, striking employees cause substantial damage to property of the employer or a third party.

Visa Waiver Program (VWP)—This allows citizens or nationals of designated countries to come to the United States for business or travel without a B visa for stays of not more than 90 days.

Wildcat strike—In wildcat strikes, individual union members go on strike without proper authorization from the union.

Worker Adjustment and Retraining Notification Act (WARN Act) (Plant Closing Act)—A federal act that requires employers with one hundred or more employees to give their employees 60 days’ notice before engaging in certain plant closings or layoffs.

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Chapter 22 Antitrust Law and Unfair Trade Practices

Why is competition important?

I. Teacher to Teacher Dialogue Antitrust law lends itself to broad overviews of political and economic history. This entire body of law arose out of a need to stem and reverse some of the abuses of the “Robber Baron” era. For those of us who enjoy such exercises, and have the time, there is a wealth of political, sociological, and economic literature that can be plowed into this subject.

Most people do not think of the trust device as a business tool. As seen in other chapters, today’s use of trusts centers on the need to hold property for the benefit of others. In another era, however, the business trust was notoriously used as a device to eliminate competition and control markets. In the late 1800s, it was common to have key commodities and the industries related to those products controlled by large corporate enterprises. These entities would band together into a form of common trust ownership. The trustee, in turn, was able to control the prices and territories of distribution of the product. For example, prior to the enactment of antitrust laws, industries such as oil, cotton, sugar, and whiskey were all dominated by such trusts. Probably the best known of these trusts was Standard Oil. In 1890, the Standard Oil Trust controlled more than 90 percent of the market for oil products in the United States. By the time the trust was “busted” in 1911, more than thirty companies were ordered separated from the parent firm. This sort of monopolization of the marketplace led to the landmark antitrust legislation in 1890, the Sherman Antitrust Act. The act has two main objectives: 1.

To prevent combinations in trust or otherwise, which act in restraint of trade, that is, illegally joining together to restrain trade.

2.

To control markets thought to have a monopoly, that is, illegal domination so strong as to ipso facto restrain trade.

These objectives are set out in Sections 1 and 2 of the Act. What is interesting about this Act is that Congress used very broad language to give the Justice Department maximum latitude in seeking enforcement of its provisions. This latitude has, in turn, not been consistently used. There appears to have been a constant shift in the enforcement strategies used by various administrations over the years.

The federal courts have taken a middle road. Under their rules of interpretation, two main classifications of offenses have evolved. The Per Se Rule is used to strike down restraints that courts deem to be so inherently anticompetitive that they cannot be allowed as a matter of law, regardless of any claimed justifications. On the other hand, the Rule of Reason has given courts latitude to accept restraints of trade on a case-by-case basis where legitimate concerns are overriding.

As strong and powerful a tool in the fight against monopolization and restraints of trade as the Sherman Act is, it has proven to be only a partial remedy. The Sherman Act sets the basic goals and objectives of keeping marketplaces open to competition. The Clayton Act and the Federal Trade Commission Act are designed to provide tools of implementation to those basic public policy objectives. As compared to the almost philosophical tenor of Sections 1 and 2 of the Sherman Act, the Clayton Act, and more particularly, the Robinson-Patman Amendment to it, speak to much more specific objectives. The objectives arose out of discriminatory practices aimed at getting the little guy.

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The biggest problem with the Clayton Act, and to a lesser extent with the FTC, is the government’s commitment to enforcement combined with some very problematic aspects of the statutes themselves. On the issue of governmental level of commitment to enforcement, there is no question that things have changed in the global scheme of economic competition. In many ways, the market factors that were sought to be protected in the early part of the twentieth century are different in the twenty-first century. A free and open market is not measured on regional or even national scales now, but rather on worldwide competitive position. These changes have provided the philosophical underpinnings for the much more tolerant view taken by the government toward mergers, acquisitions, combinations, and the like. Yet the basic economic principles of monopolization, restraint of trade, and unfair trade practices have not changed. So government finds itself in a dilemma. It is trying to recognize the need to allow our economy to stay competitive in the worldwide playing field; yet it must continue to keep the game rules fair.

The second factor involves questions that have been raised about the economic sense of the Clayton Act itself. Many critics of the Act have argued that although provisions like price discrimination look good in theory, they are difficult to enforce. The reason these particular measures have failed to live up to their billing is that some price volume cuts, incentives, and the like are all part of the competitive edge that all players are constantly looking for. To deny the reality of those competitive needs not only frustrates real competition, it may give noncompetitive parties an unwarranted wedge against more efficient competitors by way of officious intermeddling on the part of government.

II. Chapter Objectives 1. List and describe the major federal antitrust statutes and the enforcement of federal antitrust laws.

2. Describe the restraints of trade that violate Section 1 of the Sherman Act. 3. Identify acts of monopolization that violate Section 2 of the Sherman Act. 4. Explain how the lawfulness of mergers is examined under Section 7 of the Clayton Act. 5. Describe tying arrangements that violate Section 3 of the Clayton Act. 6. List and describe the types of price discrimination that violate Section 2 of the Clayton Act. 7. Describe antitrust acts and unfair methods of competition that violate Section 5 of the Federal Trade Commission Act. 8. List and describe express and implied exemptions from antitrust laws.

9. Describe the scope of state antitrust laws.

III. Key Question Checklist  What are antitrust acts designed to promote and protect?  What are the main provisions of the Sherman Act?  What are the main provisions of the Clayton Act?  What are the main provisions of the Federal Trade Commission Act?  What are the main provisions of the Robinson-Patman Act?  What are the main defenses to the Sherman Act and the other antitrust acts?  What subject matter do state antitrust acts cover?

IV. Chapter Outline Introduction to Antitrust Law and Unfair Trade Practices – The U.S. Congress enacted antitrust laws to limit anticompetitive behavior when a series of monopolies were formed as our society moved from an industrialized to an urban economy.

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Federal Antitrust Law – Antitrust statutes are broadly drafted, reflecting the government’s enforcement powers and leaving it able to respond to the rapidly changing business environment.

The federal antitrust laws allow for both government and private lawsuits.

Landmark Law: Federal Antitrust Statutes The Sherman Antitrust Act (or Sherman Act) of 1890 is a federal statute that makes certain restraints of trade and monopolistic acts illegal. The Clayton Antitrust Act (or Clayton Act) is a federal statute, enacted in 1914, that regulates mergers and prohibits certain exclusive dealing arrangements. The Federal Trade Commission Act (FTC Act) is a federal statute, enacted in 1914, that prohibits unfair methods of competition. The Robinson-Patman Act is a federal statute, enacted in 1930, that prohibits price discrimination.

Government Actions – Government enforcement of federal antitrust laws is divided between the Antitrust Division of the Department of Justice and the Bureau of Competition of the Federal Trade Commission. The Sherman Act is the only major antitrust act that includes criminal sanctions. The government may seek civil damages, including treble damages, for violations of antitrust laws.

Private Actions – Private civil actions may be brought under Section 4 of the Clayton Act, and successful plaintiffs may recover treble damages, plus costs and attorneys’ fees. A private plaintiff has four years from the date on which an antitrust injury occurred to bring a private civil treble-damages action.

Effect of a Government Judgment – In an antitrust action, a government judgment against a defendant can be used as prima facie evidence of the defendant’s liability in a private civil trebledamages action. Antitrust defendants often enter a plea of nolo contendere in criminal actions or enter into a consent decree. Both subject them to penalty without an admission of guilt that can be used against them in a civil suit. Section 16 of the Clayton Act permits the government or private plaintiff to obtain an injunction against anticompetitive behavior that violates antitrust laws. Only the Federal Trade Commission (FTC) can obtain an injunction under the FTC Act. Restraints of Trade: Section 1 of the Sherman Act – The Sherman Act, known as the “Magna Carta of free enterprise,” was passed to outlaw anti-competitive behavior. Section 1 specifically prohibits contracts, combinations, and conspiracies in restraint of trade.

Business Environment: Rule of Reason and Per Se Rule Two tests have evolved for determining the legality of a restraint. The rule of reason holds that only unreasonable restraints of trade violate the act. The courts will need to consider the competitive structure of the industry, the firm’s market share, and the pro- and anti-competitive effects of the restraint. The per se rule is applicable to restraints of trade that are inherently anticompetitive. If a restraint is deemed to be a per se violation, there can be no defense or justification. No justification or defenses will save a per se violation, and no further evidence need be considered.

Horizontal Restraints of Trade – A horizontal restraint of trade occurs when two or more competitors at the same level of distribution enter into a contract, combination, or conspiracy to restrain trade. Many horizontal restraints fall under the per se rule; others are examined under the rule of reason.

Price Fixing – Price fixing occurs when competitors in the same line of business agree to set the price of goods or services they sell. This will usually raise, depress, fix, peg, or stabilize the price 252 .

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of the commodity. Buyers may also be guilty of this by agreeing to the price that they will pay for product. Price-fixing is a per se violation of Section 1 of the Sherman Act. No defenses or justifications of any kind—such as “the price fixing helps consumers or protects competitors from ruinous competition”—can prevent the per se rule from applying.

Federal Court Case Case 22.1 Price Fixing: United States v. Apple, Inc. Facts: Amazon.com, Inc. (Amazon) produces and sells the Kindle, a portable device that can hold digital copies of books, known as e-books. Amazon offered desirable e-books, including new releases and best-selling books, for $9.99. The multi-billion-dollar book-publishing industry saw Amazon’s e-books, and particularly its $9.99 pricing strategy, as a threat to their way of doing business.

Apple, Inc. created iBookstore on its iPad to sell and distribute e-books. Apple entered negotiations with the five largest publishing companies in the U.S. to distribute their e-books.

Apple was not willing to do so at the $9.99 retail price to compete with Amazon. The publishers saw colluding with Apple as a way of breaking Amazon’s retail price and having both Apple and Amazon sell e-books at a higher price so that publishers and Apple could make a higher profit on their e-books. To put pressure on Amazon to raise prices the publishers agreed to withhold books from Amazon.

In two months, Apple had orchestrated an arrangement whereby it had coerced the five publishers to enter the same agreement with Apple whereby the publishers had the authority to set prices of their books sold on Apple’s iBookstore. The result was that Amazon was forced to give in and enter agreements with the publishers that raised the price of e-books sold on Amazon, which increased the profits that the publishers made on e-books. The price of new e-books increased by 24 percent and the price of best-seller e-books increased by 40 percent.

The U.S. Department of Justice (DOJ) filed suit in U.S. district court against Apple and the five book publishers, alleging that Apple, by entering into the same agreement with the five publishers, had conspired with the defendant publishers to engage in a price-fixing scheme to raise prices in the e-book market. The DOJ argued that this hub-and-spoke agreement between Apple and the book publishers constituted price fixing that was a per se violation of Section 1 of the Sherman Act. The defendant publishers settled their cases with the DOJ. Apple went to trial.

The U.S. district court concluded that Apple, by orchestrating a conspiracy among five major publishing companies to enter into an agreement to raise the retail price of digital books, had engaged in a per se violation of Section 1 of the Sherman Act. The district court issued an injunction against Apple that prevented it from engaging in similar conduct in the future. Apple appealed.

Issue: Is Apple liable for violating Section I of the Sherman Act? Decision: The U.S. court of appeals affirmed the district court’s decision that Apple, with the defendant publishers, had engaged in a per se violation of Section 1 of the Sherman Act. The court of appeals upheld the injunction against Apple that prevented it from engaging in similar conduct in the future.

Reasoning: Because the subject conspiracy consisted of a group of competitors—the publisher defendants—assembled by Apple to increase prices, it consisted of a horizontal price-fixing conspiracy and was a per se violation of the Sherman Act. Ethics Questions: As the court indicated, the conspiracy among Apple and the publisher defendants “comfortably” qualifies as a horizontal price-fixing conspiracy, with a coordinated effort to raise prices across the relevant market present in “every chapter of this story.”

Ethics: High-Tech Companies Settle Antitrust Charges Adobe Systems, Inc., Apple Inc., Google Inc., Intel Corporation, Intuit Inc., Lucasfilm Ltd., and Pixar (defendants) allegedly entered into non-solicitation agreements among themselves not to 253 .

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“cold-call” employees of the other companies in order to prevent a bidding war for the best talent in the area, thus depressing salaries of the affected employees. The U.S. Department of Justice (DOJ) filed complaints in federal court against the defendants for conspiracy to violate antitrust laws. The DOJ and the defendants settled the case, with the defendants enjoined from entering into an agreement like the one alleged. The settlement agreement did not require the defendants to admit any wrongdoing or violation of law. A settlement agreement gives certainty and finality to all parties involved. The DOJ benefitted from the settlement in that it was not required to prove the case beyond reasonable doubt in criminal court, and it was able to secure the defendants’ agreement not to violate antitrust laws. The defendants benefitted in the sense that they were not criminally prosecuted. Non-admission of wrongdoing is a common feature of a settlement agreement. United States v. Adobe Systems Inc. and United States v. Lucasfilm, Inc., 2011WL 2636850 (United States District Court for the District of Columbia, 2011) Division of Markets – When competitors agree that they will serve only a designated portion of the market, they are engaging in a market sharing. This is a per se violation of Section 1 of the Sherman Act. Many horizontal market-sharing arrangements contain divisions of the market.

Group Boycotts – A group boycott (or refusal to deal) occurs when two or more competitors at one level of distribution agree not to deal with others at a different level of distribution. If a group of sellers agrees not to sell their products to a certain buyer, they would be engaging in a group boycott by sellers. If a group of purchasers agrees not to purchase a product from a certain seller, they would be engaging in a group boycott by purchasers. The courts have found that most group boycotts are per se illegal. If not found to be per se illegal, a group boycott will be examined using the rule of reason.

Other Horizontal Agreements – Some horizontal agreements entered into by competitors at the same level of distribution—including trade association activities and rules, exchange of non-price information, participation in joint ventures, and the like—are examined using the rule of reason.

Reasonable restraints are lawful; unreasonable restraints violate Section 1 of the Sherman Act. Vertical Restraints of Trade – This occurs when two or more parties on different levels of distribution enter into a contract, combination, or conspiracy to restrain trade. The U.S. Supreme Court has applied both the per se rule and the rule of reason in determining the legality of vertical restraints of trade under Section 1 of the Sherman Act. Resale Price Maintenance – Resale price maintenance, or vertical price fixing, occurs when a party at one level of distribution enters into an agreement with a party at another level to adhere to a price schedule with sets or stabilizes the cost of the goods. The setting of minimum resale prices is a per se violation of Section 1, while the setting of maximum resale prices is examined using the rule of reason to determine whether it violates Section 1.

Nonprice Vertical Restraints – These are examined using the rule of reason, and will be deemed unlawful if their anticompetitive effect outweighs their procompetitive effects.

Unilateral Refusal to Deal – A firm can unilaterally decide not to deal with another firm and this will not violate Section 1 of the Sherman Act. This is not a violation of Section 1 because there is no concerted action with others. This rule was announced in United States v. Colgate & Co. and is therefore often referred to as the Colgate doctrine.

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Business Environment: Conscious Parallelism If two or more firms act the same but no concerted action is shown, there is no violation of Section 1 of the Sherman Act. This doctrine is often referred to as conscious parallelism.

Noerr Doctrine – Two or more persons may petition the executive, legislative, or judicial branch of the government or administrative agencies to enact laws or to take other action without violating antitrust laws.

Monopolization: Section 2 of the Sherman Act – Section 2 of the Sherman Act prohibits the act of monopolization. Proving that a defendant is in violation of Section 2 means proving that the defendant (1) is in a relevant market, (2) possesses monopoly power, and (3) engaged in a willful act of monopolization to acquire or to maintain that power.

1. Relevant Market—A relevant market includes substitute products or services that can be considered relatively interchangeable. This also requires sales within a relevant geographical market, which can be national, regional, state, or local markets, depending upon the product.

2. Monopoly Power—Monopoly power within a relevant market is necessary for an antitrust action to be sustained against a defendant. The courts have generally held that more than a 70 percent share is a monopoly, while under a 20 percent share is not.

3. Willful Act of Monopolizing—It is important to note that Section 2 of the Sherman Act outlaws the act of monopolizing, not monopolies. An example of monopolizing is predatory pricing.

Attempts and Conspiracies to Monopolize – Both the attempt and conspiracy to monopolize are punishable under the law. Firms that attempt or conspire to monopolize a relevant market may be found liable under Section 2 of the Sherman Act. Defenses to Monopolization – Only two narrow defenses to a charge of monopolizing have been recognized: (1) Innocent acquisition of a monopoly—This occurs because of superior business acumen, skill, foresight, or industry; and (2) Natural monopoly—This arises in a small market that can support only one competitor, such as a small-town newspaper.

Mergers: Section 7 of the Clayton Act The act gives the federal government the power to stop anticompetitive mergers. Although the act was originally applied only to stock mergers, this section of the Clayton Act is now applied to all methods of external expansion by a company, including joint ventures, consolidations, purchases, and subsidiary operations. Section 7 of the Clayton Act provides that it is illegal for a person or entity to acquire the stocks or assets of another, creating a monopoly, or substantially lessening competition. In deciding whether a merger is lawful under Section 7 of the Clayton Act, the courts must (1) define the relevant line of commerce, (2) identify the section of the country affected by the merger, and (3) determine whether the merger or acquisition creates a reasonable probability of the substantial lessening of competition or is likely to create a monopoly in the market.

1. Line of Commerce—Determining the line of commerce that will be affected by a merger involves defining the relevant product or service market. The courts will apply a functional interchangeability test. The relevant line of commerce includes products and services that customers can use as substitutes; for example, regular coffee and tea.

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2. Section of the Country—The courts will also look at the relevant section of the country and review the geographical market involved to determine if the direct and immediate effects of the merger will be felt.

3. Probability of a Substantial Lessening of Competition or Likelihood of Creating a Monopoly— The court will also consider whether the merger is likely to substantially lessen competition or to create a monopoly; both will become bars to the merger.

Horizontal Merger – A horizontal merger is a merger between two or more companies that compete in the same business and geographical market. Such mergers are subjected to strict review under Section 7 because they clearly result in an increase in concentration in the relevant market.

Vertical Merger – A vertical merger integrates the operations of both the supplier and the customer, producing either a backward vertical merger (with the supplier) or a forward vertical merger (with the customer). In determining the legality of these actions, the court will consider trends, the history of the companies involved, the economic efficiency, barriers to entry, and the elimination of potential competition. Vertical mergers do not increase market share because they serve different markets, but may still create an anticompetitive effect by foreclosing competitors from buying or selling goods.

Market Extension Merger – A market extension merger is between two companies in similar fields with non-overlapping sales. A geographical market extension merger is between two companies in the same industry that serve the same geographical market. A product market extension merger is a merger between two sellers of similar products. These mergers are examined under Section 7 of the Clayton Act. Conglomerate Merger – Conglomerate mergers are those that do not fit into any other category, or those between two totally unrelated businesses. The unfair advantage theory keeps acquiring firms from gaining an unfair advantage over its competition, so that the wealthy cannot overwhelm the marketplace.

Defenses to Section 7 Actions – There are two defenses to Section 7 actions: (1) the failing company doctrine; and (2) the small company doctrine. The former allows for mergers if there are no other alternatives for the failing company, there are no other purchasers available, and the assets would disappear from the market without the merger. The latter permits two or more smaller companies to merge in order to become more competitive.

Business Environment: Premerger Notification The Hart-Scott-Rodino Antitrust Improvement Act (HSR Act) requires certain larger firms to notify the Federal Trade Commission (FTC) and the U.S. Department of Justice of any proposed mergers and to provide information about the parties and the proposed transaction.

Tying Arrangements: Section 3 of the Clayton Act – Section 3 of the Clayton Act prohibits tying arrangements, involving the sales or leases of goods, as vertical restraints of trade. Tying arrangements are where a seller refuses to sell a product to a customer unless the customer also agrees to purchase a second product. Although some tying arrangements may be lawful, the parties must justify their actions. Section 1 of the Sherman Act forbids tying arrangements involving goods, services, intangible property, and real property.

Price Discrimination: Section 2 of the Clayton Act – Section 2 of the Clayton Act, commonly referred to as the Robinson-Patman Act, prohibits price discrimination in the sale of goods if 256 .

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specified acts occur. Section 2(a) of the Robinson-Patman Act prohibits sellers from both direct and indirect price discrimination when selling the same type and quality of goods, since this can affect competition and may produce a monopoly.

Direct Price Discrimination – Direct price discrimination involves the sale of commodities of like grade and quality at approximately the same time to two different purchasers at different prices, producing an actual injury to the plaintiff. The plaintiff cannot recover without having suffered actual injury.

Indirect Price Discrimination – Indirect price discrimination provides better prices to favored customers through favorable credit terms, freight charges, or other less obvious ways.

Defenses to Price Discrimination –There are three defenses to actions brought under Section 2(a) of the Robinson-Patman Act: (1) Cost justification—Cost justification can be based upon differences in the cost of manufacture, sale, or delivery.

(2) Changing conditions—Changing conditions in the market for or marketability of the goods is also a defense.

(3) Meeting the competition—Meeting the competition’s price is allowed under the RobinsonPatman Act. Federal Trade Commission Act – In 1914, Congress enacted the Federal Trade Commission Act (FTC Act) and created the Federal Trade Commission (FTC). Section 5 of the Federal Trade Commission Act prohibits “unfair methods of competition and unfair or deceptive acts or practices” in or affecting commerce. The FTC is exclusively empowered to enforce the FTC Act. It can issue interpretive rules, general statements of policy, trade regulation rules, and guidelines that define unfair or deceptive practices, and it can conduct investigations of suspected antitrust violations.

Exemptions from Antitrust Laws – There are three categories of exemptions from antitrust laws, including statutory exemptions, implied exemptions, and the state action exemption.

Statutory Exemptions – Statutory exemptions for labor unions, agricultural cooperatives, export activities, and state regulated insurance companies are allowed.

Implied Exemptions – The federal courts have implied several exemptions from antitrust laws.

Examples of implied exemptions include professional baseball and airlines.

State Action Exemption – Economic regulations mandated by state law are exempt from federal antitrust laws. The state action exemption extends to businesses that must comply with these regulations.

State Antitrust Laws – Most states have enacted antitrust statutes. These statutes are usually patterned after federal antitrust statutes. State antitrust laws are used to attack anticompetitive activity that occurs in intrastate commerce.

Global Law: European Union Antitrust Law The European Union (EU) is a regional organization of more than 25 countries in Europe. The EU’s commission on competition enforces EU antitrust laws. In recent decades, EU enforcement of antitrust laws has been more stringent than the enforcement of antitrust laws in the United

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States. Thus, multinational corporations must take into account EU antitrust laws when proposing mergers or engaging in business.

V. Key Terms and Concepts  Antitrust Division of the Department of Justice—Along with the Bureau of Competition of the Federal Trade Commission, responsible for government enforcement of federal antitrust laws.  Antitrust injury—To recover damages under Section 4 of the Clayton Act, plaintiffs must prove that they suffered antitrust injuries caused by the prohibited act.  Antitrust laws—A series of laws enacted to limit anticompetitive behavior in almost all industries, businesses, and professions operating in the United States.  Attempt or conspire to monopolize—A substantial step toward monopolization, or an illegal agreement between two or more parties to monopolize. Firms that attempt or conspire to monopolize a relevant market may be found liable under Section 2 of the Sherman Act.  Backward vertical merger (upstream vertical merger)—A vertical merger in which the customer acquires the supplier.  Bureau of Competition of the Federal Trade Commission—Along with the Antitrust Division of the Department of Justice, responsible for government enforcement of federal antitrust laws.  Celler-Kefauver Act—It widened the scope of Section 7 to include asset acquisitions.  Changing conditions defense—A price discrimination defense that claims prices were lowered in response to changing conditions in the market for or the marketability of the goods.  Civil damages—In the case of violation of federal antitrust laws, government may seek civil damages.  Clayton Antitrust Act (Clayton Act)—A federal statute, enacted in 1914, that regulates mergers and prohibits certain exclusive dealing arrangements.  Colgate doctrine—A unilateral refusal to deal is not a violation of Section 1 because there is no concerted action with others. This rule was announced in United States v.

Colgate &Co. and is therefore often referred to as the Colgate doctrine.  Conglomerate merger—A merger that does not fit into any other category; a merger between firms in totally unrelated businesses.  Conscious parallelism—A doctrine which states that if two or more firms act the same but no concerted action is shown, there is no violation of Section 1 of the Sherman Act.  Consent decree—Antitrust defendants often opt to settle government-brought antitrust actions by entering a plea of nolo contendere in a criminal action or a consent decree in a government civil action.  Cost justification defense—A defense to a Robinson-Patman Act Section 2(a) action that provides that a seller’s price discrimination is not unlawful if the price differential is due to “differences in the cost of manufacture, sale, or delivery” of the product.  Direct price discrimination—Price discrimination in which (1) the defendant sold commodities of like grade and quality, (2) to two or more purchasers at different prices at approximately the same time, and (3) the plaintiff suffered injury because of the price discrimination.  Division of markets (market sharing)—A restraint of trade in which competitors agree that each will serve only a designated portion of the market.  European Union—A regional organization of more than 25 countries in Europe.  Failing company doctrine—A competitor may merge with a failing company if (1) there is no other reasonable alternative for the failing company, (2) no other purchaser is 258 .

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available, and (3) the assets of the failing company would completely disappear from the market if the anticompetitive merger were not allowed to go through.

Federal antitrust statutes—A series of antitrust laws enacted by the U.S. Congress aimed at curbing abusive and monopoly practices by businesses. Examples include the Sherman Antitrust Act, the Clayton Antitrust Act, the Federal Trade Commission Act, and the Robinson-Patman Act. Federal Trade Commission (FTC)—A federal government administrative agency that is empowered to enforce the Federal Trade Commission Act. Federal Trade Commission Act (FTC Act)—A federal statute, enacted in 1914, that prohibits unfair methods of competition.

Foreclosing competition—Prohibiting competitors from either selling goods or services to or buying them from the merged firm.

Forward vertical merger (downstream vertical merger)—A vertical merger in which the suppler acquires the customer.

Geographical market extension merger—A merger between two regional brewers that do not sell beer in the same geographical area.

Government actions—The federal government is authorized to bring both civil and criminal actions to enforce federal antitrust laws.

Government judgment—A judgment obtained by the government against a defendant for an antitrust violation that may be used as prima facie evidence of liability in a private civil treble-damages action.

Group boycott (refusal to deal)—When two or more competitors at one level of distribution agree not to deal with others at another level of distribution.

Group boycott by purchasers—Occurs when a group of purchasers agrees not to purchase a product from a certain seller.

Group boycott by sellers—Occurs when a group of sellers agrees not to sell their products to a certain buyer.

Hart-Scott-Rodino Antitrust Improvement Act (HSR Act)—Requires certain firms to notify the FTC and the Justice Department in advance of a proposed merger. Unless the government challenges the proposed merger within 30 days, the merger may proceed.

Horizontal merger—A merger between two or more companies that compete in the same business and geographical market.

Horizontal restraint of trade—A restraint of trade that occurs when two or more competitors at the same level of distribution enter into a contract, combination, or conspiracy to restrain trade.

Implied exemptions—Exemptions from antitrust laws that are implied by the federal courts.

Indirect price discrimination—A form of price discrimination (e.g., favorable credit terms) that is less readily apparent than direct forms of price discrimination.

Innocent acquisition of a monopoly—Acquisition because of superior business acumen, skill, foresight, or industry.

Line of commerce—Includes products or services that consumers use as a substitute. If an increase in the price of one product or service leads consumers to purchase another product or service, the two products are substitutes for each other.

Market extension merger—A merger between two companies in similar fields whose sales do not overlap.

Maximum resale price—The setting of a maximum resale price is examined using the “rule of reason” to determine whether it violates Section 1 of the Sherman Act.

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Meeting the competition defense—A defense provided in Section 2(b) of the RobinsonPatman Act that says a seller may lawfully engage in price discrimination to meet a competitor’s price.

Minimum resale price—Setting minimum resale prices is a per se violation of Section 1 of the Sherman Act as an unreasonable restraint of trade.

Monopoly power—The power to control prices or exclude competition measured by the market share the defendant possesses in the relevant market.

Natural monopoly—Refers to a small market that can support only one competitor, such as a small-town newspaper.

Noerr doctrine—A doctrine which says that two or more persons can petition the executive, legislative, or judicial branch of the government or administrative agencies to enact laws or take other actions without violating antitrust laws.

Nolo contendere—Antitrust defendants often opt to settle government-brought antitrust actions by entering a plea of nolo contendere in a criminal action.

Non-price vertical restraint—Restraint of trade that is unlawful under Section 1 of the Sherman Act if its anticompetitive effects outweigh its procompetitive effects.

Per se rule—A rule that is applicable to those restraints of trade considered inherently anticompetitive. Once this determination is made, the court will not permit any defenses or justifications to save it.

Predatory pricing—A price that is below average or marginal cost.

Price discrimination—Sellers often offer favorable terms to their preferred customers.

Price discrimination occurs if a seller does this without just cause.

Price fixing—Occurs where competitors in the same line of business agree to set the price of the goods or services they sell: raising, depressing, fixing, pegging, or stabilizing the price of a commodity or service.

Private civil action—Section 4 of the Clayton Act permits any person who suffers antitrust injury in his or her “business or property” to bring a private civil action against the offenders.

Probability of a substantial lessening of competition or likelihood of creating a monopoly—If there is a probability that a merger will substantially lessen competition or create a monopoly, the court may prevent the merger under Section 7 of the Clayton Act. Product market extension merger—A merger between sellers of similar products.

Relevant geographical market—A relevant market that is defined as the area in which the defendant and its competitors sell the product or service.

Relevant market—The relevant market often determines whether the defendant has monopoly power.

Relevant product or service market—A relevant market that includes substitute products or services that are reasonably interchangeable with the defendant’s products or services.

Resale price maintenance (vertical price fixing)—A per se violation of Section 1 of the Sherman Act; occurs when a party at one level of distribution enters into an agreement with a party at another level to adhere to a price schedule that either sets or stabilizes prices.

Robinson-Patman Act—Section 2 of the Clayton Act is commonly referred to as the Robinson-Patman Act. Rule of reason—A rule that holds that only unreasonable restraints of trade violate Section 1 of the Sherman Act. The court must examine the pro- and anticompetitive effects of the challenged restraint.

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Section of the country—A division of the country that is based on the relevant geographical market; the geographical area that will feel the direct and immediate effects of the merger.

Section 1 of the Sherman Act—Prohibits contracts, combinations, and conspiracies in restraint of trade. Also prohibits tying arrangements involving goods, services, intangible property, and real property.

Section 2 of the Clayton Act (Robinson-Patman Act)—Prohibits price discrimination in the sale of goods if specified acts occur.

Section 2 of the Sherman Act—Prohibits the act of monopolization and attempts or conspiracies to monopolize trade.

Section 2(a) of the Robinson-Patman Act—Prohibits direct and indirect price discrimination by sellers of a commodity of a like grade and quality where the effect of such discrimination may be to substantially lessen competition or to tend to create a monopoly in any line of commerce.

Section 2(b) of the Robinson-Patman Act—A defense that provides that a seller may lawfully engage in price discrimination to meet a competitor’s price.

Section 3 of the Clayton Act—Prohibits tying arrangements involving sales and leases of goods.

Section 4 of the Clayton Act—A section which provides that anyone injured in his or her business or property by the defendant’s violation of any federal antitrust law (except the Federal Trade Commission Act) may bring a private civil action and recover from the defendant treble damages plus reasonable costs and attorneys’ fees.

Section 5 of the Federal Trade Commission Act—A section that prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce.

Section 7 of the Clayton Act—A section which provides that it is unlawful for a person or business to acquire the stock or assets of another “where in any line of commerce or in any activity affecting commerce in any section of the country, the effect of such acquisition may be substantially to lessen competition, or to tend to create a monopoly.”

Section 16 of the Clayton Act—Permits the government or a private plaintiff to obtain an injunction against anticompetitive behavior that violates antitrust laws.

Sherman Antitrust Act (Sherman Act)—A federal statute enacted in 1890 that makes certain restraints of trade and monopolistic acts illegal.

Small company doctrine—The courts have permitted two or more small companies to merge without liability under Section 7 of the Clayton Act if the merger allows them to compete more effectively with a large company.

Standard Oil Company of New Jersey v. United States—A landmark case in which the U.S. Supreme Court adopted the “rule of reason” standard for analyzing Section 1 (of the Sherman Act) cases.

State action exemption—Business activities that are mandated by state law are exempt from federal antitrust laws.

State antitrust laws—Used to attack anticompetitive activity that occurs in intrastate commerce.

Statutory exemptions—Exemptions from antitrust laws that are expressly provided in statutes enacted by Congress.

Treble damages—Triple the amount of the actual damages.

Tying arrangement—A restraint of trade where a seller refuses to sell one product to a customer unless the customer agrees to purchase a second product from the seller.

Unfair advantage theory—A theory that holds that a merger may not give the acquiring firm an unfair advantage over its competitors in finance, marketing, or expertise.

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Unfair methods of competition and unfair or deceptive acts or practices—Section 5 of the Federal Trade Commission Act prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce.

Unilateral refusal to deal (Colgate doctrine)—The choice by one party not to deal with another party. This does not violate Section 1 of the Sherman Act because there is no concerted action.

Unreasonable restraint of trade—According to the “rule of reason” standard adopted by the U.S. Supreme Court in Standard Oil Company of New Jersey v. United States, only unreasonable restraints of trade violate Section 1 of the Sherman Act. In determining whether a restraint of trade is unreasonable, the rule of reason standard evaluates the proand anticompetitive effects of the challenged restraint, the competitive structure of the industry, the firm’s market share and power, the history and duration of the restraint, and other relevant factors.

Vertical merger—A merger that integrates the operations of a supplier and a customer.

Vertical restraint of trade—A restraint of trade that occurs when two or more parties on different levels of distribution enter into a contract, combination, or conspiracy to restrain trade.

Willful act of monopolizing—Section 2 of the Sherman Act outlaws the willful act of monopolizing, not monopolies. Possession of monopoly power without the willful act of monopolizing does not violation Section 2.

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Chapter 23 Consumer Protection and Product Safety

Why must the buyer beware?

I. Teacher to Teacher Dialogue Consumer law issues include those of contracts (including UCC sales), torts, crimes, and product liability, often acting as a backup to the failures and shortcomings of those other areas of the law.

All of them provide some measure of consumer protection, yet none stand alone as being complete. They are interdependent and, as such, students must be aware of the big picture of consumer protection.

This chapter covers the four major sets of venues within a quadripartite of remedies available to a wronged or injured consumer. First, there is criminal law. Victims of consumer fraud and similar offenses have always been able to seek state-supported sanctions against wrongdoers.

This venue may provide some ephemeral satisfaction for the victim and may even, at least temporarily, protect society from further harm. But criminal law does not truly make the victim whole. As a matter of fact, most of the miscreants convicted of consumer fraud are also judgment proof (i.e., they have no assets from which civil judgments can be satisfied.)

The second area of consumer protection is found in tort law and the permutations of intentional tort, negligence tort, and strict liability. These remedies can and do provide meaningful substance to civil correction of wrongdoing where the defendant is found to have some financial means. As seen in the prior discussions of these areas, tort law, and products liability specifically, are ripe with controversy and a great deal of uncertainty in today’s legal environment. The major drawback to both the criminal law and tort law methods of consumer protection is that they represent after-the-fact remedies for harm already done. They are reactive remedies as opposed to proactive forms of prevention of harm. It has been argued that large civil judgments act as societal signals that are designed to discourage repetition of undesirable behavior.

The third side to our quadrilateral picture is found in contract. Contract law has the advantage of providing the consumer with the opportunity to anticipate any problems before they befall him or her. This notion is traditionally found in the doctrine of caveat emptor, which courts of another age used with cavalier abandon. Both the common law of contracts and its progeny, the Uniform Commercial Code, have come a long way from the “bad old days” of “Let the buyer beware.”

In spite of all this progress in the areas of crime, torts, and contracts, the gap between consumer harm and consumer protection continues to remain unfilled. Legislators at all levels of government have sought to help fill this void with a number of consumer protections measures.

These measures can, and often do, have a prophylactic effect on many potential harms to the consumer. Unfortunately, another hallmark of many of these measures is that they are the end product of a trail of harm that has reached a crisis or disastrous level. Consider how long it took to take certain dangerous prescription drugs or unsafe toys off the market. Where these laws do provide a measure of safety, some consumer comfort may be found in “at least better late than never.” Protection from harm has come a long way, but there is still no light at the end of the tunnel.

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II. Chapter Objectives 1. Describe government regulation of meat, poultry, and egg products by the U.S. Department of Agriculture.

2. Describe government regulation of foods, drugs, cosmetics, and medicinal devices by the Consumer Protection Agency.

3. Describe federal laws that regulate product safety.

4. Describe federal laws that regulate automobile, vehicle, bus, and motorcycle safety.

5. Identify and describe unfair and deceptive business practices.

6. List and describe laws that protect debtor’s rights.

7. Describe state consumer protection laws.

III. Key Question Checklist  What consumer concern is at issue—public health, product safety, services, trade practices, or a combination of two or more of these?  What consumer protection laws cover the issue?  How should the consumer protection law(s) concerned protect the consumer?  Describe the Consumer Financial Protection Bureau (CFPB).

IV. Chapter Outline Introduction to Consumer Protection and Product Safety – The principle of caveat emptor (“let the buyer beware”) led to abusive practices by businesses that sold adulterated food products and other unsafe products. In response, federal and state governments have enacted a variety of statutes that regulate the safety of food and other products. These laws are collectively referred to as consumer protection laws.

Food Safety – The safety of food is an important concern in the United States and worldwide. In the United States, the U.S. Department of Agriculture (USDA) is the federal administrative agency that is responsible primarily for regulating meat, poultry, and other food products.

Federal Court Case Case 23.1 Adulterated Food: United States v. LaGrou Distribution Systems, Incorporated Facts: LaGrou Distributions Systems, Incorporated (LaGrou) operated a cold storage food warehouse and distribution center. More than 2 million pounds of food went into and out of the warehouse each day. LaGrou had a rodent problem of which the manager of the warehouse and the president of LaGrou were aware. U.S. Department of Agriculture (USDA) inspectors discovered the rat infestation and contaminated meat. The USDA ordered the warehouse shut down, and the U.S. government brought charges against LaGrou for violating federal food safety laws. The U.S. district court ordered LaGrou to pay restitution of $8.2 million to customers who lost product and to pay a $2 million fine. In addition, it sentenced LaGrou to a five-year term of probation. LaGrou appealed.

Issue: Has LaGrou knowingly engaged in the improper storage of meat, poultry, and other food products, in violation of federal food safety laws?

Decision: The U.S. court of appeals upheld the U.S. district court’s finding that LaGrou had knowingly engaged in the improper storage of meat, poultry, and other food products in violation of federal food safety laws. The court of appeals affirmed the judgment of the district court, except that it reduced the fine from $2 million to $1.5 million.

Reason: LaGrou’s president, managers, and several employees were aware of the unsanitary conditions in the Pershing Road warehouse.

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Ethics Questions: LaGrou management knowingly engaged in the improper storage of food products. The facts in this case were egregious. Arguably, the penalties imposed on LaGrou were not sufficient in light of the shocking nature of the company’s wrongdoing.

Food, Drugs, and Cosmetics Safety – The Food, Drug, and Cosmetic Act (FDCA or FDC Act) is the federal statute that regulates the safety of food, drugs, cosmetics, and medicinal devices.

Landmark Law: Food, Drug, and Cosmetic Act The Food, Drug, and Cosmetic Act (FDCA or FDC Act) established the Food and Drug Administration (FDA) to regulate the testing, manufacture, distribution, and sale of foodstuff, drugs, cosmetics, and medicinal devices. The FDA is empowered to enforce the act, and requires most food additives, drugs, and medicinal devices to receive approval before entering the market.

The FDA is a federal administrative agency with legislative, executive, and judicial powers.

Regulation of Food – The FDCA prohibits the sale or shipment of adulterated food. It also prohibits false and misleading labeling of food products.

Adulterated Food – The FDCA prohibits the shipment, distribution, or sale of adulterated food.

Food is deemed adulterated if: (1) It consists in whole or in part of any “filthy, putrid, or decomposed substance or if it is otherwise “unfit for food”; (2) It has been prepared, packed, or held under unsanitary conditions; (3) It contains an unsafe food additive, color additive, animal drug, or pesticide chemical residue; (4) It contains any poisonous or deleterious substance which may render the food injurious to health; or (5) Its container is composed of any poisonous or deleterious substance which may render the food injurious to health.

It is unlawful to alter food by adding a substance to increase the food’s bulk or weight, to reduce its quality or strength, or make it appear more valuable than it is. This is called economic adulteration.

Food does not have to be entirely pure to be distributed or sold; it only must be unadulterated.

False and Misleading Labeling or Packaging – The FDCA prohibits false and misleading labeling or packaging of food products, dietary supplements, and vitamins and minerals. A manufacturer may be held liable for deceptive or misleading labeling or packaging.

Food Labeling – The Nutrition Labeling and Education Act (NLEA) of 1990 requires food manufacturers and processors to provide nutritional information on some 20,000 food items and prohibits them from making unsubstantiated health claims. Meat, poultry, and eggs are exempt from the act because they are regulated by the USDA. Contemporary Environment: Nutrition Facts Label After several decades of usage of the originally required labels, the FDA decided that the labels should be updated to reflect new scientific data and consumers’ usage of food products. In 2016, the FDA announced a new Nutrition Facts Label, requiring the disclosure of new relevant nutritional information that is more visible to consumers. The new label will make it easier for consumers to make informed food choices. Some of the changes include: (1) Serving size—Serving size must now be based on amounts of the food and beverages that people actually consume in one sitting;

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(2) List of fats—The label will continue to require “Total Fat,” “Saturated Fat,” and “Trans Fat” to be disclosed, but “Calories from Fat” is being removed because the type of fat is more important than the total amount; (3) Added sugars—Because of the link between obesity and excess sugar consumption, the regulation requires that a new item, “Added sugars,” be disclosed on the label, stated both in grams and as a percent of Daily Value; and (4) Grams and daily value—All items must be listed in grams and in percent of Daily Value.

Ethics: Restaurants Required to Disclose Calories of Food Items The FDA has adopted a Menu Labeling Rule that requires restaurants and retail food establishments with 20 or more locations to disclose calorie counts of their food items and supply information on how many calories a healthy person should eat.

Regulation of Drugs – The FDA had the power to regulate the testing, manufacture, distribution, and sale of drugs. Under the Drug Amendment to the FDCA (1962), the FDA has the power to license new drugs and has devised a procedure for application and testing of new medicines, which might eventually lead to approval for distribution and sale.

Regulation of Cosmetics – Cosmetics include any substances and preparations for cleansing, altering appearance of, or promoting the attractiveness of an individual, and are regulated by the FDA. The FDA also requires labeling of all cosmetic products.

Regulation of Medicinal Devices – In accordance with the Medicinal Device Amendment to the Food, Drug, and Cosmetic Act, the FDA also regulates and requires exact labeling for all medicinal devices.

Critical Legal Thinking: Family Smoking Prevention and Tobacco Control Act This act gives the FDA the authority to regulate the tobacco industry. The act puts in place specific restrictions on marketing tobacco products to kids.

Product Safety – The Consumer Product Safety Act (CPSA) established an independent federal regulatory agency known as the Consumer Product Safety Commission (CPSC), which adopts rules and regulations, conducts research on consumer products, and collects data regarding injuries. The CPSC issues product safety standards for consumer products, and can force manufacturers to recall, repair, or replace products that are deemed imminently hazardous. As an administrative agency, the CPSC can seek injunctions and bring lawsuits, seeking both civil and criminal penalties. Private parties can also sue for an injunction under the act.

Automobile and Vehicle Safety – The National Traffic and Motor Vehicle Safety Act is a federal statute that regulates the safety of automobiles, SUVs, vans, trucks, electric-powered vehicles, self-driving vehicles, school buses, and motorcycles. The act created the National Highway Traffic Safety Administration (NHTSA), a federal administrative agency which is part of the U.S. Department of Transportation, to administer the act.

Contemporary Environment: Federal Motor Vehicle Safety Standards (FMVSS) To reduce the number of fatalities and injuries caused by automobiles and other vehicles, the NHTSA has adopted safety regulations called the Federal Motor Vehicle Safety Standards (FMVSS). The standards are divided into three categories: (1) crash avoidance; (2) crashworthiness; and (3) post-crash survivability.

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Unfair and Deceptive Practices – The Federal Trade Commission Act (FTC Act) of 1914 prohibits unfair and deceptive trade practices. The Federal Trade Commission (FTC), a federal administrative agency, was established to promulgate rules and regulations under this act, and to take all necessary actions to protect the general public and obtain compensation on their behalf for violations. Section 5 of the FTC Act prohibits unfair methods of competition and unfair or deceptive acts or practices, and has been used extensively to regulate business conduct. The FTC may take administrative actions like ordering a cease-and-desist order or sue in either state or federal court.

False and Deceptive Advertising – Advertising is deemed to be false and deceptive if it contains misinformation or omits material information that is likely to deceive a reasonable consumer or makes unsubstantiated claims. Statements of opinion and sales talk are not considered false or deceptive.

Federal Court Case Case 23.2 Deceptive Advertising: Federal Trade Commission v. Bronson Partners, LLC Facts: Bronson Partners, LLC, Martin Howard, H & H Marketing, and Sandra Howard (collectively Bronson) advertised and sold two purportedly miraculous weight loss products.

Bronson advertised that its Chinese Diet Tea “SHEDS POUND ADTER POUND OF FAT— FAST!” Bronson’s advertisements claimed the tea “eliminates an amazing 91% of absorbed sugars,” “prevents 83% of fat absorption,” and “doubles your metabolic rate to burn calories fast.” Bronson advertised its Bio-Slim Patch would achieve “LASTING weight loss.” The advertisements promised that by “carrying on with your normal lifestyle” and wearing the patch, “repulsive, excess ugly fatty tissue will disappear at a spectacular rate.” The claims were bogus.

The Federal Trade Commission (FTC) sued Bronson for engaging in deceptive advertising in violation of the Federal Trade Commission Act (FTC Act). The U.S. district court held that Bronson had engaged in false advertising. The court ordered Bronson to pay $1,942,325 in monetary damages, which is the disgorgement of the revenues earned from the sales of the tea and patch and entered a permanent injunction against Bronson engaging in false advertising.

Issue: Did Bronson engage in false advertising that warranted the assessment of monetary damages and the imposition of a permanent injunction?

Decision: The U.S. court of appeals upheld the district court’s finding of false advertising, the imposition of a permanent injunction, and the disgorgement of profits.

Reasoning: The district court properly assessed Bronson’s unjust gains as $1,942,325, the amount Bronson received from the sales of the Chinese Diet Tea and the Bio-Slim Patch.

Ethics Questions: Unfair and deceptive advertising is closely regulated by the Federal Trade Commission, as such advertising has the tendency or likelihood to mislead consumers and prevents consumers from making reasoned purchase decisions.

Ethics: False Advertising by Juice Producer POM Wonderful, LLC produces, markets, and sells pomegranate-based products, including drinks and pills. POM products are contained in distinctively designed bottles. In a series of advertisements, POM touted that daily consumption if its products could treat, prevent, or reduce the risk of various ailments, including heart disease, prostate cancer, and erectile dysfunction.

The Federal Trade Commission (FTC), a federal administrative agency, filed an administrative complaint alleging that POM had made false, misleading, and unsubstantiated representations in violation of the Federal Trade Commission Act (FTC Act). The FTC complaint alleged that POM’s advertisements mischaracterized the evidence concerning the health benefits of POM’s products.

The FTC found that 19 of POM’s advertisements and promotional items made false and misleading claims, held that POM had violated the FTC Act, and ordered it to cease and desist 267 .

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from making further misleading and inadequately supported claims about the health benefits of POM products. The FTC decision required that POM gain the support of randomized, controlled human clinical trial studies before claiming a causal relationship between consumption of POM products and the treatment or prevention of any diseases. The defendants appealed.

The U.S. court of appeals upheld the finding of liability, stating “The FTC Act proscribes—and the First Amendment does not protect—deceptive and misleading advertisements.” POM Wonderful, Inc. v. Federal Trade Commission, 777 F.3d 478, 2015 U.S. App. Lexis 1489 (United States Court of Appeals for the District of Columbia, 2015) Contemporary Environment: Do-Not-Call Registry The Do-Not-Call Implementation Act, a federal statute, requires the Federal Trade Commission (FTC) to create and administer the National Do-Not-Call Registry. Consumers can place their telephone numbers on this registry and free themselves from most unsolicited telemarketing and commercial telephone calls.

When a person registers a phone, it is recorded in the Do-Not-Call Registry the next day.

Telemarketers and other businesses then have 31 days to remove the customer’s phone number from their sales call list and cease calling the number. Registration of a telephone on the Do-NotCall Registry is permanent.

A robocall is a phone call that is made by a computerized autodialer that features a pre-recorded message. The Federal Communications Commission (FCC) adopted a rule that prohibits any person or organization, including charities and political parties and politicians, from making robocalls to cell phones unless the recipient has given prior consent. The FCC rule applies whether the cell phone has been listed on the Do-Not-Call Registry or not.

Consumer Financial Protection – Consumer financial protection laws are related to the extension and collection of credit.

Consumer Financial Protection Bureau – In 2010, the U.S. Congress created a new federal government agency called the Consumer Financial Protection Bureau (CFPB). The CFPB has authority to prohibit unfair, deceptive, or abusive acts or practices regarding consumer financial products and services.

Landmark Law: Truth-in-Lending Act The Truth-in-Lending Act (TILA) requires creditors who regularly extend or arrange credit for consumers to make certain disclosures when engaging in consumer transactions.

Regulation Z, an administrative agency regulation, sets forth detailed rules for compliance with the TILA. This regulation requires that creditors disclose specific items to the consumer-debtor, including the cash price of a product, the down payment and trade-in allowance, any unpaid cash price, finance charges, the APR, and all other charges. The total amount to be financed must be listed, the date finance charges start to accrue, and the dates of payments. A description of any security interest and penalties, including prepayment penalties, must be included.

Consumer Leasing Act – The Consumer Leasing Act (CLA) is a federal statute that extends the TILA’s coverage to lease terms in consumer leases.

Fair Credit Billing Act – The act requires that creditors promptly acknowledge in writing consumer billing complaints and investigate billing errors, and protects the consumer’s credit standing until the investigation is completed.

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Ethics: Credit CARD Act Credit card companies, including banks and other issuers of credit cards, have long engaged in unfair, abusive, deceptive, and unethical practices that took advantage of consumer-debtors. This changed when Congress enacted the Credit Card Accountability Responsibility and Disclosure Act of 2009, more commonly referred to as the Credit CARD Act. Among other mandates, the Credit CARD Act requires that the terms of a credit card agreement be written in plain English and in no less than 12-point font. Credit cards cannot be issued to individuals under the age of 21 unless they have a co-signer or they can prove they have the means to pay credit card expenses.

The Credit Card Act also prohibits the universal default rule from being applied retroactively to existing balances that cardholders have on their credit cards.

The Credit CARD Act does not limit how high an interest rate can be charged on a credit card, and the act does not apply to commercial or business credit cards.

Fair Credit Reporting Act – This is a federal statute that protects a consumer who is the subject of a credit report by setting rules for credit bureaus to follow and permitting consumers to obtain information from credit reporting businesses.

Fair and Accurate Credit Transactions Act – This act gives consumers the right to obtain one free credit report once every 12 months from the three nationwide credit reporting agencies (Equifax, Experian, and TransUnion). Consumers may purchase, for a reasonable fee, their credit score and how the credit score is calculated. The act permits consumers to place fraud alerts on their credit files.

Fair Debt Collection Practices Act – This law protects consumer-debtors from abusive, deceptive, and unfair practices used by debt collectors. A debt collector is not allowed to contact a debtor: (1) At any inconvenient time (generally, before 8 a.m. or after 9 p.m.); (2) At inconvenient places, such as at a place of worship or social events; (3) At the debtor’s place of employment, if the debtor objects to such contact; (4) If the debtor is represented by an attorney; or (5) If the debtor gives a written notice to the debt collector that he or she refuses to pay the debt or does not want the debt collector to contact him or her again.

Equal Credit Opportunity Act – The Equal Credit Opportunity Act (ECOA) prohibits discrimination in the extension of credit based on sex, marital status, race, color, national origin, religion, age, or receipt of income from public assistance programs.

Fair Credit and Charge Card Disclosure Act – This act requires disclosures to consumers concerning credit card terms, adds transparency to the creditor-debtor relationship, and eliminates many of the abusive practices of credit card issuers.

State Consumer Protection Laws – Many states have enacted various consumer protection laws that prohibit fraudulent and deceptive and unfair trade practices that harm consumers. Some local governments, such as cities and towns, have also enacted local consumer protection laws that regulate the safety of restaurant food, prohibit deceptive and false advertising, and the like.

Information Technology: Security Breach Notification Laws All 50 states have enacted security breach notification laws, also called data breach notification laws. These laws require private and governmental entities that have been subject to a data breach to notify customers or other affected parties of the security breach that their personal information has been obtained by an unauthorized party.

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Entities that suffer a data security breach are usually only subject to civil liability if they (1) have failed to implement steps that are required by law or that are reasonable in the circumstances to protect private information from being stolen, or (2) have not complied with data breach notification laws or taken reasonable post-breach actions to remedy the situation or mitigate the harm caused by the breach.

V. Key Terms and Concepts  Adulterated food—Food is deemed adulterated if it consists in whole or in part of any “filthy, putrid, or decomposed substance” or if it is otherwise “unfit for food.”  Annual percentage rate (APR)—Regulation Z requires the creditor to disclose the annual percentage rate (APR) of the finance charges.  Caveat emptor—“Let the buyer beware,” the traditional guideline of sales transactions.  Consumer credit—Credit extended to natural persons for personal, family, or household purposes.  Consumer financial protection—These laws cover the extension and collection of credit.  Consumer Financial Protection Bureau (CFPB)—A federal administrative agency that is responsible for enforcing federal consumer financial protection statutes.  Consumer Leasing Act (CLA)—A federal statute that extends the TILA’s coverage to lease terms in consumer leases.  Consumer Product Safety Act (CPSA)—A federal statute that regulates potentially dangerous consumer products and created the Consumer Product Safety Commission.  Consumer Product Safety Commission (CPSC)—An independent federal regulatory agency empowered to (1) adopt rules and regulations to interpret and enforce the Consumer Product Safety Act, (2) conduct research on safety, and (3) collect data regarding injuries.  Consumer protection laws—Federal and state statutes and regulations that promote product safety and prohibit abusive, unfair, and deceptive business practices.  Credit Card Accountability, Responsibility, and Disclosure Act of 2009 (Credit CARD Act)—A federal statute that requires disclosures to consumers concerning credit card terms, adds transparency to the creditor–debtor relationship, and eliminates many of the abusive practices of credit card issuers.  Credit report—Information about a person’s credit history that can be secured from a credit bureau.  Creditor (lender)—The lender in a consumer credit transaction. The lender typically has greater leverage than the borrower in a consumer credit transaction.  Debt collectors—Agents who collects debts for other parties.  Debtor (borrower)—The borrower in a consumer credit transaction. The borrower typically has less leverage than the lender in a consumer credit transaction.  Do-Not-Call Implementation Act—A federal law enacted by the U.S. Congress in 2003, which required the Federal Trade Commission (FTC) to create and administer the National Do-Not-Call Registry.  Drug Amendment to the FDCA—A federal law that gives the FDA broad powers to license new drugs in the United States.  Economic adulteration—It is unlawful to alter food by adding a substance to increase the food’s bulk or weight, to reduce its quality or strength, or make it appear more valuable than it is. This is called economic adulteration.  Egg Products Inspection Act—A federal statute that requires the U.S. Department of Agriculture (USDA) to inspect plants that produce shell eggs and egg products for human consumption.

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Equal Credit Opportunity Act (ECOA)—A federal statute that prohibits discrimination in the extension of credit based on sex, marital status, race, color, national origin, religion, age, or receipt of income from public assistance programs.

Fair and Accurate Credit Transactions Act—Gives consumers the right to obtain one free credit report each year from the credit reporting agencies.

Fair Credit and Charge Card Disclosure Act—An amendment to the TILA that requires disclosure of certain credit terms on credit- and charge-card solicitations and applications.

Fair Credit Billing Act (FCBA)—A federal statute that requires that creditors promptly acknowledge in writing consumer billing complaints and investigate billing errors, and affords consumer-debtors other protection during billing disputes.

Fair Credit Reporting Act (FCRA)—An amendment to the TILA that protects customers who are subjects of a credit report by setting out guidelines for credit bureaus.

Fair Debt Collection Practices Act (FDCPA)—An act enacted in 1977 that protects consumer-debtors from abusive, deceptive, and unfair practices used by debt collectors.

False and deceptive advertising—Advertising is false and deceptive under Section 5 of the FTC Act if it (1) contains misinformation or omits important information that is likely to mislead a “reasonable consumer,” or (2) makes an unsubstantiated claim (e.g., “This product is 33 percent better than our competitor’s”).

False and misleading labeling or packaging—Labels on food products, dietary supplements, vitamins, and minerals, and the packaging of such items, that is misleading or deceptive. The Food, Drug, and Cosmetic Act prohibits such labeling or packaging.

Family Smoking Prevention and Tobacco Control Act (Tobacco Control Act)—This act puts in place specific restrictions on marketing tobacco products to kids.

Federal Meat Inspection Acts—Federal statutes that require the U.S. Department of Agriculture (USDA) to inspect all cattle, sheep, swine, goats, and horses to be slaughtered and processed into products for human consumption.

Federal Motor Vehicle Safety Standards (FMVSS)—To reduce the number of fatalities and injuries caused by automobiles and other vehicles, the National Highway Traffic Safety Administration (NHTSA) has adopted safety regulations divided into the following three categories: (1) crash avoidance; (2) crashworthiness; and (3) post-crash survivability.

Federal Trade Commission (FTC)—The federal administrative agency empowered to enforce the Federal Trade Commission Act and other federal consumer protection statutes.

Federal Trade Commission Act (FTC Act)—The Federal Trade Commission Act (FTC Act) was enacted in 1914.

Food and Drug Administration (FDA)—A federal administrative agency that administers and enforces the federal Food, Drug, and Cosmetic Act (FDCA) and other federal consumer protection laws.

Food, Drug, and Cosmetic Act (FDCA or FDC Act)—A federal statute enacted in 1938 that provides the basis for the regulation of much of the testing, manufacture, distribution, and sale of foods, drugs, cosmetics, and medicinal products.

Local consumer protection laws—Some local governments, such as cities and towns, have enacted local consumer protection laws that regulate the safety of restaurant food, prohibit deceptive and false advertising, and the like.

Medicinal Device Amendment—In 1976, the U.S. Congress enacted the Medicinal Device Amendment to the Food, Drug, and Cosmetic Act (FDCA). This amendment gives the Food and Drug Administration (FDA) authority to regulate medicinal devices such as heart pacemakers, kidney dialysis machines, defibrillators, surgical equipment, and other diagnostic, therapeutic, and health devices.

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Menu Labeling Rule—The Food and Drug Administration (FDA) has adopted a Menu Labeling Rule that requires restaurants and retail food establishments with 20 or more locations to disclose calorie counts of their food items and supply information on how many calories a healthy person should eat in a day.

National Do-Not-Call Registry—A register created by federal law where consumers can add their phone numbers and free themselves from most unsolicited telemarketing and commercial telephone calls.

National Highway Traffic Safety Administration (NHTSA)—NHTSA is a federal administrative agency that administers and issues regulations to enforce the National Traffic and Motor Vehicle Safety Act. National Traffic and Motor Vehicle Safety Act—A federal statute that regulates the safety of automobiles, SUVs, vans, trucks, electric-powered vehicles, school buses, and motorcycles.

Nutrition Facts Label—A label required by federal law that must appear on certain food and beverage items that discloses nutrition information that is easily visible to consumers.

Nutrition Labeling and Education Act (NLEA)—An act that requires food manufacturers and processors to provide nutritional information on some 20,000 food items and prohibits them from making unsubstantiated health claims.

Poultry Products Inspection Acts—Federal statutes that require the U.S. Department of Agriculture (USDA) to inspect any domesticated birds intended for human food, including chickens, turkeys, ducks, geese, squabs, and other birds.

Product safety standards—Because the CPSC regulates potentially dangerous consumer products, it issues product safety standards for consumer products that pose unreasonable risk of injury.

Regulation Z—A regulation that sets forth detailed rules for compliance with the TILA. Robocall—A robocall is a phone call that is made by a computerized autodialer that features a pre-recorded message. Robocalls are restricted by the Federal Communications Commission and the Do-Not-Call Registry.

Section 5 of the Federal Trade Commission Act—Prohibits unfair and deceptive practices.

Security breach notification laws (data breach notification laws)—State laws that require private and governmental entities that have been subject to a data breach to notify customers or other affected parties of the security breach.

State consumer protection laws—Many states have enacted various state consumer protection laws that prohibit fraudulent and deceptive and unfair trade practices that harm consumers.

Truth-in-Lending Act—A federal statute that requires creditors to make certain disclosures to debtors in consumer transactions.

Unfair or deceptive acts or practices—Business acts or practices that have the tendency or likelihood to mislead consumers. Section 5 of the Federal Trade Commission Act prohibits unfair or deceptive acts or practices.

Unfair methods of competition—Section 5 of the Federal Trade Commission Act prohibits unfair methods of competition.

Universal default rule—A practice used extensively by credit card companies prior to the enactment of the Credit CARD Act of 2009. Allowed all credit card companies with whom a cardholder had a credit card to raise the interest rate on his or her card, including on the existing balances, if the cardholder was late in making a payment to any credit card company. The Credit CARD Act does not eliminate the universal default rule; it allows credit card companies to apply the rule only to future balances.

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U.S. Department of Agriculture (USDA)—A federal administrative agency that is responsible for regulating the safety of meat, poultry, and other food products.

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Chapter 24 Environmental Protection

What do we do with the waste?

I. Teacher to Teacher Dialogue Some topics are easier to teach than others. When dealing with subjects like negotiable instruments, students appreciate the necessity of learning the ins and outs of the system, but they do not like it. The same goes for topics involving taxation. In both scenarios, the subject matter is seen as a necessary evil or a cost of getting by in society. Environmental law is different. Most students are keenly aware of the environmental issues found in the news every day. They either want to know more about what our government is doing to protect its citizens from harm, or they are looking for ways to balance these needs against those of business.

I like to focus on one illustrative issue from each area of air, land, and water. For example, in Denver, the “Brown Cloud” continues to be one of our most vexing problems, so I spend a fair amount of time talking about the measures being taken at the local level in addressing that issue.

The more you can localize the issues to your own area, the more your students will become engaged in the learning process. In addition, the materials on Superfund give you an opportunity to examine how government can take a good idea and mess it up. Out of every dollar generated to pay for Superfund cleanups, over 50 percent is spent on court costs. A charity is considered inefficient if it spends over five percent of its revenues on overhead. Is it any wonder that environmental law continues to be one of the fastest growing specializations chosen by today’s law students?

The range of topics covered under the auspices of environmental law is immense. I like to have my students each select a different incident, write a brief paper, and do a short presentation on it. Many of the issues they identify are fascinating, and allow you to engage the students in a discussion on balancing the needs of business and those of the environment. How do we as Americans explain our attitudes regarding the environment, when we still demand inefficient power sources and often bend hard-fought-for rules to allow developers to proceed? We have hesitated to join international accords, yet scream that over a hundred species of life disappear every day. Perhaps Orwell had it right.

II. Chapter Objectives 1. Describe environmental protection and identify when an environmental impact statement must be completed.

2. Define an environmental impact statement and identify when the federal government is required to prepare one prior to enacting laws.

3. Describe the Clean Air Act and national ambient air quality standards.

4. Describe the Clean Water Act and effluent water standards.

5. Explain how environmental laws regulate the use of toxic substances and the disposal of hazardous wastes.

6. Describe how the Endangered Species Act protects endangered and threatened species and their habitats.

7. Describe state environmental protection laws.

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III. Key Question Checklist  What are the basic powers of the Environmental Protection Agency?  What statutes govern air or radiation, water resources, hazardous waste, wildlife preservation, and noise pollution?  How does the Endangered Species Act protect threatened species?  What statutes govern the disposal of toxic substances and hazardous wastes?

IV. Chapter Outline Introduction to Environmental Protection – Federal and state governments have enacted environmental protection laws to contain the levels of pollution and to clean up hazardous waste sites. Many laws provide both civil and criminal penalties.

Environmental Protection – In the 1970s, the federal government began enacting statutes to protect the nation’s resources from pollution, sought to protect wildlife, and to regulate hazardous wastes.

Environmental Protection Agency – The Environmental Protection Agency (EPA) is a federal agency that promulgates rules and regulations concerning the implementation and enforcement of federal environmental protection laws. It can hold hearings, issue decisions, and force remedies, including fines.

Environmental Impact Statement – The National Environmental Policy Act (NEPA) mandates that the federal government consider the “adverse impact” of all legislation on our environment.

NEPA requires an environmental impact statement (EIS) for every major federal action. The EIS will include enough information to determine the feasibility of the project, describing the affected environment, describing the impact on the environment, identifying all alternatives, listing the resources needed, and setting forth a cost-benefit analysis. The EIS is made available to the public for review and comment before the EPA approves any project.

Air Pollution – The Clean Air Act was enacted in 1963 to assist states in dealing with air pollution. The act has been amended several times, most recently by the Clean Air Act Amendments of 1990. The Clean Air Act, as amended, provides comprehensive regulation of air quality in the United States.

Stationary Sources of Air Pollution – Substantial amounts of air pollution are emitted by stationary sources of air pollution (for example, industrial plants, oil refineries, and public utilities). The Clean Air Act requires states to identify major stationary sources and develop plans to reduce air pollution from these sources.

Mobile Sources of Air Pollution – Automobiles and other vehicle emissions are major sources of air pollution in the United States. In an effort to control emissions from these mobile sources of air pollution, the Clean Air Act requires air pollution controls to be installed on motor vehicles.

Emission standards have been set for automobiles, trucks, buses, motorcycles, and airplanes.

National Ambient Air Quality Standards – The EPA establishes national ambient air quality standards (NAAQS) for a number of pollutants. These standards are set at two different levels: primary (to protect human beings) and secondary (to protect vegetation, matter, climate, visibility, and economic values.) Each state is responsible for the enforcement of these standards, and is required to create a state implementation plan (SIP) to show how the state will meet the

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standards. Each state is divided into air quality control regions (AQCRs), which are monitored for compliance.

U.S. Supreme Court Case Case 24.1 Air Pollution: Michigan v. Environmental Protection Agency Facts: The Clean Air Act directs the Environmental Protection Agency (EPA) to regulate emissions of hazardous air pollutants from power plants if the EPA finds such regulation “appropriate and necessary.” Pursuant to this authority the EPA issued a regulation that would require power plants to spend $9.6 billion per year to prevent certain forms of air pollution. The benefits from this expenditure were $4 to $6 million per year. Thus, the costs to power plants were between 1,600 and 2,400 times as great as the benefits from reduced emissions of hazardous air pollutants. The EPA did not take into account costs of compliance when issuing its regulation.

Business organizations and 23 states challenged the EPA’s refusal to consider cost when deciding to regulate power plants. The U.S. court of appeals upheld the EPA’s decision. The U.S. Supreme Court agreed to hear the appeals of the petitioner business organizations and states.

Issue: Was it reasonable for the EPA to refuse to consider cost when deciding to regulate emissions of power plants?

Decision: The U.S. Supreme Court held that the EPA acted unreasonably when it did not consider cost when it regulated emissions from power plants. The Supreme Court reversed the decision of the U.S. court of appeals and remanded the case for further proceedings.

Reasoning: The phrase “appropriate and necessary” requires at least some attention to cost. The EPA must consider cost, including the cost of compliance, before deciding whether regulation is appropriate and necessary.

Ethics Questions: Students might find it interesting to research how the court determined that the subject emissions regulation would constitute a benefit of only $4 to $6 million per year. How does one truly measure the benefit of preserving and protecting the only environment currently available to humankind?

Nonattainment Areas – Any region that fails to meet the standards is designated as a nonattainment area and classified into one of five categories—marginal, moderate, serious, severe, or extreme—based on the degree to which it exceeds the ozone standard. Deadlines are established for attainment and detailed plans must be drawn and followed. Failure to meet standards may result in the loss of federal highway funds and limitations on new emissions.

Contemporary Environment: Indoor Air Pollution The Environmental Protection Agency (EPA) states that air inside some buildings may be 100 times more polluted than outside air. Doctors increasingly attribute a wide range of symptoms to indoor air pollution, or sick building syndrome. Many office and other buildings have been highly insulated and built with sealed windows and no outside air ducts. As a result, no fresh air enters many workplaces. The lack of air can cause a wide range of health problems.

The other chief cause of sick building syndrome, which may affect as much as one-third of U.S. office buildings, is hazardous chemicals and construction materials. Noxious fumes are omitted from building materials, copy machines, cleaning fluids, and the like.

Sick building syndrome is likely to spawn a flood of litigation.

Water Pollution – The U.S. Congress enacted the Federal Water Pollution Control Act (FWPCA) and its multiple amendments, collectively known as the Clean Water Act. The EPA administers the act and has established water quality standards for different water usages.

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Point Sources of Water Pollution – The EPA has established pollution control standards for point sources of water pollution. Point sources are stationary sources of pollution. Point source dischargers of pollutants are required to maintain monitoring equipment, keep samples of discharges, and keep records.

Federal Court Case Case 24.2 Environmental Pollution: United States v. Maury Facts: The Atlantic States Cast Iron Pipe Company pumped contaminated wastewater into the Delaware River. John Prisque (plant manager), Jeffrey Maury (maintenance superintendent), and Craig Davidson (finishing superintendent) knew of this, actually ordering that the wastewater be handled in such fashion. Prisque also ordered workers to burn drums of waste paint in the plant’s furnace at night, causing chemical air pollution. Prisque, Maury, and Davidson were charged with criminal violations of the Clean Water Act, and the company and Prisque were charged with criminal violations of the Clean Air Act. Individual defendants were charged with lying to investigators. The U.S. district court convicted the defendants. The court sentenced Prisque to 70 months imprisonment, Maury to 30 months imprisonment, and Davison to 6 months imprisonment. The defendants appealed.

Issue: Are the defendants guilty of violating environmental protection statutes?

Decision: The U.S. court of appeals affirmed the judgment of the U.S. district court.

Reason: The defendants were found to have illegally pumped contaminated water into storm drains and, as a result, into the Delaware River, and to have unlawfully burned 50-gallon drums of paint waste in a furnace and emitted the fumes from those activities into the air. The jury found that the defendants engaged in a conspiracy to commit these acts and to impede the resulting federal investigation.

Ethics Questions: The individual defendants clearly did not act ethically in this case. Neither did the employees who carried out the managers’ orders. In terms of punishment, if anything, the defendants should have received even longer prison sentences in this case, especially when one considers the effects their criminal actions had on the state of New Jersey and the people who live there.

Thermal Pollution – The Clean Water Act forbids the discharge of heated water or materials into the waterways because of their effect on the environment. Sources of thermal pollution (for example, electric utility companies and manufacturing plants) are subject to the provisions of the Clean Water Act and regulations adopted by the EPA. Wetlands – In order to fill or dredge wetlands, a permit must first be obtained from the U.S. Army Corps of Engineers (USACE). Wetlands are areas that are inundated or saturated with water and support vegetation and life forms that thrive in saturated soil conditions.

Safe Drinking Water Act – This act authorizes the EPA to establish national primary drinking water standards (setting the minimum quality of water for human consumption). The states are primarily responsible for enforcing the act.

Ocean Pollution – The Marine Protection, Research, and Sanctuaries Act extended environmental protection to the oceans requiring permits to dump wastes into the oceans and establishing marine sanctuaries. The Oil Pollution Act of 1990 requires the oil industry to adopt procedures to allow for a rapid response in the event of an oil spill.

Ethics: BP Oil Spill in the Gulf of Mexico The 2010 Deepwater Horizon oil spill (commonly referred to as the BP oil spill) in the Gulf of Mexico is one of the greatest environmental disasters in U.S. history. The damage caused to the 277 .

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coastline and to the ecosystem will take decades to overcome, and some of the damage will never be repaired. The BP oil spill was the largest in U.S. history, more than 20 times larger than the previous largest oil spill, the Exxon-Valdez oil spill in the waters off the coast of Alaska.

Thousands of civil lawsuits against BP and other potentially responsible parties were filed by individuals and businesses seeking to recover damages caused by the oil spill. BP established a $20 billion trust fund to cover individual compensation claims. Many individual claims have been settled while other claims are still being litigated.

In 2013, BP plead guilty to 11 counts of felony manslaughter and paid $4.5 billion to settle criminal charges. In 2015, the federal government and five affected states—Texas, Louisiana, Mississippi, Alabama, and Florida—announced a $20 billion settlement of claims arising from the incident. The settlement requires BP to engage in a massive cleanup in the Gulf Coase area to restore wildlife, habitat, and water quality. The U.S. district court approved the settlement in 2016. In re: Oil Spill by the Oil Rig “Deepwater Horizon” in the Gulf of Mexico, 2016 U.S. Dist.

Lexis 165001 (United States District Court for the Eastern District of Louisiana, 2016) Toxic Substances and Hazardous Wastes – Toxic substances cause serious diseases, cancers, and health-related injuries to humans, as well as injury and death to animals, birds, fish, and vegetation. These substances are contained in the chemicals we use on a regular basis in our homes, businesses, industries, and for agricultural pursuits. Additionally, the wastes that are generated by our industries, agricultures, and homes can add to air, water, and land pollution.

Toxic Substances Control – The Toxic Substances Control Act is promulgated by the EPA, which is authorized to identify and establish standards for toxic air pollutants. All new chemicals must be tested to determine their effect on the environment. The EPA is empowered to limit or prohibit the manufacture and sale of these substances, and can force them to be removed from commerce.

Insecticides, Fungicides, and Rodenticides – The federal Insecticide, Fungicide, and Rodenticide Act allows the EPA to regulate any of these chemicals, and forces them to be registered before they can be sold.

Hazardous Waste – Because the disposal of hazardous wastes can cause land pollution, Congress enacted the Resource Conservation and Recovery Act, regulating the disposal. The EPA is charged with regulating the facilities that generate, treat, store, transport, and store these wastes.

Landmark Law: Superfund Superfund is a tort law that imposes strict liability, or liability without fault, and joint and several liability, which means that each individual defendant is legally liable for the entire cleanup no matter how small that defendant’s pollution was relative to all pollution on the site. The EPA can recover the cost of the cleanup from (1) the generator who deposited the wastes, (2) the transporter of the wastes to the site, (3) the owner of the site at the time of the disposal, and (4) the current owner and operator of the site.

Nuclear Waste – Nuclear power plants create radioactive wastes; additionally, accidents, errors, and faulty construction can cause radiation pollution. The Nuclear Regulatory Commission (NRC) licenses the construction and operation of these plants. The EPA sets the standards for the amount of radioactivity in the environment and regulates thermal pollution. The Nuclear Waste Policy Act of 1982 mandates that the federal government develop permanent sites for the disposal of nuclear wastes.

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Endangered Species – The Endangered Species Act empowers the secretary of the interior to designate wildlife as endangered or threatened, and requires the EPA and the Department of Commerce to identify and designate critical habitats for each endangered and threatened species.

These areas have prohibited or severely restricted development. The Endangered Species Act applies both to the government and private parties, and prohibits the “taking” of any endangered species. Taking is defined as an act intended to “harass, harm, pursue, hunt, shoot, wound, kill, trap, capture, or collect” an endangered animal.

Critical Legal Thinking: Should Endangered Species Be Saved?

The TVA is a wholly owned public corporation of the U.S. It operates a series of dams, reservoirs, and water projects that provide electric power, irrigation, and flood control to areas in several southern states. With appropriations from Congress, the TVA began construction of the Tellico Dam on the Little Tennessee River.

Seven years after construction began, a previously unknown species of perch, the snail darter, was found to live in the river downstream from the dam. The snail darter lived nowhere else in the world. The impounding of the water behind the Tellico Dam would destroy the snail darter’s food and oxygen supplies, thus causing an extinction.

The dam was completed, but a Tennessee conservation group filed an action seeking to enjoin the TVA from closing the gates of the dam and impounding the water in the reservoir on the grounds that those actions would violate the Endangered Species Act by causing the extinction of the snail darter. The U.S. district court held in favor of the TVA. The U.S. court of appeals reversed and issued a permanent injunction, halting the operation of the Tellico Cam. The TVA appealed to the U.S. Supreme Court.

The U.S. Supreme Court held that the Endangered Species Act prohibited the impoundment of the Little Tennessee River by the Tellico Dam. The Court affirmed the injunction ordered by the U.S. court of appeals against the operation of the dam.

Eventually, after substantial research and investigation, it was determined that the snail darter could live in another habitat that was found for it. After the snail darter was removed to this new location, the TVA was permitted to close the gates of the Tellico Dam and begin the operation.

Tennessee Valley Authority v. Hill, Secretary of the Interior, 437 U.S. 153, 98 S.Ct. 2279, 1978 U.S. Lexis 33 (Supreme Court of the United States) State Environmental Protection Laws – Most states and local governments have enacted statutes and ordinances protecting the environment. Most states require that an environmental impact statement (EIS) or a report be prepared for any proposed state action. In addition, under their police power to protect the “health, safety, and welfare” of their residents, many states require private industry to prepare EISs for proposed developments.

V. Key Terms and Concepts  Air pollution—Pollution caused by factories, homes, vehicles, and the like that affects the air.  Air quality control regions (AQCRs)—The EPA has divided each state into air quality control regions. Each region is monitored to ensure compliance.  BP oil spill—A 2010 oil spill in the Gulf of Mexico. The spill was caused by a leak in a mobile offshore oil drilling rig called Deepwater Horizon. This was the largest oil spill in U.S. history, more than 20 times larger than the Exxon-Valdez oil spill in the waters off the coast of Alaska.  Clean Air Act—A federal statute that provides comprehensive regulation of air quality in the United States.

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Clean Air Act Amendments—The Clean Air Act was amended in 1970 and 1977 and, most recently, by the Clean Air Act Amendments of 1990.

Clean Water Act—A federal statute that establishes water quality standards and regulates water pollution.

Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or Superfund)—A federal statute that authorizes the federal government to deal with hazardous wastes. The act creates a monetary fund to finance the cleanup of hazardous waste sites.

Endangered Species Act—A federal statute that protects endangered and threatened species of wildlife.

Environmental impact statement (EIS)—A document that must be prepared for any proposed legislation or major federal action that significantly affects the quality of the human environment.

Environmental protection—Protection of the environment, often through federal and/or state government regulation.

Environmental Protection Agency (EPA)—An administrative agency created by the U.S. Congress in 1970 to coordinate the implementation and enforcement of the federal environmental protection laws.

Environmental protection laws—Laws designed to protect the environment. One example is the Clean Water Act. Federal Water Pollution Control Act (FWPCA)—In 1948, Congress enacted the Federal Water Pollution Control Act to regulate water pollution.

Hazardous wastes—Solid waste that may cause or significantly contribute to an increase in mortality or serious illness or pose a hazard to human health or the environment if improperly managed.

Indoor air pollution (sick building syndrome)—Air pollution that occurs inside some buildings.

Insecticide, Fungicide, and Rodenticide Act—A federal statute that requires pesticides, herbicides, fungicides, and rodenticides to be registered with the EPA; the EPA may deny, suspend, or cancel registration.

Land pollution—Pollution of the land that is generally caused by hazardous waste being disposed of in an improper manner.

Marine Protection, Research, and Sanctuaries Act—A federal statute enacted in 1972 that extends environmental protection to the oceans.

Mobile sources of air pollution—Automobile and other vehicle emissions are a major source of air pollution in this country.

National ambient air quality standards (NAAQS)—Standards for certain pollutants set by the EPA that protect (1) human beings (primary level), and (2) vegetation, matter, climate, visibility, and economic values (secondary level).

National Environmental Policy Act (NEPA)—A federal statute which mandates that the federal government consider the adverse impact a federal government action would have on the environment before the action is implemented.

Nonattainment area—A region that does not meet air quality standards.

Nuclear Regulatory Commission (NRC)—A federal agency that licenses the construction and opening of commercial nuclear power plants.

Nuclear Waste Policy Act—A federal statute that says the federal government must select and develop a permanent site for the disposal of nuclear waste.

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Nuclear wastes—Nuclear-powered fuel plants create nuclear wastes that maintain a high level of radioactivity. Radioactivity can cause injury and death to humans and other life, and can also cause severe damage to the environment.

Oil Pollution Act—A federal statute that requires the oil industry to take measures to prevent oil spills and to readily respond to and clean up oil spills.

Point sources of water pollution—Sources of water pollution such as paper mills, manufacturing plants, electric utility plants, and sewage plants.

Radiation pollution—Emissions from radioactive wastes that can cause injury and death to humans and other life and can cause severe damage to the environment.

Resource Conservation and Recovery Act (RCRA)—A federal statute that authorizes the EPA to regulate facilities that generate, treat, store, transport, and dispose of hazardous wastes.

Safe Drinking Water Act—A federal statute enacted in 1974 and amended in 1986 that authorizes the EPA to establish national primary drinking water standards.

State implementation plan (SIP)—Each state is required to prepare a state implementation plan (SIP) that sets out how the state plans to meet the federal standards.

Stationary sources of air pollution—Substantial amounts of air pollution are emitted by stationary sources of air pollution (e.g., industrial plants, oil refineries, public utilities).

Strict liability—Liability without fault.

Thermal pollution—Heated water or material discharged into waterways that upsets the ecological balance and decreases the oxygen content.

Toxic air pollutants—Air pollutants that cause serious illness or death to humans.

Toxic substances—Chemicals used by agriculture, industry, business, mining, and households that cause injury to humans, birds, animals, fish, and vegetation.

Toxic Substances Control Act—A federal statute enacted in 1976 that requires manufacturers and processors to test new chemicals to determine their effect on human health and the environment before the EPA will allow them to be marketed.

U.S. Army Corps of Engineers (USACE)—The U.S. Army Corps of Engineers (USACE) is authorized to enforce this statute and to issue permits for discharge of dredged or fill material into navigable waters and qualified wetlands in the United States.

Water pollution—Pollution of lakes, rivers, oceans, and other bodies of water.

Wetlands—Areas that are inundated or saturated by surface water or ground water that support vegetation typically adapted for life in such conditions.

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Chapter 25 Real Property and Land Use Regulation

What do we really own?

I. Teacher to Teacher Dialogue This chapter tends to be an eye-opener for the students in that, while they already have a basic grasp of real property as tenants, they generally do not have much contact with the law of real estate as it relates to issues of minerals, air rights, co-ownership, and the like. As such, this chapter allows you to broaden their horizons beyond the metes and bounds of what they can immediately see before them.

To introduce students to the law of air rights, it might be useful to describe some of the changes going on in major metropolitan areas. For many years, much valuable land has been used for railroads because of the early development of our nation’s transportation infrastructure.

Chicago had long been considered the original hub of the railway universe. Yet much of that land can and does have additional or alternative uses by way of development of the air rights over the land.

In the mid-1800s, the state of Illinois had granted to the Illinois Central Railroad a grant “in fee simple” of land along the lakefront of Chicago to be used for railroad development. In the late 1960s, the railroad wanted to build a billion dollar development of hotels, office buildings, and shopping malls by selling the air over its railroad tracks. The state of Illinois objected, and Chicago Title had guaranteed the railroad’s title. The Illinois Supreme Court eventually reaffirmed the basic definition of “fee simple absolute” to include air rights (subject to zoning restrictions).

By using such examples, students quickly come to appreciate the importance of real property law in both their business and personal lives.

This chapter is designed to introduce students to the law of real property from two key perspectives: first, ownership and the rights and duties that arise out of the ownership of real property, and second, use of real property and the respective rights and duties that can arise out of that use vis-à-vis others.

Real property represents the largest single outlay most people make in the course of their earning years. Even if they choose to rent, the price of keeping a roof over one’s head will still probably be their biggest expense. Real estate is not only necessary as a matter of physical survival, it is critically important to our economic system because of this large dollar outlay. One of the most basic terms used in the law of real estate is “fee simple absolute.” It connotes the highest form of recognized ownership in real property. It is infinite, with no limitation on inheritability, and does not end upon the happening of any event. Think of fee simple absolute as the whole pie. That pie, in turn, may be sliced and diced into all sorts of smaller morsels.

Another way to look at real estate as a circular object is in the physical shape of the earth. It is round, and each ownership of land is a unique wedge-shaped slice of that round body. The basic parameters of that ownership start with the surface rights as defined by the surveyed metes and bounds in the legal description. In addition to those rights, real estate extends theoretically to the center of the earth in minerals below the surface and in development of air rights. Both these rights are subject to use limitations and the rights of other owners of adjoining properties.

The other interesting aspect of this chapter goes into more detail on forms of co-ownership of property. Most of us, sooner or later, will get involved with co-ownership of property. Anyone 282 .

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who is married is a likely co-owner. Anyone who shares property interests by gift, inheritance, or earnings is likely to be a co-owner. Even if one’s property is entirely his own, he or she will need to know the rules of the co-ownership game for purposes of credit, finance, business planning, and the like. How, when, and where co-ownership rights and duties are created is as important as the basic terms of real property law itself.

II. Chapter Objectives 1. List and describe the different types of real property.

2. Describe the different types of freehold estates and life estate.

3. Identify and describe the different types of concurrent ownership of real property.

4. Identify and describe the different types of future interests in real property.

5. Explain how ownership interests in real property can be transferred.

6. Describe and apply the doctrine of adverse possession.

7. List and describe the different types of easements.

8. Define a landlord-tenant relationship and describe how it is created.

9. List and describe the civil rights and fair housing laws that apply to real estate.

10. Describe zoning laws and how they apply to real property.

11. Describe the government’s power of eminent domain in taking real property.

III. Key Question Checklist  What are the basic physical classifications of real property?  What are the main classifications of legal estates in real property?  What are the forms of co-ownership of real property?  What are nonpossessory interests in real property?  How is real property transferred?  How can you be sure that the title to real property is correct and marketable?  How is a landlord-tenant relationship created?  What are the various types of tenancy?  What are the antidiscrimination laws that apply to real estate?  What is the government’s power of eminent domain?

IV. Chapter Outline Introduction to Real Property and Land Use Regulation – The concept of real property is concerned with the legal rights to the property rather than the physical attributes of the tangible land. Thus, real property includes some items of personal property that are affixed to real property and other rights. Individuals and families rent houses and apartments, professionals and businesses lease office space, small businesses rent stores, and businesses lease commercial and manufacturing facilities. In these situations, a landlord–tenant relationship is created. The parties to a landlord–tenant relationship have certain legal rights and owe duties that are governed by a mixture of real estate and contract law.

Real Property – Real property is the land itself, as well as buildings, vegetation, minerals, and all things permanently affixed to land.

Land and Buildings – Land is the most common form of real property. Landowners usually purchase only the surface rights to land, and may develop and use it as they want, subject to government regulations. Buildings are constructed on real property.

Subsurface Rights – Subsurface rights are rights to the earth located below the surface.

Subsurface rights may be sold separately from surface rights.

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Plant Life and Vegetation – Plant life and vegetation are also considered to be real property.

Sales of land includes the plant life, unless otherwise stated (crops may be harvested separately).

Fixtures – Fixtures are personal property that is so closely associated with real property that it is considered affixed to it, and included with it.

Contemporary Environment: Air Rights Common law and modern law both allow the owner of property to have the right to the air space parcel above his or her property, which may be sold separately.

Estates in Land – An ownership right to possess, use, and enjoy real property is called an estate in land. A freehold estate is an estate in which the owner has a present possessory interest in the real property; that is, the owner may use and enjoy the property as he or she sees fit, subject to applicable government regulation or private restraint. There are three types of freehold estates: (1) fee simple absolute (or fee simple); (2) fee simple defeasible (or qualified fee); and (3) life estate.

Fee Simple Absolute (or Fee Simple) – A fee simple absolute (or fee simple) is a freehold estate that gives the owner the fullest bundle of legal rights that a person can hold in real property.

Fee Simple Defeasible (or Qualified Fee) – A fee simple defeasible (or qualified fee) grants the owner all the incidents of a fee simple absolute except that ownership may be taken away if a specified condition occurs or does not occur.

Life Estate – A life estate is an interest in the land for the life of a person. A life estate may also be measured by the life of a third party, which is called estate pour autre vie. A life estate may be defeasible. Upon the death of the named person, the life estate terminates, and the property reverts to the grantor or the grantor’s estate or other designated person.

Concurrent Ownership – Two or more persons may own a piece of real property. This is called concurrent ownership, or co-ownership. The following forms of co-ownership of real property are recognized: (1) Joint tenancy; (2) Tenancy in common; (3) Tenancy by the entirety; (4) Community property; (5) Condominiums; and (6) Cooperatives.

Joint Tenancy – Two or more parties can own real estate as joint tenants. The most distinguished feature of a joint tenancy is the co-owners’ right of survivorship. Each joint tenant has a right to sell or transfer his or her interest in the property, but such conveyance terminates the joint tenancy.

Tenancy in Common – In this form of concurrent ownership, the interest of a deceased tenant passes to the deceased tenant’s estate and not to the co-tenants. Unless otherwise agreed, a tenant in common can sell, give, devise, or otherwise transfer his or her interest in the property without the consent of the other co-owners.

Tenancy by the Entirety – This form of tenancy can only be used by married couples, and neither spouse may sell or transfer their interest without the other spouse’s consent.

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Contemporary Environment: Community Property Nine states—Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin—recognize the concept of community property. Under these laws, each spouse owns an equal one-half share of the income both spouses earned during the marriage and one-half of the assets acquired by this income during the marriage, regardless of who earns the income. All properties owned prior to the marriage are retained by the person who brought it to the marriage.

In the event of a divorce proceeding, each spouse has a right to one-half of the community property.

Condominium – Condominiums are a common form of ownership in multiple-dwelling buildings. Purchasers of a condominium (1) have title to their individual units, and (2) own the common areas as tenants in common with the other owners. Owners may sell or mortgage their individual units without permission of the other owners.

Cooperative – A cooperative is a form of co-ownership of a multiple-dwelling building in which a corporation owns the building, and the residents own shares in the corporation. Each shareholder then leases a unit from the corporation under a renewable long-term lease. Residents may not secure loans on the units, but the corporation can get a blanket mortgage for which each shareholder is jointly and severally liable. Shareholders may not sell their shares or sublease their unit without the permission of the other shareholders.

Future Interests – A person may be given the right to possess property in the future rather than in the present. This right is called a future interest. The two forms of future interests are (1) reversion and (2) remainder.

Reversion – A reversion is a right of possession that returns to the grantor after the expiration of a limited or contingent estate.

Remainder – If the right of possession returns to a third party upon the expiration of a limited or contingent estate, it is called a remainder. The person who is entitled to the future interest is called a remainder beneficiary.

Transfer of Ownership of Real Property – Title to property may be transferred by sale, gift, will, inheritance, tax sale, and adverse possession.

Sale of Real Estate – A sale, or conveyance, is the most common method of transferring ownership rights in real property. The buyer and seller negotiate terms and record them in a real estate sales contract, in accordance with the Statute of Frauds. At the closing, the seller delivers the deed to the buyer, who, in exchange, pays the purchase price.

Types of Deeds – Deeds are used to convey real property by sale or gift. The seller or donor is called the grantor. The buyer or recipient is called the grantee. State laws recognize the following three types of deeds: (1) general warranty deed; (2) special warranty deed; and (3) quitclaim deed.

General Warranty Deed – A general warranty deed (or grant deed) contains the greatest number of warranties and provides the highest level of protection to a grantee. General warranty deeds are usually used as a deed from a seller to a buyer of real property.

Special Warranty Deed – A special warranty deed (or limited warranty deed) only protects a buyer from defects in a title that were caused by the seller.

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Quitclaim Deed – A quitclaim deed is a deed in which the grantor transfers only whatever interest he has in the real property. In a quitclaim deed, the grantor does not guarantee that he owns the property.

Contemporary Environment: Recording Statutes Every state has a recording statute which requires that all documents concerning real property be filed in a government office and be available as part of the public record. Recording statutes are intended to prevent fraud and to establish certainty in the ownership and transfer of property.

Instruments are usually filed in the county recorder’s office of the county in which the property is located.

State Court Case Case 25.1 Reformation of a Deed: Robenolt v. Zyznar Facts: Ardell and Eileen Robenolt owned 48 acres in Mahoning County, Ohio. J. Gary Zyznar contacted the Robenolts about purchasing a 13-acre portion of the land with the intention of building a home on it. The Robenolts agreed to sell the property but only if they would retain the mineral rights to the property. Zyznar agreed and a sales contract was drawn up and signed by the parties wherein the Robenolts would sell the property to Zyznar for $300,000 and the Robenolts would retain the mineral rights to the property. The transaction closed and a deed was filed with the county clerk. Subsequently, it was discovered that the deed did not reserve the mineral rights to the Robenolts. When Zyznar refused to sign a corrective deed, the Robenolts sued Zyznar seeking reformation of the deed based upon mutual mistake. The trial court granted reformation of the deed to reflect that the Robenolts retained the mineral rights to the property they sold to Zyznar. Zyznar appealed.

Issue: Was there a mutual mistake that would warrant reformation of the deed?

Decision: The court of appeals ordered that the deed be reformed to reflect that the Robenolts retained the mineral rights to the property that they sold to Zyznar.

Reasoning: Equity allows for reformation of an instrument to reflect the real intention of the parties.

Ethics Questions: In this case, there was competent, credible evidence to support the trial court’s finding of mutual mistake. The real estate sales contract was the best evidence of the parties’ true intent, and it clearly stated that the Robenolts were retaining their mineral rights to the property.

Quiet Title Action – A party who is concerned about his or her ownership rights in a parcel of real property can bring a quiet title action, which is a lawsuit to have a court determine the extent of those rights.

Adverse Possession – In most states, a person who wrongfully possesses someone else’s real property obtains title to that property if certain statutory requirements are met. This is called adverse possession. Property owned by federal and state governments is not subject to adverse possession. To obtain title under adverse possession, most states require that the wrongful possession must be: (1) For a statutorily prescribed period of time—This time period varies from state to state, but it is usually between 7 and 20 years; (2) Open, visible, and notorious—The adverse possessor must occupy the property so as to put the owner on notice of the possession; (3) Actual and exclusive—The adverse possessor must physically occupy the premises. The planting of crops, grazing of animals, or building of a structure on the land constitutes physical occupancy; (4) Continuous and peaceful—The occupancy must be continuous and uninterrupted for the required statutory period; and 286 .

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(5) Hostile and adverse—The possessor must occupy the property without the express or implied permission of the owner.

State Court Case Case 25.2 Adverse Possession: Paine v. Sexton Facts: Robert Paine’s parents operated a commercial campground beginning in 1958. The campground, which is very large, includes roads and cleared campsites, as well as picnic tables, fire rings, toilet buildings, a volleyball pit, play areas, a parking lot, and an office building. A wall of railroad ties is set on the road frontage to the property but fencing and walls do not enclose the entirety of the campground. The campground is operated on a seasonal basis and charges a fee to customers.

Robert Paine, on behalf of the persons who now own and operate the campground, filed a petition in Massachusetts Land Court to register by adverse possession 36 acres that the campground occupies but to which the owners of the campground do not own record title. For their claims of adverse possession, the plaintiffs assert non-permissive use of the disputed property for more than the statutorily required 20 years in a manner that was actual, open, notorious, exclusive, and adverse. David Sexton, as trustee for the defendant record owners of the 36 acres, contends that the plaintiffs cannot establish their claim of adverse possession because they have not enclosed the disputed property. The land court ruled that the plaintiffs had acquired the 36 acres through adverse possession. The defendants appealed.

Issue: Have the plaintiffs obtained the disputed property through adverse possession?

Decision: The appeals court affirmed the land court’s decision finding that the plaintiffs had acquired the disputed 36 acres through adverse possession.

Reason: In the present case, in which the plaintiffs operated the locus as a commercial campground advertised as such, improved the site by clearing campsites and constructing roadways, toilet buildings, and an office, and restricted access to paying customers, the Appeals Court of Massachusetts was satisfied that the judge was correct in his assessment that the plaintiffs’ use was sufficient to place the record owners on notice that the plaintiffs occupied the locus under a claim of right.

Ethics Questions: The determination of whether a set of activities is sufficient to support a claim of adverse possession is inherently fact-specific.

Easements – A person may own a nonpossessory interest in another’s real estate, such as an easement. An easement is an interest in land that gives the holder the right to make limited use of another’s property without owning or leasing it.

An easement appurtenant is created when the owner of a piece of land is given an easement over an adjacent piece of land. The land over which the easement is granted is called the servient estate, while the land that benefits from the easement is called the dominant estate. An easement in gross authorizes a person who does not own adjacent land to use another’s land. Express easements are expressly created by words, and include easements by grant and easements by reservation. An easement by grant is established when a landowner expressly grants another party an easement across his property, such as when a landowner gives a neighbor permission to use his driveway. An easement by reservation occurs where an owner sells land that she owns to another party but expressly reserves an easement on the sold land, such as the right to use a road that crosses over the sold property.

Implied easements are implied from the circumstances, and include easements by necessity and easements by implication. An easement by necessity grants a party who owns a piece of “landlocked” property the right to cross a surrounding piece of property so that the owner of the landlocked property can enter and exit his property. An easement by implication occurs where an owner subdivides a piece of property that has a beneficial appurtenant on it, such as a well, path,

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or road, that serves the entire parcel. Purchasers of individual pieces of property have an implied easement to use the well, path, or road.

An easement by prescription is created by adverse possession.

State Court Case Case 25.3 Easement: The Willows, LLC v. Bogy Facts: Herbert and Juanita Bogy (Bogy) and The Willows, LLC (“Hass”) owned adjoining pieces of farmland. Bogy cannot access a portion of his property from his own land because a railroad track bisects the property. Since 1972, Bogy and his farming tenants accessed that portion of the property by driving on a road that runs across Hass’s property. Bogy never requested or received permission from Hass to use the road. In 2008, Hass blocked Bogy’s access to the road. Bogy sued, claiming there was a prescriptive easement across Hass’s property. The trial court granted Bogy a prescriptive easement across Hass’s property. Hass appealed.

Issue: Has a prescriptive easement been created?

Decision: The court of appeals affirmed the trial court’s decision that granted Bogy a prescriptive easement to use the road that runs across Hass’s property.

Reason: The trial court found that for 39 years, Bogy had overtly and adversely used the land for access to the property, which entitled him to an easement by prescription.

Ethics Questions: It is not unethical for a property owner to claim an easement across another party’s property without that party’s permission when the property owner’s land is otherwise inaccessible. Arguably, Hass did not act ethically in blocking the road that had been used by Bogy for 39 years; however, one of the benefits of private property is the right to do with the property as the owner sees fit.

Landlord–Tenant Relationship – A landlord–tenant relationship is created when the owner of a freehold estate in real estate transfers a right to exclusively and temporarily possess the owner’s property. The tenant receives a nonfreehold estate in the real property. The tenant’s interest in the real property is called a leasehold estate, or leasehold. The owner who transfers the leasehold estate is called the landlord, or lessor. The party to whom the leasehold estate is transferred is called the tenant, or lessee.

Lease – A lease is a transfer of the right to the possession and use of real property for a set term in return for certain consideration. It is the rental agreement between a landlord and a tenant.

There are four types of tenancies associated with a lease: (1) tenancy for years; (2) periodic tenancy; (3) tenancy at will; and (4) tenancy at sufferance.

Tenancy for Years – A tenancy for years is a tenancy in which the landlord and tenant agree on a specific duration of time for the lease. The lease expires automatically at the end of the time period, without notice.

Periodic Tenancy – This lease specifies intervals at which payments are due, but not a term for the lease. Either party may terminate the tenancy at the end of the payment interval, with appropriate notice.

Tenancy at Will – A tenancy at will is a lease that may be terminated at any time by either party with some minimum advanced notice.

Tenancy at Sufferance – In a tenancy at sufferance, the tenant remains in possession of property after the expiration of a lease without the owner’s consent. The tenant is liable for rent during this time, but is technically a trespasser. The owner may need to evict this holdover tenant through

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either self-help, if allowed by their state, or through eviction or unlawful detainer proceedings in a court.

Duty to Pay Rent – A residential or commercial tenant owes a duty to pay the agreed-on amount of rent for the leased premises to the landlord at the agreed-on time and terms. This is referred to as the tenant’s duty to pay rent. In a gross lease, the tenant pays a gross sum to the landlord. The landlord is responsible for paying the utilities, insurance, property taxes, and assessments on the property. If a tenant is responsible for paying rent and utilities it is called a modified gross lease, which is often used in residential leases.

In a net lease arrangement, the tenant is responsible for paying rent and property taxes. In a double net lease, the tenant is responsible for paying rent, property taxes, and utilities. In a net, net, net lease (triple net lease), the tenant is responsible for paying rent property taxes, utilities, and insurance.

On nonpayment of rent, the landlord is entitled to recover possession of the leased premises from the tenant. This may require the landlord to evict the tenant. Most states provide a summary procedure called an unlawful detainer action that a landlord can bring to evict a tenant. The landlord may also sue to recover the unpaid rent from the tenant. The more modern rule requires the landlord to make reasonable efforts to mitigate damages (i.e., to make reasonable efforts to release the premises).

Implied Warranty of Habitability – This warranty provides that a leased property is fit, safe, and suitable for ordinary use. If the landlord fails to maintain the property, state statutes usually provide remedies like allowing the tenant to withhold the rent or a portion of the rent, repair the defect and deduct the expenses from rental payments, cancel the lease if the problem constitutes constructive eviction, and sue for damages based on a reduction of value of the leasehold estate.

Civil Rights and Fair Housing Laws – Federal, state, and local governments have enacted statutes that prohibit discrimination in the sale, rental, and use of real property. Several important federal statutes that prohibit discrimination in housing are: (1) Civil Rights Act of 1866 – This federal statute prohibits discrimination in the selling and renting of property based on race or color.

(2) Fair Housing Act – The Fair Housing Act of 1968, as amended, is a federal statute that makes it unlawful for a party to refuse to sell, rent, finance, or advertise housing to any person because of his or her race, color, national origin, sex, religion, disability, or family status. The Fair Housing Act is administered by the U.S. Department of Housing and Urban Development (HUD).

(3) Title III of the Americans with Disabilities Act of 1990 – Title III of the Americans with Disabilities Act of 1990, as amended by the American with Disabilities Act Amendments Act (ADAAA) of 2008, prohibits discrimination on the basis of a physical or mental disability in places of public accommodation operated by private entities. Title III of the ADA applies to public accommodations and commercial facilities. Title III requires covered facilities to be designed, constructed, and altered in compliance with specific accessibility requirements established by regulations issued pursuant to the ADA. State and local governments may provide fair housing laws that prohibit discrimination in housing. State and local laws that are stricter than federal laws are permitted.

Zoning – Most counties and municipalities have enacted zoning ordinances to regulate land use.

Zoning generally (1) establishes land use districts within the municipality (i.e., areas are generally designated residential, commercial, or industrial); (2) restricts the height, size, and location of buildings on a building site; and (3) establishes aesthetic requirements or limitations for the exterior of buildings. A zoning commission usually formulates zoning ordinances, conducts

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public hearings, and makes recommendations to the city council, which must vote to enact an ordinance.

An owner who wants to use his or her property for a use different from that permitted under a current zoning ordinance may seek relief from the ordinance by obtaining a variance. To obtain a variance, the landowner must prove that the ordinance causes an undue hardship by preventing him or her from making a reasonable return on the lad as zoned.

Zoning laws act prospectively; that is, uses and buildings that already exist in the zoned area are permitted to continue even though they do not fit within new zoning ordinances. Such uses are called nonconforming uses.

Government Taking of Real Property – The Takings Clause of the Fifth Amendment to the U.S. Constitution allows the government to take private property for public use. This is done by the government exercising its power of eminent domain. The government must allow the owner of the property to make a case for keeping the property. The Just Compensation Clause of the Fifth Amendment to the U.S. Constitution requires the government to compensate the property owner (and possibly others, such as lessees) when it exercises the power of eminent domain.

Critical Legal Thinking: Eminent Domain The City of New London, Connecticut was targeted by state and local officials for economic redevelopment, which involved acquiring 90 acres in part of the city. Much of the subject land was owned by individual homeowners. Susette Kelo and several other homeowners in the redevelopment district (collectively referred to as “Kelo”) refused to sell their properties and opposed the taking of their properties through eminent domain. Kelo argued that such a taking violated the “public use” requirement of the Fifth Amendment, since the properties were being taken from private citizens and transferred to other private citizens (the developers), instead of being taken for use by the government. The state trial court found for the homeowners, but the Connecticut Supreme Court reversed, and held that the taking was legitimate. The question of whether the taking was an appropriate use of eminent domain was determined by the U.S. Supreme Court, which upheld the taking of private property for economic redevelopment in a 5-4 decision. The purpose of the Takings Clause of the Fifth Amendment to the U.S. Constitution is to ensure that private property rights are respected, with the government allowed to take property only for public use, and only after paying just compensation to the landowner. Many believe the U.S. Supreme Court did not properly satisfy the “public use” requirement for a government taking of private property in this case. Kelo v. City of New London, Connecticut, 545 U.S. 469, 125 S.Ct. 2655, 2005 U.S. Lexis 5011 (Supreme Court of the United States) V. Key Terms and Concepts  Actual and exclusive—For establishing adverse possession, the adverse possessor must physically occupy the premises.  Adverse possession—When a person who wrongfully possesses someone else’s real property obtains title to that property if certain statutory requirements are met.  Air rights—The owners of land may sell or lease air space parcels above their land.  Air space parcel—The air space above the surface of the earth of an owner’s real property.  Americans with Disabilities Act Amendments Act (ADAAA) of 2008—A federal statute that prohibits discrimination against disabled individuals in employment, public services, public accommodations and services, and telecommunications.  Americans with Disabilities Act (ADA) of 1990—As amended by the Americans with Disabilities Act Amendments Act (ADAAA) of 2008, this federal statute prohibits

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discrimination on the basis of a physical or mental disability in places of public accommodation operated by private entities.

Buildings—Structures constructed on land.

Civil Rights Act of 1866—It was amended by the Americans with Disabilities Act Amendments Act (ADAAA) of 2008.

Closing (settlement)—The finalization of a real estate sales transaction that passes title to the property from the seller to the buyer.

Community property—A form of ownership in which each spouse owns an equal onehalf share of the income of both spouses and the assets acquired during the marriage.

Concurrent ownership (co-ownership)—A situation in which two or more persons own a piece of real property.

Condominium—A common form of ownership in a multiple-dwelling building where the purchaser has title to the individual unit and owns the common areas as a tenant in common with the other condominium owners.

Constructive notice—Recording the deed gives constructive notice to the world of the owner’s interest in the property.

Continuous and peaceful—For establishing adverse possession, the occupancy must be continuous and uninterrupted for the required statutory period.

Cooperative—A form of co-ownership of a multiple-dwelling building where a corporation owns the building and the residents own shares in the corporation.

County recorder’s office—Instruments are usually filed in the county recorder’s office of the county in which the property is located.

Deed—A writing that describes a person’s ownership interest in a piece of real property.

Dominant estate—The land that benefits from an easement.

Double net lease—In a double net lease arrangement, the tenant is responsible for paying rent, property taxes, and utilities.

Duty to pay rent—A residential or commercial tenant owes a duty to pay the agreed-on amount of rent for the leased premises to the landlord at the agreed-on time and terms.

This is referred to as the tenant’s duty to pay rent.

Easement—A given or required right to make limited use of someone else’s land without owning or leasing it.

Easement appurtenant—An easement that is created when the owner of a piece of land is given an easement over an adjacent piece of land.

Easement by grant—Easements may be expressly created by grant.

Easement by implication—An easement can be created by implication.

Easement by necessity—An easement may be created by necessity.

Easement by prescription—An easement created by adverse possession.

Easement by reservation—An easement may be expressly created by reservation.

Easement in gross—An easement that authorizes a person who does not own adjacent land to use another’s land.

Eminent domain—The right of the government to take private property, subject to due process and just compensation, for public use.

Estate in land (estate)—Ownership rights in real property; the bundle of legal rights that the owner has to possess, use, and enjoy the property.

Estate pour autre vie—A life estate measured in the life of a third party.

Eviction proceeding (unlawful detainer action)—Most states require an owner to go through certain legal proceedings, called an eviction proceeding, or unlawful detainer action, to evict a holdover tenant.

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Express easement—An easement created expressly by words. Examples include an easement by grant and an easement by reservation.

Fair Housing Act of 1968—A federal statute that makes it unlawful for a party to refuse to sell, rent, finance, or advertise housing to any person because of his or her race, color, national origin, sex, religion, handicap, or familial status.

Fee simple absolute (fee simple)—A type of ownership of real property that grants the owner the fullest bundle of legal rights that a person can hold in real property.

Fee simple defeasible (qualified fee)—A type of ownership of real property that grants the owner all the incidents of a fee simple absolute except that it may be taken away if a specified condition occurs or does not occur.

Fixtures—Goods that are affixed to real estate so as to become part thereof.

Freehold estate—An estate where the owner has a present possessory interest in the real property.

Future interest—The interest that the grantor retains for him- or herself or a third party.

General warranty deed (grant deed)—A deed that protects a grantee of real property from defects in title caused by the grantor and prior owners of the property.

Grantee—The party to whom an interest in real property is transferred.

Grantor—The party who transfers an ownership interest in real property.

Gross lease—In a gross lease, the tenant pays a gross sum to the landlord. The landlord is responsible for paying the utilities, insurance, property taxes, and assessments on the property.

Hostile and adverse—For establishing adverse possession, the possessor must occupy the property without the express or implied permission of the owner.

Implied easement—An easement that is implied based on the circumstances. Examples include an easement by implication and an easement by necessity.

Implied warranty of habitability—A warranty that provides that the leased premises must be fit, safe, and suitable for ordinary residential use.

Joint tenancy—A form of co-ownership that includes the right of survivorship.

Joint tenants—Two or more parties can own real estate as joint tenants.

Just Compensation Clause—A clause of the U.S. Constitution that requires the government to compensate the property owner, and possibly others, when the government takes property under its power of eminent domain.

Land—The most common form of real property; includes the land and buildings and other structures permanently attached to the land.

Landlord (lessor)—An owner who transfers a leasehold.

Landlord–tenant relationship—A relationship created when the owner of a freehold estate (landlord) transfers a right to exclusively and temporarily possess the owner’s property to another (tenant).

Lease—A transfer of the right to possession and use of real property for a set term in return for certain consideration; the rental agreement between a landlord and a tenant.

Leasehold estate (leasehold)—The tenant’s interest in the real property is called a leasehold estate, or leasehold.

Life estate—An interest in the land for a person’s lifetime; upon that person’s death, the interest will be transferred to another party.

Life tenant—The person who is given a life estate.

Mitigate damages—With regard to landlord-tenant law, the more modern rule requires the landlord to make reasonable efforts to mitigate damages (i.e., to make reasonable efforts to release the premises).

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Modified gross lease—If a tenant is responsible for paying rent and utilities it is called a modified gross lease, which is often used in residential leases.

Month-to-month tenancy—A periodic tenancy that requires a one-month notice of termination.

Net lease—In a net lease arrangement, the tenant is responsible for paying rent and property taxes.

Net, net, net lease (triple net lease)—In this lease arrangement, the tenant is responsible for paying rent, property taxes, utilities, and insurance.

Nonconforming use—Uses for real estate and buildings that already exist in a zoned area that are permitted to continue even though they do not fit within a new zoning use established for the area.

Nonfreehold estate—An estate in which the tenant has a right to possession of the property but not title to the property.

Nonpossessory interest—When a person holds an interest in another person’s property without actually owning any part of the property.

Open, visible, and notorious—For establishing adverse possession, the adverse possessor must occupy the property so as to put the owner on notice of the possession.

Periodic tenancy—A tenancy created when a lease specifies intervals at which payments are due but does not specify how long the lease is for.

Plant life and vegetation—Real property that is growing in or on the surface of the land.

Present possessory interest—A freehold estate is an estate in which the owner has a present possessory interest in the real property.

Quiet title action—An action brought by a party, seeking an order of the court declaring who has title to disputed property. The court “quiets title” by its decision.

Quitclaim deed—A deed in which the grantor of real property transfers whatever interest he has in the property to the grantee.

Real estate sales contract—When a buyer has been located and the parties have negotiated the terms of the sale, a real estate sales contract is executed by the parties.

Real property—The land itself as well as buildings, trees, soil, minerals, timber, plants, and other things permanently affixed to the land.

Recording statute—A state statute that requires a mortgage or deed of trust to be recorded in the county recorder’s office of the county in which the real property is located.

Remainder—The right of possession returns to a third party upon the expiration of a limited or contingent estate.

Remainder beneficiary—The person who is entitled to the future interest is called a remainder beneficiary.

Rent—A residential or commercial tenant owes a duty to pay the agreed-on amount of rent for the leased premises to the landlord at the agreed-on time and terms.

Rent-control ordinance—Local government regulation that stipulates the amount of rent a landlord can charge for residential housing.

Rent-control ordinance—Many local communities across the country have enacted rentcontrol ordinances that stipulate the amount of rent a landlord can charge for residential housing.

Reversion—A right of possession that returns to the grantor after the expiration of a limited or contingent estate.

Right of survivorship—A legal rule that provides upon the death of one joint tenant the deceased person’s interest in the real property automatically passes to the surviving joint tenant or joint tenants.

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Sale (conveyance)—The passing of title from a seller to a buyer for a price. Also called a conveyance.

Separate property—With reference to community property, property that is acquired through gift or inheritance either before or during marriage remains separate property.

Servient estate—The land over which an easement is granted.

Special warranty deed (limited warranty deed)—A deed that protects a grantee of real property from defects in title caused by the grantor.

Statutory prescribed period of time—To obtain title under adverse possession, most states require that the wrongful possession must be for a statutorily prescribed period of time.

Subsurface rights (mineral rights)—Rights to the earth located beneath the surface of the land.

Surface rights—A landowner usually purchases the surface rights to the land.

Takings Clause—A provision of the Fifth Amendment to the U.S. Constitution that requires the government to compensate citizens when it takes private property for public use.

Tenancy at sufferance—A tenancy created when a tenant retains possession of property after the expiration of another tenancy or a life estate without the owner’s consent.

Tenancy at will—A lease that may be terminated at any time by either party.

Tenancy by the entirety—A form of co-ownership of real property that can be used only by married couples.

Tenancy for years—A tenancy created when the landlord and the tenant agree on a specific duration for the lease.

Tenancy in common—A form of co-ownership in which the interest of a surviving tenant in common passes to the deceased tenant’s estate and not to the co-tenants.

Tenant (lessee)—The party to whom a leasehold is transferred.

Tenant in common—A party to a tenancy in common.

Title III of the Americans with Disabilities Act—It prohibits discrimination on the basis of a physical or mental disability in places of public accommodation operated by private entities.

Unlawful detainer action—Most states require an owner to go through certain legal proceedings, called an eviction proceeding or unlawful detainer action, to evict a holdover tenant.

Variance—An exception that permits a type of building or use in an area that would not otherwise be allowed by a zoning ordinance.

Wrongful possession—It occurs when a tenant retains possession of property after the expiration of a tenancy or a life estate without the owner’s consent.

Zoning—Generally establishes land use districts within the municipality, restricts the height, size, and location of buildings on a building site, and establishes aesthetic requirements or limitations for the exterior of buildings.

Zoning commission—Usually formulates zoning ordinances, conducts public hearings, and makes recommendations to the city council, which must vote to enact an ordinance.

Zoning ordinance—Local laws that are adopted by municipalities and local governments to regulate land use within their boundaries.

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Chapter 26 International and World Trade Law Why do we do business beyond the U.S. borders?

I. Teacher to Teacher Dialogue From the teaching perspective, this chapter presents challenges that are similar to those of trying to bring ethics into mainline business law teaching. In both cases, we have had an awareness of the importance of these issues all along. But they have tended to be treated as peripheral or collateral to the substantive black-letter law that occupied most of our class time.

Well, history has a way of overcoming the present. And recent history has shown us that we can no longer afford to treat either ethics or international law as some sort of “back burner” item only to be casually honored with a “tip of the hat.” These topics need to be integrated into every aspect of what we teach. This chapter is designed to help you as teachers identify the basic infrastructure of international law for further elaboration in later chapters.

This chapter starts off with an opening discussion on the practical difficulties involved in the enforcement of international law. This material always stirs a good opening debate among students as to just what the practical limitations in this area are. The word oxymoron is defined as a combination of contradictory or incongruous words or phrases. To many, the term international law represents one such example. At best, defining international law along the traditional domestic lines of a body of rules of behavior and mechanisms designed to enforce those rules cannot work as well when the protagonists are sovereign nations. By definition, sovereignty incorporates the notion of freedom from external controls and supreme power over one’s own affairs. Perhaps that might be a starting point to resolve this oxymoronic dilemma. A nation does need to have ultimate control over its internal affairs, but its national interests and the welfare of its citizens do not end at its borders. Nations, just like individuals, can only find protection for their own rights when they are willing to honor the rights of others. Law eventually works its way through to a system of cooperative behavior for the larger mutual good. Law, domestic or international, calls for some sacrifice of individual freedoms for the betterment of the corporate body. This is the fundamental reality upon which all law is ultimately based. Consequences of the failure to honor that reality at the global level are readily apparent to all of us. If the role of law is to act as a mechanism for civilization and to make violence the last resort, then international law is a goal worth striving for by all nations, even at the cost of some of their respective autonomies.

II. Chapter Objectives 1. Describe the U.S. government’s power under the Foreign Commerce Clause and Treaty Clause of the U.S. Constitution.

2. Describe the functions, governance, and organizations of the United Nations.

3. Describe the European Union (EU) and list the countries that belong to the EU. 4. Describe the North American Free Trade Agreement (NAFTA) and list the countries that belong to NAFTA. 5. Describe the Association of Southeast Asian Nations (ASEAN) and list the countries that belong to ASEAN. 6. Describe the Organization of Petroleum Exporting Countries (OPEC) and list the countries that belong to OPEC. 7. Describe the trade organizations of South America, Central America, and the Caribbean.

8. Describe the trade organizations of Africa.

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9. Describe the World Trade Organization (WTO) and explain how its dispute-resolution procedure works.

10. Describe the jurisdiction of U.S. courts over international disputes.

11. Describe the scope of international religious laws.

III. Key Question Checklist  Who has the authority to act—the federal government or the states?  What are the sources of international law?  What are the main international organizations that may be used to help resolve international disputes between nations?  What are some of the legal principles used to help resolve international disputes?

IV. Chapter Outline Introduction to International and World Trade Law – International law governs affairs between nations and regulates transactions between individuals and businesses of different countries.

The United States and Foreign Affairs – The U.S. Constitution divides the power to regulate the internal affairs of this country between the federal and state governments. On the international level, however, the Constitution gives most of the power to the federal government. Two constitutional provisions establish this authority: (1) the Foreign Commerce Clause; and (2) the Treaty Clause.

Foreign Commerce Clause – Article I, Section 8, Clause 3 of the U.S. Constitution—the Foreign Commerce Clause—vests the U.S. Congress with the power to regulate commerce with foreign nations.

Treaty Clause – Article II, Section 2, Clause 2 of the U.S. Constitution—the Treaty Clause empowers the president, by and with the advice and consent of the U.S. Senate, to make treaties.

A treaty is a formal agreement between two (bilateral) or more (multinational) nations that is signed and ratified by each party. Conventions are treaties that are sponsored by international organizations and normally have many signatories.

United Nations – The United Nations (UN) was created by a multinational treaty with an eye toward maintaining peace and security in the world, promoting economic and social cooperation, and protecting human rights.

General Assembly – This legislative body of the United Nations is composed of all UN member nations. It adopts resolutions concerning human rights, trade, finance, and economics, as well as the other matters within the scope of the UN Charter.

Security Council – The Security Council is composed of 15 member nations, five of which are permanent members (China, France, Russia, the United Kingdom, and the United States), and ten which serve two-year terms. The council is responsible primarily for maintaining international peace and security and has authority to use armed force. Each of the five permanent members may exercise veto power and prevent the adoption of any substantive resolution of the UN. Secretariat – The Secretariat administers the day-to-day operations under the secretary-general, who is elected by the General Assembly.

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United Nations Agencies – There are a number of autonomous UN agencies dealing with a number of global economic and social problems, including the United Nations Educational, Scientific, and Cultural Organization (UNESCO), the United Nations Children’s Fund (UNICEF), the International Monetary Fund (IMF), the World Bank, and the International Fund for Agricultural Development (IFAD).

Global Law: World Bank The World Bank is a United Nations agency that comprises more than 180 member nations. It is financed by contributions from developed nations, and provides money to developing countries in order to fund humanitarian purposes and to relieve poverty. It provides money to build roads, dams, water projects, hospitals, and develop agriculture, in the form of long-term, low-interest loans, as well as debt relief for these same loans.

International Court of Justice – The International Court of Justice (ICJ), also known as the World Court, is the judicial branch of the UN and is located in The Hague, the Netherlands. It consists of fifteen judges who serve nine-year terms. Only nations, not individuals or businesses, can have cases decided by this court. The ICJ hears cases that nations refer to it as well as cases involving treaties and the UN Charter.

Global Law: International Monetary Fund The International Monetary Fund (IMF), an agency of the United Nations, was established by a treaty in 1945 to help promote the world economy following the Great Depression of the 1930s and the end of World War II in 1945. The IMF comprises more than 180 countries that are each represented on the board of directors, which makes the policy decisions of the IMF. The IMF is funded by monetary contributions of member nations, assessed based on the size of each nation’s economy. The IMF’s headquarters is in Washington, DC. The primary functions of the IMF are to promote sound monetary, fiscal, and macroeconomic policies worldwide and to provide assistance to poor countries. The IMF responds to financial crises around the globe. It does so by providing short-term loans to member countries to help them weather problems caused by unstable currencies, to balance payment problems, and to recover from the economic policies of past governments. The IMF examines a country’s economy as a whole and its currency accounts, inflations, balance of payments with other countries, employment, consumer and business spending, and other factors to determine whether the country needs assistance. In return for the financial assistance, a country must agree to meet certain monetary, fiscal, employment, inflation, and other goals established by the IMF. European Union – The European Union (EU) is composed of a number of countries in Europe.

The EU represents more than 450 million people and a gross community product that approximately equals that of the United States, Canada, and Mexico combined.

United Kingdom – The United Kingdom (UK) is comprised of four countries, Britain, Wales, Scotland, and Northern Ireland. In 1973, the United Kingdom joined the European Community, which is now the EU. In 2016, the electorate of the United Kingdom voted to leave the EU. The reasons cited for doing so include restoring British sovereignty, freeing itself of EU laws, ending free movement of EU workers into the UK, and regaining control over immigration.

EU Administration – The Council of Ministers is composed of representatives from each member nation and vote on significant issues and changes to the treaty. The European Union commission is independent of the member nations and has the authority to enact legislation and enforce its regulations.

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Euro – The European Union has introduced a single monetary unit, the euro. Many but not all EU countries have voted to use the euro. The countries that have voted to use the euro comprise the Eurozone and the euro can be used in all countries of the Eurozone. An EU central bank, equivalent to the U.S. Federal Reserve Board, has been established to set common monetary policy.

North American Free Trade Agreement – In 1992, the North American Free Trade Agreement (NAFTA) was signed by the U.S., Mexico, and Canada, creating a massive free-trade zone, eliminating or reducing most of the tariffs, duties, and quotas among the three countries, and establishing special protection for favored industries. The results are lower prices for a wide variety of goods, and a competitive supernational trading region that can compete with Asia or the EU. Association of Southeast Asian Nations – Since 1967, the Association of South East Asian Nations (ASEAN) has cooperated in promoting economic, political, and cultural issues. The population of the ASEAN countries is more than 600 million.

Organization of the Petroleum Exporting Countries – The Organization of the Petroleum Exporting Countries (OPEC) is an association comprising many of the oil-producing and exporting countries of the world. OPEC sets quotas on the output of oil production by member nations, which account for more than 40 percent of global oil production. OPEC members contain more than 70 percent of proven oil reserves. The population of the OPEC countries is more than 450 million.

South American, Central American, and Caribbean Trade Organizations – There are several major regional economic organizations in South America, Central America, and the Caribbean, including Mercosur, the Andean Community of Nations, and the Central America-Dominican Republic Free Trade Agreement (CAFTA-DR).

Mercosur – Mercosur, also called Mercusol or the Southern Common Market, is a regional trade block in South America comprised of Argentina, Brazil, Paraguay, and Uruguay. It is the largest regional economic organization in South America, bringing together more than 300 million people.

Andean Community of Nations – The Andean Community of Nations, also called the Andean Community or CAN, is a regional trading block in South America comprised of the countries of Bolivia, Columbia, Ecuador, and Peru. It is the second largest regional economic organization in South America, with the combined population of the countries of the Andean Community exceeding 120 million people.

Central America-Dominican Republic Free Trade Agreement (CAFTA-DR) – This trade agreement includes the United States and the Central American countries of Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua.

African Trade Organizations – There are multiple regional trading blocks in Africa, with many overlapping country memberships.

African Economic Community (AEC) – This is an economic and political organization in Africa whose goal is to establish a continent-wide single market free trade zone that includes all of the countries of Africa.

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Regional Trade Organizations of Africa – The primary regional economic communities of Africa are: 1. The Common Market of Eastern and Southern Africa (COMESA)—This is a regional trade block of countries located in eastern and southern Africa. It is the most successful economic trade organization in Africa.

2. The Economic Community of West African States (ECOWAS)—This is a regional trade area of countries of West Africa that have a combined population of more than 350 million people.

3. The Economic Community of Central African States (ECCAS)—This is a regional political and economic community of countries of Central Africa.

African Union (AU) – This is an organization comprised of all 55 countries located on the African continent whose goal is to establish an integrated, politically united, and prosperous African continent based on the ideals of Pan-Africanism and Africa’s Renaissance.

Other Trade Agreements – There are many other regional trade agreements among the countries of the world. In addition, countries have entered into trade agreements with other individual countries, as well as with international regional organizations, and some regional trade organizations have entered into trade agreements with other regional trade groups.

World Trade Organization – The World Trade Organization (WTO) was created as a multilateral treaty that establishes trade agreements and limits tariffs and trade restrictions among its more than 160 member nations. Its main function is to ensure that trade flows as smoothly, predictably, and freely as possible.

WTO Dispute Resolution – The WTO hears and decides trade disputes between member nations. Disputes are heard by a three-member panel made up of professional judges from member nations. Their report is referred to in the dispute settlement body of the WTO, which adopts the findings unless a consensus of the members votes otherwise. Most of the reports are adopted. There is an appellate body to which a party can appeal any decision, made up of seven professional justices from member nations.

Jurisdiction of U.S. Courts to Decide International Disputes – Most cases involving international law disputes are heard by national courts of individual nations. This is primarily the case for commercial disputes between private litigants that do not qualify to be heard by international courts. Some countries have specialized courts that hear international commercial disputes. Other countries permit such disputes to proceed through their regular court systems. In the United States, commercial disputes between U.S. companies and foreign governments or parties may be brought in U.S. district courts.

Judicial Procedure – Most international contracts will include a choice of forum clause which designates which nation’s court will have jurisdiction to hear disputes, and a choice of law clause that designates which country’s laws will be applied.

Critical Legal Thinking: Act of State Doctrine This doctrine states that judges in one country cannot question the validity of an act committed by another country within that other country’s borders, based on the principle that a country has absolute authority over what transpires within its own borders.

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Federal Court Case Case 26.1 Act of State Doctrine: Glen v. Club Mediterranee, S.A. Facts: Prior to the Communist revolution in Cuba, Elvira de la Vega Glen and her sister, Ana Maria de la Vega Glen, were Cuban citizens and residents who jointly owned beachfront property on the Penninsula de Hicacos in Varadero, Cuba. On or about January 1, 1959, in conjunction with Fidel Castro’s Communist revolution, the Cuban government expropriated the property without paying the Glens. Also in 1959, the sisters fled Cuba. Ana Maria de la Vega Glen died and passed any interest she had in the Varadero beach property to her nephew Robert M. Glen. In 1997, Club Mediterranee, S.A. and Club Mediterranee Group (Club Med) entered into a joint venture with the Cuban government to develop the property. Club Med constructed and operated a five-star luxury hotel on the property that the Glens had owned. The Glens sued Club Med in a U.S. District Court located in the state of Florida. The Glens alleged that the original expropriation of their property by the Cuban government was illegal and that Club Med had trespassed on their property and had been unduly enriched by its joint venture with the Cuban government to operate a hotel on their expropriated property. The Glens sought to recover the millions of dollars in profits earned by Club Med from its alleged wrongful occupation and use of the Glens’ expropriated property. The U.S. District Court held that the act of state doctrine barred recovery by the Glens and dismissed the Glens’ claims against Club Med. The Glens appealed.

Issue: Does the act of state doctrine bar recovery by the Glens?

Decision: Yes. The U.S. Court of Appeals applied the act of state doctrine and affirmed the judgment of the U.S. District Court that dismissed the Glens’ claim against Club Med. Reason: The act of state doctrine is a judicially-created rule of decision that precludes the courts of this country from inquiring into the validity of the public acts by foreign sovereign power committed within its own territory. The doctrine prevents any court in the United States from declaring that an official act of a foreign sovereign performed within its own territory is invalid. It requires that the acts of foreign sovereigns taken within their own jurisdictions shall be deemed valid. The act of state doctrine is a product of judicial concern for separation of powers, a result of the judiciary’s recognition that it is the province of the executive and legislative branches to establish and pursue foreign policy and that judicial determinations regarding the validity of the acts of foreign sovereigns might negatively affect those policies.

Ethics Questions: In appropriating the property, the Cuban government acted unethically.

Students will argue both sides of this relative to Club Med. Club Med did not take the property, Cuba did.

Critical Legal Thinking: Doctrine of Sovereign Immunity The doctrine of sovereign immunity establishes that countries are immune from lawsuits in the courts of other countries. Originally, the U.S. granted absolute immunity to foreign governments from suits in U.S. courts. In 1952, the U.S. switched to the principle of qualified immunity, or restricted immunity, which was eventually codified in the Foreign Sovereign Immunities Act (FSIA) of 1976. This act now exclusively governs suits against foreign nations in the U.S., whether in federal court or state court. Most Western nations have adopted the principle of restricted immunity.

Exceptions to the FSIA – The U.S. grants immunity to qualified countries, as codified under the Foreign Sovereign Immunities Act (FSIA), which provides that a foreign country is not immune if it has waived its immunity or if the action is based upon commercial activities carried on in the U.S. by a foreign country, or is carried on outside the U.S. but directly impacts the U.S.

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U.S. Supreme Court Case Case 26.2 Sovereign Immunity: OBB Personenverkehr AG v. Sachs Facts: OBB Personenverkehr AG (OBB), which is wholly owned by the Austrian Federal Ministry of Transport, carries more than 200 million passengers each year on routes within Austria and to and from points outside of Austria. OBB and other railways throughout Europe are members of the Eurail Group, which sells Eurail passes to non-Europeans for unlimited travel on the railroads for a designated period of time. Eurail passes may be purchased directly from the Eurail Group or indirectly through a worldwide network of travel agents not owned by the Eurail Group. Carol Sachs, a resident of Berkeley, California, purchased a Eurail pass over the internet from The Rail Pass Experts, a Massachusetts-based travel agent. Sachs arrived at the Innsbruck, Austria train station planning to use her Eurail pass to ride an OBB train to Prague, Czech Republic. As she attempted to board the train, Sachs fell from the platform onto the tracks.

OBB’s moving train crushed her legs, both of which had to be amputated above the knee.

Sachs sued OBB in the U.S. district court in California, asserting claims of negligence and strict liability for the design of the train and platform. OBB claimed sovereign immunity and moved to dismiss the suit for lack of subject matter jurisdiction. Sachs argued that her lawsuit fell under the commercial activity exception to sovereign immunity. The U.S. district court held that Sachs’s suit did not fall within the commercial activity exception and granted OBB’s motion to dismiss.

The U.S. court of appeals reversed, holding that the commercial activity exception applied and permitted Sachs to sue OBB in the U.S. district court. OBB appealed to the U.S. Supreme Court.

Issue: Does the commercial activity exception to sovereign immunity apply to the facts of the case?

Decision: The U.S. Supreme Court held that the Sachs action is based upon the railway’s conduct in Innsbruck, Austria, and therefore the suit falls outside of the commercial activity exception and is barred by sovereign immunity.

Reasoning: The conduct constituting the gravamen of Sachs’s suit plainly occurred abroad.

Ethical Questions: Although the doctrine of sovereign immunity is controversial, the tragic incident in Innsbruck, Austria was the foundation for Sachs’s lawsuit. Sachs failed to demonstrate that her suit fell within the commercial activity exception to sovereign immunity, since there was nothing wrongful about the sale of the Eurail pass standing alone.

International Religious Laws – Religious law governs or at least affects the laws of many nations.

Global Law: Jewish Law and the Torah Jewish law is based on the Torah, which prescribes all the rules of religious, political, and legal life. Problems are determined by Halakhah (rabbinic jurisprudence) and are administered by rabbi-judges sitting as the Beis Din, or house of judgment.

Global Law: Islamic Law and the Qur’an The Islamic law system is derived from the Koran, the Sunnah, and reasonings by Islamic scholars. Islamic law was frozen in the tenth century when scholars closed the door on independent reasoning. Today, Islamic law (Shari’a) is used primarily in marriage, divorce, inheritance, and criminal law, and is ignored in commercial transactions.

Global Law: Christian and Canon Law Canon law consists of laws and regulations that have been adopted by Catholic and other Christian ecclesiastical authorities that relates to internal laws that govern the church and its members. The canons of Christian faiths provide rules for believers to follow in living their lives and professing their faith. However, the Christian canons are often separate from the secular laws that govern the conduct of persons.

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Global Law: Hindu Law—Dharmasastra Hindu law is based on neither civil codes nor court decisions, but on the works of private scholars that were recorded in law books (smitris/dharmasastra) as the doctrine of proper behavior. Most Hindu law is concerned with family matters and the law of succession.

V. Key Terms and Concepts  Act of state doctrine—States that judges of one country cannot question the validity of an act committed by another country within that other country’s borders. It is based on the principle that a country has absolute authority over what transpires within its own territory.  African Economic Community (AEC)—An economic and political organization in Africa whose goal is to establish a continent-wide single market free trade zone that includes all of the countries of Africa.  African Union (AU)—An organization comprised of all 55 countries located on the African continent whose goal is to establish an integrated, politically united, and prosperous African continent based on the ideals of Pan-Africanism and Africa’s Renaissance.  Andean Community of Nations (Andean Community or Comunidad Andina or CAN)—A regional economic organization in South America comprised of Bolivia, Columbia, Ecuador, and Peru.  ASEAN-China Free Trade Area (ACFTA)—A free trade agreement between China and the member countries of ASEAN.  ASEAN-India Free Trade Area (AIFTA)—A free trade agreement between India and ASEAN.  ASEAN-Japan Comprehensive Economic Partnership—A free trade agreement between Japan and ASEAN.  ASEAN-Korea Free Trade Area (AKFTA)—A free trade agreement between Korea and ASEAN.  ASEAN Plus Three—A current association called ASEAN Plus Three—the three being China, Japan, and South Korea—has informal relations to discuss regional issues.  Association of Southeast Asian Nations (ASEAN)—An association of many countries of Southeast Asia that provides for economic and other coordination among member nations.  Bilateral treaty—A treaty between two nations.  Canon law—Canon law consists of laws and regulations that have been adopted by Catholic and other Christian ecclesiastical authorities that relates to internal laws that govern the church and its members.  Central America-Dominican Republic Free Trade Agreement (CAFTA-DR)—An association of several Central American countries and the United States designed to reduce tariffs and trade barriers among member nations.  Choice of forum clause (forum-selection clause)—Clause in an international contract that designates which nation’s court has jurisdiction to hear a case arising out of the contract.

Also known as a forum-selection clause.  Choice of law clause—Clause in an international contract that designates which nation’s laws will be applied in deciding a dispute.  Commercial activity exception—An exception which states that a foreign country is subject to lawsuit in the United States if it engages in commercial activity in the United States or if it carries on such activity outside the United States but causes a direct effect in the United States.

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Common Market of Eastern and Southern Africa (COMESA)—A regional trading block of countries located in eastern and southern Africa.

Convention—A treaty that is sponsored by an international organization.

Council of Ministers—The EU’s Council of Ministers is composed of representatives from each member country who meet periodically to coordinate efforts to fulfill the objectives of the treaty.

Doctrine of sovereign immunity—States that countries are granted immunity from suits in courts of other countries.

East African Community (EAC)—A regional trading block of countries located in East Africa.

Economic Community of Central African States (ECCAS)—A regional trading block of 8 countries located in Central Africa.

Economic Community of West African States (ECOWAS)—A regional trading block of countries located in West Africa.

Euro—A single monetary unit that has been adopted by many countries of the EU that comprise the eurozone.

European Union (EU)—A regional international organization that comprises many countries of Western and Eastern Europe and was created to promote peace and security as well as economic, social, and cultural development.

European Union Commission—The European Union Commission, which is independent of its member nations, is charged to act in the best interests of the union.

Eurozone—Comprised of many EU countries that have voted to use the euro.

Foreign Commerce Clause—Clause of the U.S. Constitution that vests Congress with the power “to regulate commerce with foreign nations.”

Foreign Sovereign Immunities Act (FSIA)—Governs exclusively suits against foreign nations that are brought in federal or state courts in the United States; codifies the principle of qualified or restricted immunity.

General Assembly—The legislative body of the United Nations that is composed of all UN member nations.

Hindu Law—Hindu law is a religious law. Hindu law—called dharmasastra in Sanskrit (“the doctrine of proper behavior”)—is linked to the divine revelation of Veda (the holy collection of Indian religious songs, prayers, hymns, and sayings written between 2000 and 1000 BCE).

International Court of Justice (ICJ) (World Court)—The judicial branch of the United Nations that is located in The Hague, the Netherlands. Also called the World Court.

International law—Laws that govern affairs between nations and that regulate transactions between individuals and businesses of different countries.

International Monetary Fund (IMF)—An agency of the United Nations whose primary function is to promote sound monetary, fiscal, and macroeconomic policies worldwide by providing assistance to needy countries.

Islamic Law—The Islamic law system is derived from the Qur’an, the Sunnah (decisions and sayings of the prophet Muhammad), and reasonings by Islamic scholars.

Jewish Law—Jewish law, which has existed for centuries, is a complex legal system based on the ideology and theology of the Torah.

Mercosur (Mercusol or Southern Common Market)—A regional economic organization in South America comprised of Argentina, Brazil, Paraguay, Uruguay, and Venezuela.

Multilateral treaty—A treaty involving more than two nations.

National courts—The courts of individual nations.

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North American Free Trade Agreement (NAFTA)—A treaty that has removed or reduced tariffs, duties, quotas, and other trade barriers between the United States, Canada, and Mexico.

Organization of the Petroleum Exporting Countries (OPEC)—An association comprising many of the oil-producing countries of the world.

Qualified immunity (restricted immunity)—Less than absolute immunity. The principle of qualified immunity was codified in the Foreign Sovereign Immunities Act (FSIA) of 1976. It is an act that exclusively governs suits against foreign nations in the U.S. Secretariat—A staff of persons that administers the day-to-day operations of the UN. It is headed by the secretary-general.

Secretary-general—The person who heads the Secretariat of the United Nations. The secretary-general is elected by the General Assembly of the United Nations.

Security Council—A council composed of 15 member nations, five of which are permanent members and ten other countries chosen by the members of the General Assembly. It is responsible for maintaining international peace and security.

Treaty—An agreement between two or more nations that is formally signed by an authorized representative of each nation and ratified by each nation.

Treaty Clause—Clause of the U.S. Constitution that states the president “shall have the power...to make treaties, provided two-thirds of the senators present concur.”

United Nations (UN)—An international organization created by a multilateral treaty in 1945 to promote social and economic cooperation among nations and to protect human rights.

United Nations Children’s Fund (UNICEF)—An agency of the United Nations whose primary function is to provide aid to improve the lives of the world’s children.

Veto power—Each of the five permanent members of the United Nations (UN) Security Council may exercise veto power and prevent the adoption of any substantive resolution of the UN. World Bank—An agency of the United Nations whose primary function is to provide money to developing countries to fund projects for humanitarian purposes and to relieve poverty.

World Trade Organization (WTO)—An international organization of more than 130 member nations created to promote and enforce trade agreements among member nations.

WTO appellate body—A panel of seven judges selected from WTO member nations that hears and decides appeals from decisions of the dispute-settlement body.

WTO dispute settlement body—A board composed of one representative from each WTO member nation that reviews panel reports.

WTO panel—A body of three WTO judges that hears trade disputes between member nations and issues panel reports.

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Chapter 27 Accountants’ Duties and Liability

What is the potential liability of an accountant?

I. Teacher to Teacher Dialogue A word of warning about this chapter—some students may be skeptical about the merit of its coverage. “Why should I worry about accountant liability if I am not going to be an accountant?” might be a refrain from students if this chapter is included on their course syllabus! As instructors, it is our responsibility to impress upon students the importance of studying accountants’ duties and liabilities, even if some of them are not majoring in accounting, hoping to become an accountant, or planning on sitting for the certified public accountant (CPA) examination. The truth is that accounting affects all of us, both directly and indirectly. Our employment compensation depends on accounting. An accountant will assist many of us in determining our state and local tax obligations. And whether a prospective stock investment is a sound one will depend upon a CPA’s issuance of an audit of the issuing firm’s financial condition. The accounting function is at the very heart of our economy.

Given its vital role in our economy, legal standards dictate what an accountant can and cannot do in the performance of accounting duties, and provide sanctions for violation of those standards. In this chapter, students will learn the concepts of generally accepted accounting principles (GAAPS), generally accepted auditing standards (GAASs), and the auditing function.

The material also covers accountants’ liability to their clients, based on theories of breach of contract, fraud, and negligence. Students will learn the various ways to determine accountants’ liability to third parties: the Ultramares doctrine, Section 552 of the Restatement (Second) of Torts, and the foreseeability standard. The chapter covers the various laws that address the civil and criminal liability of accountants for violating federal and state securities laws. Finally, the material addresses the Sarbanes-Oxley Act of 2002, one of the most significant federal laws regulating the accounting profession to be enacted by the United States Congress in recent decades.

If students remain skeptical about the importance of this chapter, be a storyteller. Tell them the story of Bernard Madoff. Tell them the stories of Enron, WorldCom, and Tyco. Tell them that based on the lessons learned from these sagas, all of us must understand that our economy depends on proper oversight of the accounting profession. Accounting is fundamental!

II. Chapter Objectives 1. Describe public accounting and define the term certified public accountant.

2. Describe Generally Accepted Accounting Principles (GAAPs) and Generally Accepted Auditing Standards (GAASs).

3. Define audit and describe auditor’s opinions.

4. Describe how accountants can be found liable to their clients.

5. Describe how accountants can be found liable to third parties, including under the Ultramares doctrine, Section 552 of the Restatement (Second) of Torts, and the foreseeability standard.

6. Describe how accountants can be held liable for violating securities laws.

7. Describe how accountants can be found criminally liable for their actions.

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8. Describe the provisions of the Sarbanes-Oxley Act and how they apply to accountants.

9. Explain under what circumstances an accountant-client privilege applies.

III. Key Question Checklist  What is an accountant’s liability to his or her client for breach of contract or fraud?  What is an accountant’s liability to third parties under the Ultramares doctrine?  What is an accountant’s liability to third parties under the Restatement (Second) of Torts and the foreseeability standard?  What is an accountant’s potential civil liability and criminal liability under federal securities laws?  What are the duties of accountants under the Sarbanes-Oxley Act? IV. Chapter Outline Introduction to Accountants’ Duties and Liability – Accountants’ primary functions are (1) auditing financial statements, and (2) rendering opinions about those audits. Accountants also prepare unaudited financial statements for clients, render tax advice, prepare tax forms, and provide consulting and other services to clients.

Public Accounting – The term accountant applies to persons who perform a variety of services, including bookkeepers and tax preparers. The term certified public accountant (CPA) applies to an accountant who has met certain educational requirements, has passed the CPA examination, and has had a certain number of years of auditing experience. A public accountant is an accountant who is not certified.

Limited Liability Partnership (LLP) – Most public accounting firms are organized and operated as limited liability partnerships (LLPs). In this form of partnership, all the partners are limited partners who lose only their capital contribution in the LLP if the LLP fails. A limited partner whose negligent or intentional conduct causes injury is personally liable for his or her own conduct.

Accounting Standards and Principles – Certified public accountants must comply with two uniform standards of professional conduct: (1) Generally Accepted Accounting Principles (GAAPs); and (2) Generally Accepted Accounting Standards (GAASs).

Generally Accepted Accounting Principles – Generally Accepted Accounting Principles (GAAPs) are standards for the preparation and presentation of financial statements. Most companies in other countries abide by the International Financial Reporting Standards (IFRSs).

These principles are promulgated by the International Accounting Standards Board (IASB), which is located in London, England.

Generally Accepted Auditing Standards – Generally Accepted Auditing Standards (GAASs) specify the methods and procedures that are to be used by public accountants when conducting external audits of company financial statements. The standards are set by the American Institute of Certified Public Accountants (AICPA).

Audit and Auditor’s Opinions – An audit is the verification of a company’s books and records pursuant to federal securities laws, state laws, and stock exchange rules that must be performed by an independent CPA. An accountant’s failure to follow Generally Accepted Auditing Standards (GAASs) when conducting audits constitutes negligence.

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Auditor’s Opinions – An auditor’s opinion relates to how fairly the financial statements of the client company represent the company’s financial position, results of operations, and change in cash flows. The various types of auditor’s opinions include: (1) An unqualified opinion; (2) A qualified opinion; and (3) An adverse opinion.

An unqualified opinion represents an auditor’s finding that the company’s financial statements fairly represent the company’s financial position, the results of its operations, and the change in cash flows for the period under audit, in conformity with generally accepted accounting principles (GAAPs). This is the most favorable opinion an auditor can give.

A qualified opinion states that the financial statements are fairly represented except for, or subject to, a departure from GAAPs, a change in accounting principles, or a material uncertainty. The exception, departure, or uncertainty is noted in the auditor’s opinion.

An adverse opinion determines that the financial statements do not fairly represent the company’s financial position, results of operations, or change in cash flows in conformity with GAAPs. This type of opinion is usually issued when an auditor determines that a company has materially misstated certain items on its financial statements.

Disclaimer of Opinion – A disclaimer of opinion is an auditor’s opinion expressing the auditor’s inability to draw a conclusion about the accuracy of the company’s financial records.

Accountants’ Liability to Their Clients – Under the common law, accountants may be found liable to the clients who hire them under several legal theories, including breach of contract, fraud, and negligence.

Liability to Clients: Breach of Contract – The terms of an engagement are specified when an accountant and a client enter into a contract for the provision of accounting services by the accountant. An accountant who fails to perform may be sued for damages caused by the breach of contract.

Liability to Clients: Fraud – Where an accountant has been found liable for actual or constructive fraud, the client may bring a civil lawsuit and recover any damages proximately caused by that fraud. Actual fraud is an intentional misrepresentation or omission of a material fact that is relied on by the client and causes the client damage. Constructive fraud occurs when an accountant acts with “reckless disregard” for the truth or consequences of his or her actions.

This type of fraud is sometimes categorized as gross negligence.

Liability to Clients: Accounting Malpractice (Negligence) – Accounting malpractice, or negligence, occurs when an accountant breaches the duty of reasonable care, knowledge, skill, and judgment that he or she owes to a client when providing auditing and other accounting services to the client.

Accountants’ Liability to Third Parties – There are three major rules of liability that a state can adopt in determining whether an accountant is liable for negligence to third parties: (1) The Ultramares doctrine; (2) Section 552 of the Restatement (Second) of Torts; and (3) The foreseeability standard.

Liability to Third Parties: Ultramares Doctrine – The landmark case that initially defined the liability of accountants for their negligence to third parties was Ultramares Corporation v.

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Touche. The case established the Ultramares doctrine, a rule stating that an accountant is liable only for negligence to third parties who are in privity of contract or in a privity-like relationship with the accountant. It provides a narrow standard for holding accountants liable to third parties for negligence. A minority of states apply the privity or near privity rules for finding accountants liable to third parties for their negligence.

Liability to Third Parties: Section 552 of the Restatement (Second) of Torts – Section 552 of the Restatement (Second) of Torts is a rule stating that an accountant is liable only for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. It provides a broader standard for holding accountants liable to third parties for negligence than does the Ultramares doctrine. The majority of states have adopted this standard.

State Court Case Case 27.1 Accountants’ Liability to a Third Party: Cast Art Industries, LLC v. KPMG LLP Facts: Papel Giftware (Papel) produced and sold collectible figurines and giftware. KPMG LLP (KPMG) had audited Papel’s financial statements for many years, producing audited financial statements with unqualified opinions. In reliance on KPMG’s unqualified audits, Cast Art (Cast) acquired Papel. After the merger, Cast experienced difficulty in collecting some of Papel’s accounts receivable. Cast failed financially as a result. Cast and its shareholders sued KPMG, alleging that KPMG had been negligent in auditing Papel’s financial statements. KPMG argued that it was not liable, since the New Jersey Accountant Liability Act (Act) had adopted the rules of Section 552 of the Restatement (Second) of Torts. The trial court held that KPMG was liable and awarded damages of $38 million to the plaintiffs. The appellate court upheld the verdict.

KPMG appealed to the supreme court of New Jersey.

Issue: Is KPMG liable to the plaintiff-third parties for accounting malpractice?

Decision: The supreme court of New Jersey held that KPMG was not liable to the non-client third-party plaintiffs and ordered the case dismissed.

Reason: Because Cast Art failed to establish that KPMG knew at the time of the engagement by the client or thereafter agreed that Cast Art could rely on its work in proceeding with the merger, Cast Art failed to satisfy the requisite elements required for KPMG’s liability.

Ethics Questions: Section 552 of the Restatement (Second) of Torts holds that an accountant is liable only for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. Although this rule provides a broader standard for holding accountants liable to third parties for negligence than does the Ultramares doctrine, it still limits accountant liability for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. Reasonable minds might differ in terms of whether this is a more reasonable rule than the Ultramares doctrine.

Liability to Third Parties: Foreseeability Standard – A few states have adopted a rule known as the foreseeability standard for holding accountants liable to third parties for negligence. Under this standard, an accountant is liable for negligence to third parties who are foreseeable users of the client’s financial statements. This is the broadest standard for holding accountants liable to third parties for negligence.

Liability to Third Parties: Fraud – If an accountant engages in actual or constructive fraud, a third party that relies on the accountant’s fraud and is thereby injured, may bring a tort action against the accountant to recover damages. Actual fraud is the intentional misrepresentation or omission of a material fact that is relied on by the client and causes the client damage, while constructive fraud is when an accountant acts with “reckless disregard” for the truth or consequences of his or her actions.

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Liability to Third Parties: Breach of Contract – Third parties usually cannot sue accountants for breach of contract because the third parties are usually incidental beneficiaries who do not acquire any rights under the accountant-client contract. In other words, they are not in privity of contract with the accountants.

Securities Law Violations – Accountants can be held liable for violating various federal and state securities laws.

Section 11(a) of the Securities Act of 1933 – This section of the Securities Act of 1933 imposes civil liability on accountants and others for: (1) Making misstatements or omissions of material facts in a registration statement; or (2) Failing to find such misstatements or omissions.

Accountants can assert a due diligence defense to liability under Section 11(a). An accountant avoids liability if he or she had, after reasonable investigation, reasonable grounds to believe and did believe, at the time of the registration statement became effective, that the statements made therein were true and there was no omission of a material fact that would make the statements misleading.

Section 10(b) of the Securities Exchange Act of 1934 – This section of the Securities Exchange Act of 1934 prohibits any manipulative or deceptive practice in connection with the purchase or sale of a security. Pursuant to its authority under Section 10(b), the Securities and Exchange Commission (SEC) promulgated Rule 10b-5. This rule makes it unlawful for any person, by the use or means or instrumentality of interstate commerce to employ any device or artifice to defraud; to make misstatements or omissions of material fact; or to engage in any act, practice, or course of conduct that would operate as a fraud or deceit on any person in connection with the purchase or sale of any security.

Section 18(a) of the Securities Exchange Act of 1934 – This section of the Securities Exchange Act of 1934 imposes civil liability on any person who makes false or misleading statements in any application, report, or document filed with the SEC. There are two ways an accountant or another defendant can defeat the imposition of liability under Section 18(a): (1) The defendant can show that he or she acted in good faith; or (2) The defendant can show that the plaintiff had knowledge of the false or misleading statement when the securities were purchased or sold.

Private Securities Litigation Reform Act of 1995 – This is a federal statute that changed the liability of accountants and other securities professionals by imposing pleading and procedural requirements that make it more difficult for plaintiffs to bring class action securities lawsuits, and by instituting proportionate liability on defendants, which limits a defendant’s liability to his or her proportionate degree of fault.

Ethics: Accountants’ Duty to Report a Client’s Illegal Activity This section addresses Section 10A of the Securities Exchange Act of 1934, a law that imposes duties on auditors to detect and report illegal acts committed by their clients. Section 10A imposes the following reporting requirements on accountants: (1) Unless an illegal act is “clearly inconsequential,” the auditor must inform the client’s management and audit committee of the illegal act; (2) If management fails to take timely and appropriate remedial action, the auditor must report the illegal act to the client’s full board of directors if (a) the illegal act will have a material effect on the client’s financial statements, and (b) the auditor expects to issue a nonstandard audit report or intends to resign from the audit engagement; and 309 .

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(3) Once the auditor reports the illegal act to the board of directors, the board of directors must inform the Securities and Exchange Commission (SEC) of the auditor’s conclusion within one business day; if the client fails to do so, the auditor must notify the SEC the next business day.

Criminal Liability of Accountants – Many statutes impose criminal penalties on accountants who violate their provisions.

Criminal Liability: Section 24 of the Securities Act of 1933 – This section of the Securities Act of 1933 makes it a criminal offense for any person to: (1) Willfully make any untrue statement of material fact in a registration statement filed with the SEC; (2) Omit any material fact necessary to ensure that the statements made in the registration statement are not misleading; or (3) Willfully violate any other provision of the Securities Act of 1933 or rule or regulation adopted thereunder.

Criminal Liability: Section 32(a) of the Securities Exchange Act of 1934 – This section of the Securities Exchange Act of 1934 makes it a criminal offense for any person willfully and knowingly to make or cause to be made any false or misleading statement in any application, report, or other document required to be filed with the SEC pursuant to the Securities Exchange Act of 1934 or any rule or regulation adopted thereunder.

Criminal Liability: Tax Preparation – The Tax Reform Act of 1976 imposes criminal liability on accountants and others who prepare federal tax returns if they: (1) Willfully understate a client’s tax liability, (2) Negligently understate the tax liability; or (3) Aid or assist in the preparation of a false tax return.

Criminal Liability: Racketeer Influenced and Corrupt Organizations Act – Accountants and other professionals can be named as defendants in lawsuits that assert violations of the Racketeer Influenced and Corrupt Organizations Act (RICO), an act that provides for both criminal and civil penalties for securities fraud.

Criminal Liability: State Securities Laws – Most states have enacted securities laws, many of which are patterned after federal securities laws. State securities laws provide for a variety of civil and criminal penalties for violations of these laws. Many states have enacted all or part of the Uniform Securities Act, a model act promulgated by the National Conference of Commissioners on Uniform State Laws. Section 101 of the Uniform Securities Act makes it a criminal offense for accountants and others to willfully falsify financial statements and other reports.

Sarbanes-Oxley Act – During the late 1990s and early 2000s, many corporations in the United States engaged in fraudulent accounting in order to report inflated earnings or to conceal losses.

Many public accounting firms that were hired to audit the financial statements of these companies failed to detect fraudulent accounting practices. In response, the U.S. Congress enacted the Sarbanes-Oxley Act, a federal law that imposes significant rules for the regulation of the accounting profession.

Business Environment: Public Company Accounting Oversight Board Created by the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board has the authority to adopt rules concerning auditing, accounting quality control, independence, and ethics of public companies and public accountants. The Securities and Exchange Commission (SEC) 310 .

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has oversight and enforcement authority over the board. The board may discipline public accountants and accounting firms and order sanctions for intentional or reckless conduct, including suspending or revoking registration with the board, placing temporary limitations on activities, and assessing civil money penalties.

Audit and Non-Audit Services – The Sarbanes-Oxley Act makes it unlawful for a registered public accounting firm to provide simultaneous audit and certain non-audit services to a public company. Prohibited non-audit services include bookkeeping services, financial information systems, appraisal or valuation services, internal audit services, management functions, human resources services, broker, dealer, or investment services, investment banking services, legal services, or any other services determined by the board.

Audit Report Sign-Off – Each audit by a certified public accounting firm is assigned an audit partner of the firm to supervise the audit and approve the audit report. The Sarbanes-Oxley Act requires that a second partner of the accounting firm review and approve audit reports prepared by the firm.

Certain Employment Prohibited – Any person who is employed by a public accounting firm that audits a client cannot be employed by that client as the chief executive officer (CEO), chief financial officer (CFO), controller, chief accounting officer, or equivalent position for a period of one year following the audit.

Business Environment: Audit Committee The Sarbanes Oxley Act requires that public corporations have an audit committee that is composed of independent members of the board of directors. The audit committee is responsible for the appointment of, payment of compensation for, and oversight of public accounting firms employed to audit the company. The audit committee must approve all audit and permissible nonaudit services to be performed by a public accounting firm.

Accountants’ Privilege and Work Papers – In the course of conducting audits and providing other services to clients, accountants obtain information about their clients and prepare work papers. Sometimes clients are sued in court, and the court seeks information about the client from the accountant. Certain law applies to these matters.

Contemporary Environment: Accountant-Client Privilege Approximately twenty states prohibit an accountant from being called as a witness against a client in a court action. The majority of states follow the common law, which provides that an accountant may be called at court to testify against his or her client. The U.S. Supreme Court has held that there is no accountant-client privilege under federal law.

Accountants’ Work Papers – Some states provide work product immunity, which means an accountant’s work papers cannot be discovered in a court case against the accountant’s client.

Most states do not provide this protection, and an accountant’s work papers can be discovered.

Federal law allows for discovery of an accountant’s work papers in a federal case against the accountant’s client.

V. Key Terms and Concepts  Accountant—Persons who perform a variety of services, including bookkeepers and tax preparers.  Accountant-client privilege—A state law providing that an accountant cannot be called as a witness against a client in a court action.

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Accountant’s work papers—Some states provide work product immunity, which means an accountant’s work papers cannot be discovered in a court case against the accountant’s client. Most states do not provide this protection, and an accountant’s work papers can be discovered. Federal law allows for discovery of an accountant’s work papers in a federal case against the accountant’s client.

Accounting malpractice (negligence)—Negligence where the accountant breaches the duty of reasonable care, knowledge, skill, and judgment that he or she owes to a client when providing auditing and other accounting services to the client.

Actual fraud—Intentional misrepresentation or omission of a material fact that is relied on by the client and causes the client damage.

Adverse opinion—An auditor’s opinion that the company’s financial statements do not fairly represent the company’s financial position, results in operations, or change in cash flows in conformity with GAAPs. American Institute of Certified Public Accountants (AICPA)—A professional accounting organization that, among its various responsibilities related to the accounting profession, maintains the Generally Accepted Auditing Standards (GAASs).

Audit—A verification of a company’s books and records pursuant to federal securities laws, state laws, and stock exchange rules that must be performed by an independent CPA. Audit committee—The Sarbanes Oxley Act requires that public corporations have an audit committee that is composed of independent members of the board of directors.

Auditor’s opinion—An opinion of an auditor about how fairly the financial statements of the client company represent the company’s financial position, results of operations, and change in cash flows.

Breach of contract—The failure to fulfill a contractual obligation. An accountant who fails to fulfill a contractual obligation to a client may be sued for damages caused by breach of contract.

Certified public accountant (CPA)—An accountant who has met certain educational requirements, has passed the CPA examination, and has had a certain number of years of auditing experience.

Constructive fraud—Occurs when an accountant acts with “reckless disregard” for the truth or consequences of his or her actions. This type of fraud is sometimes categorized as gross negligence.

Disclaimer of opinion—An auditor’s opinion expressing the auditor’s inability to draw a conclusion about the accuracy of the company’s financial records.

Due diligence defense—A defense an accountant can assert and, if proven, avoids liability under Section 11(a) of the Securities Act of 1933.

Engagement—A formal entrance into a contract between a client and an accountant.

Expertised portion—Accountants are considered experts, and the financial statements they prepare are considered an expertised portion of a registration statement filed pursuant to the requirements of the Securities Act of 1933.

Foreseeability standard—A rule stating that an accountant is liable for negligence to third parties who are foreseeable users of the client’s financial statements. This is the broadest standard for holding accountants liable to third parties for negligence.

Foreseen class of users—According to the foreseeability standard of accountants’ negligence liability to third parties, an accountant is liable to any member of a foreseen class of users of the client’s financial statements. The accountant’s liability does not depend on his or her knowledge of the identity of either the user or the intended class of users.

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Fraud—In the context of accountant liability, either the intentional misrepresentation or omission of a material fact that is relied on by the client and causes the client damage (actual fraud), or when an accountant acts with “reckless disregard” for the truth or consequences of his or her actions (constructive fraud).

Generally Accepted Accounting Principles (GAAPs)—Standards for the preparation and presentation of financial statements.

Generally Accepted Auditing Standards (GAASs)—Specify the methods and procedures that are to be used by public accountants when conducting external audits of company financial statements.

International Accounting Standards Board (IASB)—An organization located in London, England which promulgates International Financial Reporting Standards (IFRSs).

International Financial Reporting Standards (IFRSs)—These principles are promulgated by the International Accounting Standards Board (IASB). Most companies in other countries abide by these standards.

Joint and several liability—Collective and individual liability; one party or several atfault parties could be made to pay all of a judgment.

Limited class of intended users—According to Section 552 of the Restatement (Second) of Torts, an accountant is liable for his or her negligence to any member of a limited class of intended users for whose benefit the accountant has been employed to prepare the client’s financial statement or to whom the accountant knows the client will supply copies of the financial statement. In other words, the accountant does not have to know the specific name of the third party in order for the accountant to be liable to the third party for negligence.

Limited liability partnership (LLP)—A special form of partnership in which all partners are limited partners.

Private Securities Litigation Reform Act of 1995—A federal statute that changed the liability of accountants and other securities professionals by imposing pleading and procedural requirements that make it more difficult for plaintiffs to bring class action securities lawsuits, and by instituting proportionate liability on defendants, which limits a defendant’s liability to his or her proportionate degree of fault.

Privity-like relationship—According to the Ultramares doctrine, an accountant is liable only for negligence to third parties who are in privity of contract or in a privity-like relationship with the accountant. Privity of contract means that parties to a contract can sue one another for breach of the contract, but that third parties (with few exceptions) cannot sue for such breach because they are not parties to the contract.

Proportionate liability—A rule that limits a defendant’s liability to his or her proportionate degree of fault.

Public accountant—An accountant who is not certified.

Public Company Accounting Oversight Board (PCAOB)—Created by the SarbanesOxley Act, this board has the authority to adopt rules concerning auditing, accounting quality control, independence, and ethics of public companies and public accountants.

Qualified opinion—An auditor’s opinion that the company’s financial statements are fairly represented except for, or subject to, a departure from GAAPs, a change in accounting principles, or a material uncertainty.

Racketeer Influenced and Corrupt Organizations Act (RICO)—A federal act that provides for both criminal and civil penalties for securities fraud.

Registration statement—The Securities Act of 1933 requires that before a corporation or another business sells securities to the public, the issuer must file a registration statement with the Securities and Exchange Commission (SEC).

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Rule 10b-5—A rule adopted by the SEC to clarify the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities.

Sarbanes-Oxley Act of 2002 (SOX)—A federal act that imposes significant rules for the regulation of the accounting profession.

Section 10A of the Securities Exchange Act of 1934—A law that imposes a duty on auditors to detect and report illegal acts committed by their clients.

Section 10(b) of the Securities Exchange Act of 1934—A section of the Securities Exchange Act of 1934 that prohibits any manipulative or deceptive practice in connection with the purchase or sale of a security.

Section 11(a) of the Securities Act of 1933—A section of the Securities Act of 1933 that imposes civil liability on accountants and others for (1) making misstatements or omissions of material facts in a registration statement, or (2) failing to find such misstatements or omissions.

Section 18(a) of the Securities Exchange Act of 1934—A section of the Securities Exchange Act of 1934 that imposes civil liability on any person who makes false or misleading statements in any application, report, or document filed with the SEC. Section 24 of the Securities Act of 1933—A section of the Securities Act of 1933 that makes it a criminal offense for any person to (1) willfully make any untrue statement of material fact in a registration statement filed with the SEC, (2) omit any material fact necessary to ensure that the statements made in the registration statement are not misleading, or (3) willfully violate any other provision of the Securities Act of 1933 or rule or regulation adopted thereunder.

Section 32(a) of the Securities Exchange Act of 1934—A section of the Securities Exchange Act of 1934 that makes it a criminal offense for any person willfully and knowingly to make or cause to be made any false or misleading statement in any application, report, or other document required to be filed with the SEC pursuant to the Securities Exchange Act of 1934 or any rule or regulation adopted thereunder.

Section 101 of the Uniform Securities Act—Makes it a criminal offense for accountants and others to willfully falsify financial statements and other reports.

Section 552 of the Restatement (Second) of Torts—A rule stating that an accountant is liable only for negligence to third parties who are members of a limited class of intended users of the client’s financial statements. It provides a broader standard for holding accountants liable to third parties for negligence than does the Ultramares doctrine.

Tax Reform Act of 1976—An act that imposes criminal liability on accountants and others who prepare federal tax returns if they (1) willfully understate a client’s tax liability, (2) negligently understate the tax liability, or (3) aid or assist in the preparation of a false tax return.

Ultramares Corporation v. Touche—The landmark case that initially defined the liability of accountants for their negligence to third parties.

Ultramares doctrine—A rule stating that an accountant is liable only for negligence to third parties who are in privity of contract or in a privity-like relationship with the accountant. It provides a narrow standard for holding accountants liable to third parties for negligence.

Unaudited financial statements—Financial statements that have not been verified by a certified public accountant (CPA).

Uniform Securities Act—A model act promulgated by the National Conference of Commissioners on Uniform State Laws. Many states have enacted all or part of the act.

Section 101 of the Uniform Securities Act makes it a criminal offense for accountants and others to willfully falsify financial statements and other reports.

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Unqualified opinion—An auditor’s opinion that the company’s financial statements fairly represent the company’s financial position, the results of its operations, and the change in cash flows for the period under audit.

Work product immunity—Some state statutes provide accounting work product immunity, which means an accountant’s work papers cannot be discovered in a court case against the accountant’s client.

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LEGAL ENVIRONMENT OF BUSINESS NINTH EDITION By Henry Cheeseman

Pearson Education, Inc.

Answers to End-of-Chapter Critical Legal Thinking Cases and Ethics Cases

Chapter 1 Legal Heritage and the InformationAge Answer to Critical Legal Thinking Case 1.1 Fairness of the Law Many students will react that the statute is unfair as it does not afford women equal status in the workplace. In light of today’s standards, that position is well founded. However, it is a useful exercise to consider arguments for the opposite position in the context of the time period. In enacting such a statute, the legislature presumably entertained the view that women had special needs, were subject to certain weaknesses, and therefore the demands made on them had to be accommodated in the workplace. That these premises, i.e., special needs and presumed weaknesses, might be false does not necessarily preclude one from acting morally. Moralists might label this ignorance as excusable in that it is “invincible,” i.e., an ignorance that cannot be destroyed or offers no moral reason for doing so. Of course, modern experience and knowledge require that we question these premises. It almost certainly would not be lawful today. Not only have the items relevant to the test of equal protection broadened under present constitutional interpretations, but also Title VII of the Civil Rights Act of 1964 prohibits any discrimination on the basis of sex in the “terms, conditions and benefits of employment.” W. C. Ritchie & Co. v.

Wayman, Attorney for Cook Country, Illinois, 91 N.E. 695, 1910 Ill. Lexis 1958 (Supreme Court of Illinois)

Answer to Ethics Case 1.2 Ethics Case The better case is made by the dissent. The law has not been progressive in this instance. It is likely that legislators entertained an unconscious premise that women should not be required to fight a war. This speculation might be supported by the fact that the majority of the Supreme

Court summoned a technical legal point to justify their ruling. The Court held that Congress was the proper party to articulate the public policy that women should not fight at the front, thereby removing themselves from any further consideration of the substantive issue, i.e., whether equality was being served as a matter of fairness. Rostker, Director of the Selective Service v.

Goldberg, 453 U.S. 57, 101 S.Ct. 2646, 1981 U.S. Lexis 126 (Supreme Court of the United States)

Chapter 2 Ethics and Social Responsibility of Business Answers to Critical Legal Thinking Cases 2.1 False Advertising No. Papa John’s advertising slogan “Better Ingredients. Better Pizza” is not false advertising.

One form of non-actionable statements of general opinion under Lanham Act has been referred to as “puffery.” Prosser and Keeton on the Law of Torts (5th edition) define “puffing” as “a seller’s privilege to lie his head off, so long as he says nothing specific, on the theory that no reasonable man would believe him, or that no reasonable man would be influenced by such talk.”

Bisecting the slogan “Better Ingredients. Better Pizza,” it is clear that the assertion by Papa John’s that it makes a “Better Pizza” is a general statement of opinion regarding the superiority of its product over all others. Consequently, it appears indisputable that Papa John’s assertion “Better Pizza” is non-actionable puffery. Moving next to consider the phrase “Better Ingredients,” the same conclusion holds true. Like “Better Pizza” it is typical puffery. Thus, it is equally clear that Papa John’s assertion that it uses “Better Ingredients” is one of opinion not actionable under the Lanham Act. Consequently, the slogan as a whole is a statement of nonactionable opinion. The U.S. Court of Appeals found that no false advertising had occurred and held in favor of Papa John’s. Pizza Hut, Inc. v. Papa John’s International, Inc., 227 F.3d 489, 2000 U.S. App. Lexis 23444 (United States Court of Appeals for the Fifth Circuit, 2000)

2.2 Liability Yes, an ethicist applying the utilitarian approach to the question of bankruptcy might approve of the company’s decision to seek bankruptcy protection. Identifying and weighing the good and bad in this case would reveal some of the following. Filing a petition in bankruptcy erects a barrier against those claimants who have already gone to court to demand immediate relief in the form of compensation for their terrible loss. The initial order of relief granted by a bankruptcy court freezes all such proceedings pending in other courts. The benefits (the good) from filing in

bankruptcy include preserving the assets of the company so that it can ultimately accept responsibility and compensate many more, if not all, who have a valid claim. Further, it would do the company employees no good for the company assets to be quickly dissipated by payment to those first in line. There are other goods that flow inferentially from those stated above. Given the points raised above, the company has met its social responsibility. A director could ethically, and practically, have voted for a filing in bankruptcy for the reasons stated above. In re JohnsManville Corporation, 36 B.R. 727, 1984 Bankr. Lexis 6384 (United States Bankruptcy Court for the Southern District of New York)

Answers to Ethics Cases 2.3 Ethics Case No. Plaintiff Jazlyn Bradley has not stated a valid case against McDonald’s for deceptive and unfair acts and practices in violation of the New York Consumer Protection Act. It is well-known that fast food in general, and McDonald’s products in particular, contain high levels of cholesterol, fat, salt and sugar, and that such attributes are bad for one. The plaintiff therefore either knew or should have known enough of the critical facts. Bradley is alleged to have “consumed McDonald’s foods her entire life during school lunch breaks and before and after school, approximately five times per week, ordering two meals per day.” What the plaintiff has not done, however, is to address the role that a number of other factors other than diet may come to play in obesity and the health problems of which the plaintiff complains. In order to allege that McDonald’s products were a significant factor in the plaintiff’s obesity and health problems, the complaint must address these other variables and, if possible, eliminate them or show that a McDiet is a substantial factor despite these other variables. Similarly, with regards to plaintiff’s health problems that she claims resulted from her obesity, it would be necessary to allege that such diseases were not merely hereditary or caused by environmental or other factors. Without this additional information, McDonald’s does not have sufficient information to determine if its foods are the cause of the plaintiff’s obesity, or if instead McDonald’s foods are only a contributing factor. The U.S. District Court granted the motion of defendant McDonald’s to dismiss the plaintiff’s complaint.

McDonald’s knew that it sold food products that could cause obesity. As required by law, McDonalds and other fast food restaurants must now disclose calorie and other information about its food products. McDonald’s does not, however, disclose at its restaurants that “super heavy users”—defined as those persons who eat McDonald’s ten times or more a month—make up approximately 75 percent of McDonald’s sales. Bradley v. McDonald’s Corporation, 2003 U.S. Dist. Lexis 15202 (United States District Court for the Southern District of New York, 2003)

2.4 Ethics Case The question as to whether companies owe a duty of social responsibility to provide an affirmative action program is dependent upon which ethical view a moral judge takes of the corporate purpose. If corporations are merely organizational vehicles to achieve profit for their owners, the extent to which they should expend assets for the general benefit of society is limited. Following a legal analogy, one can see why a company should donate funds to a local hospital that would ultimately take care of its employees. That such a company should donate to another hospital in a town some distance away is questionable unless the company entertains a corporate citizenship stance.

By analogy, affirmative action programs are almost like the hypothetical hospital some distance away. Further, affirmative action programs bear an additional burden. The moral position for affirmative action is based on a restitution theory that, unfortunately, looks for relief from those who did not cause the loss. The U.S. Constitution demands equality, equal protection, and an ethical position. To suspend such equality for the purposes of restitution seems fair if the party required to contribute caused the loss.

In this case, the training program is legal under Title VII. Despite the plain language of the statute, which prohibits discrimination in the terms, conditions, and benefits of employment, the Court reasoned that: This situation was one the statute was intended to remedy; the method chosen was agreed to by the union as representative of all workers; the number and duration of the minority preference was limited to such time as the percentage of minorities in skilled jobs mirrored the population in the local workforce. United Steelworkers of America v. Weber, 443 U.S. 193, 99 S.Ct. 2721, 1979 U.S. Lexis 40 (Supreme Court of the United States)

2.5 Ethics Case Whether Warner-Lambert acted unethically would depend upon the extent to which it knew the claims it was making were false. Ethicists would point out that one does not have to have perfect vision and information in order to recommend a product. The state of science is such that medical positions today will be supplanted by others tomorrow. For example, in 1879, alcohol, Listerine’s major ingredient, was presumed to kill certain germs. This is even today a partial truth. The company’s claim is misleading. Warner-Lambert was ordered to include a disclaimer that “Listerine does not kill the germs that cause colds” on its labels for two years. The court declined to include prefatory language requested by the FTC, “Contrary to previous claims.”

Warner-Lambert Company v. Federal Trade Commission, 562 F.2d 749, 1977 U.S. App. Lexis 11599 (United States Court of Appeals for the District of Columbia Circuit)

Chapter 3 Courts, Jurisdiction, and Administrative Law

Answers to Critical Legal Thinking Cases

3.1 Personal Jurisdiction No, defendants Live Siri Art, Inc. and Siri Galliano are not subject to lawsuit in New York pursuant to New York’s long-arm statute. This is because defendant Live Siri Art, Inc, a California corporation, and defendant Siri Galliano, a California resident, did not have the requisite minimum contacts with the state of New York to make them subject to a lawsuit brought by plaintiff Richtone Design Group LLC (Richtone), a New York LLC, in a New York court pursuant to the New York long-arm statute. Assuming that the defendants did violate the plaintiff’s copyright by selling Richtone’s pilates manuals in New York using a website and made $1,000 in more than a decade doing so, this is but de minimis contact that does not arise to the minimum contact required by due process to subject them to a lawsuit in New York. The U.S. district court dismissed plaintiff Richtone’s New York lawsuit against the California defendants for lack of personal jurisdiction. Richtone Design Group, LLC v. Live Art, Inc., 2013 U.S. Dist. Lexis 157781 (United States District Court for the Southern District of New York, 2013)

3.2 Service of Process Yes, May Facebook, Inc. may use alternative service of process by sending email notices to the defendants’ websites. Facebook sued the defendants for trademark infringement, cybersquatting,

and false designation of origin by their use of typosquatting schemes whereby the defendants register internet domain names that are confusingly similar to facebook.com (e.g., facebock.com) so that potential users of Facebook’s website who enter a typographical error are diverted to the typesquatter’s website, which is designed to look strikingly similar in appearance to Facebook’s website, to trick users into thinking that they are using Facebook’s website. Facebook has introduced evidence that it has not been able to serve the defendants personally, by mail, or by telephone. The U.S. district court granted Facebook’s motion to be permitted to serve these defendants by sending an email notice to the defendants’ websites. The U.S. district court stated “Here, service by email is reasonably calculated to provide actual notice.” The U.S. district court issued an order permitting Facebook to serve the defendants by email. Facebook, Inc. v. Banana Ads LLC. 2012 U.S. Dist. Lexis 65834 (United States District Court for the Northern District of California, 2012)

3.3 Standing to Sue Michigan law, and not Ohio law, applies in this case. The court noted that because the accident took place in Michigan, there is a presumption that Michigan law applies absent any other jurisdiction having more substantial contacts. Plaintiff Bertram, however, contended that Ohio law should apply, because all of the parties were residents of Ohio at the time of the accident and all consequences flowing from his injury occurred in Ohio. The court disagreed. The court stated, ”Because the snowmobiling accident took place in Michigan, the place where the conduct causing Bertram’s injury occurred in Michigan and Michigan has enacted specific legislation involving the risks of snowmobiling, we find that Michigan law clearly controls in this case.

While all parties are residents of and have their relationships in the State of Ohio, we are not

persuaded by Bertram’s argument that this issue should control.” The Court of Appeals of Ohio held that the law of the state of Michigan, where the accident occurred, and not the law of the state of Ohio, the state of the residence of the parties, applied. The court applied the Michigan assumption of the risk statute and granted summary judgment to the three defendant friends of plaintiff Bertram. Bertram v. Norden, et al., 823 N.E.2d 478, 2004 Ohio App. Lexis 550 (Court of Appeals of Ohio, 2004)

3.4 Long-Arm Statute Yes, the Missouri court has personal jurisdiction over the Illinois casino based on Missouri’s long-arm statute. Although the Casino Queen casino is located in Illinois, it could reasonably foresee its pervasive advertising directed at Missouri residents would entice those residents, such a Mark Myers, to cross the state line into Illinois to participate in gambling at the Illinois casino.

If an Illinois defendant can reasonably foresee that his or her negligent actions have consequences felt in Missouri, personal jurisdiction is authorized under the Missouri long-arm statute. The U.S. court of appeals held that Casino Queen, which operated a casino in Illinois, is subject to personal jurisdiction in courts in Missouri under Missouri’s long-arm statute. The court of appeals stated, “While Myers’s injuries did not arise out of Casino Queen’s advertising in a strict proximate cause sense, his injuries are nonetheless related to Casino Queen’s advertising activities because he was injured after responding to the solicitation.” The court of appeals ruled that Casino Queen must stand trial in a Missouri court and defend the charges brought against it by Myers. Myers v. Casino Queen, Inc., 689 F.3d 904, (United States Court of Appeals for the Eighth Circuit, 2012)

3.5 Standing to Sue No. The U.S. District Court held that Phoenix of Broward, Inc. (Phoenix), a franchisee of Burger King did not have standing to sue McDonald’s and dismissed the case. In deciding the case the court noted that the goal of standing is to determine whether the plaintiff is a proper party to invoke judicial resolution of the dispute and the exercise of the court's remedial powers. It was Simon Marketing, Inc. (Simon), who McDonald’s hired to operate the promotional games, who committed fraud by steering cash prizes of up to $1 million to its conspirators. McDonald’s may have been negligent in allowing this to happen. Thus, McDonald’s customers who did not have a chance to win the cash prizes because of the fraud would have standing to sue Simon and McDonald’s. However, the court held that Phoenix of Broward, Inc. (Phoenix), a franchisee of Burger King, did not have standing to sue McDonald’s. The court stated, “In this case, the harm caused by McDonald's allegedly false advertisements more directly affects the customers who were denied the opportunity to compete for the high-value prizes criminally co-opted by Jacobson. While these customers do not have standing to sue under the Lanham Act, they could and did vindicate the public interest by suing McDonald's for fraud. Thus, there is no need to empower Phoenix to act as a private attorney general in this case.” Phoenix of Broward, Inc. v.

McDonald’s Corporation, 441 F.Supp.2d 1241, 2006 U.S. Dist. Lexis 55112 (United States District Court for the Northern District of Georgia, 2006)

3.6 U.S. Supreme Court Decision This is a plurality decision of the U.S. Supreme Court and does not create precedent for further cases. This is because although 5 justices upheld the Salinas’s verdict of guilty, 3 did so for one reason and 2 did so for a different reason. If the 5 justices would have agreed to the verdict of

guilty based on the same reason as to why the evidence of the defendant’s silence at the precustodical hearing could be admitted at trial, then it would have been a majority opinion, and a majority opinion would have become precedent. However, in this case, 5 justices upheld the guilty verdict, but 3 for one reason and 2 justices for another reason, with 4 justices dissenting, created a plurality decision that does not create precedent. Salinas v. Texas, 133 S.Ct. 2174, 2012 U.S. Lexis 4697 (Supreme Court of the United States, 2012)

Answers to Ethics Cases

3.7 Ethics Case Yes, the Maryland court has personal jurisdiction over the Florida defendant Ladawn Banks.

Chanel is engaged in the business of manufacturing and distributing throughout the world various luxury goods, including handbags, wallets, and numerous other products under the federally registered trademark “Chanel” and monogram marks. Chanel alleged that Banks owned and operated the fully interactive website www.lovenamebrands.com, through which she sold handbags and wallets bearing counterfeit trademarks identical to the registered Chanel marks.

According to Chanel, although defendant Banks is a resident of Florida, she conducted business in Maryland via several interactive websites. The Zippo court distinction between interactive, semi-interactive, and passive websites is particularly relevant. Defendant’s website at issue in this case was highly interactive and provided a platform for the commercial exchange of information, goods, and funds. Thus, the Maryland court, under its long-arm statute, has personal jurisdiction over the Florida defendant Banks in this matter. The court granted default judgment

to Chanel, assessed damages of $133,712 against Banks, and issued a permanent injunction prohibiting Banks from infringing on Chanel’s trademarks.

Regarding the issue of ethics, if defendant Ladawn Banks operated the website www.lovenamebrands.com and sold knock-off handbags and wallets bearing counterfeit trademarks identical to the registered Chanel marks, she has acted unethically. Stealing another party’s rightful trademarks and selling knock-off goods bearing those trademarks is not only unethical but it also constitutes illegal trademark infringement. Chanel, Inc. v. Banks, 2010 U.S. Dist. Lexis 135374 (United States District Court for Maryland, 2010)

3.8 Ethics Case No, Hertz Corporation is not a citizen of California and therefore is not subject to plaintiff Melinda Friend’s—a California citizen—suit in California state court. A corporation is a citizen of the state in which it is incorporated and in which it has its principal place of business. Hertz Corporation is incorporated in the state of Delaware and has its headquarters office in the state of New Jersey. Hertz is not incorporated in California nor does it have its principal place of business in California. The U.S. Supreme Court stated, “We conclude that the phrase ‘principal place of business’ refers to the place where the corporation’s high level officers direct, control, and coordinate the corporation’s activities. We believe that the ‘nerve center’ will typically be found at a corporation’s headquarters. The metaphor of a corporate ‘brain,’ while not precise, suggests a single location.” Here, that location for Hertz was Hertz’s headquarters office in New Jersey. Because Hertz was not a citizen of California, and plaintiff Friend was a resident of California, there was diversity of citizenship and Hertz can legally have Friend’s lawsuit moved from California state court to the U.S. district court in California.

It was probably not unethical for Hertz to deny citizenship in California even though it has

such a large presence in California with its 270 rental car locations and more than 2,000 employees in California. Finding diversity in this case does not mean that Friend cannot sue Hertz in California. Friend will get her day in court against Hertz, but it will be in a U.S. district court in California and not in a California state court. Hertz Corporation v. Friend, 130 S.Ct. 1181, 2010 U.S. Lexis 1897 (Supreme Court of the United States, 2010)

Chapter 4 Judicial, Alternative, and E-Dispute Resolution

Answers to Critical Legal Thinking Cases

4.1 Summary Judgment No, the defendants’ motions for summary judgment should not be granted. The U.S. district court found that substantial issues of fact needed to be decided at trial, which included whether the butter popcorn flavoring made by the defendants was dangerous, and if so the extent of the danger caused to someone who smelled and ate microwave popcorn, the amount of popcorn flavorings eaten by Deborah that was produced by each of the three defendants—Chr. Hansen, Inc., Symrise, Inc., and Firmenich, Inc.—and, if liability was found, what damages should be awarded and to what degree would each defendant be responsible. The court stated, “I find that the information and circumstances generate genuine issues of material fact as to whether defendants knew or had reason to know that their butter flavorings posed a potential risk, at some level, to consumers, thus triggering the necessity for a warning.” The U.S. district court denied the defendants’ motion for summary judgment based on failure to warn claims, thus permitting the case to go to trial. Daughetee v. Chr. Hansen, Inc., 2013 U.S. Dist. Lexis 50804 (United States District Court for the Northern District of Iowa, 2013)

4.2 Service of Process No, plaintiff Jon Summervold did not properly serve defendant Wal-Mart, Inc. South Dakota law requires that service of process on a corporate defendant be made on president, officer, director, or registered agent of a defendant corporation. Here, plaintiff served a nonofficer employee of Walmart, the assistant manager of the apparel department of the Walmart store in Aberdeen, South Dakota. Based on the fact that the president, directors, or officers of Wal-Mart, Inc. were not located in South Dakota at the time of the plaintiff’s lawsuit, the plaintiff should have had the process server serve the registered agent the service of process. Because the plaintiff had failed to comply with South Dakota’s applicable service of process statute, the court held that the

service of process was invalid. Because the three year statute of limitations had run on the plaintiff’s claim, the court dismissed the plaintiff’s lawsuit against Walmart. The judge stated “It is a most unpleasant task for any judge to dismiss a case at this stage.” Sommervold v. WalMart, Inc., 709 F.3d 1234, 2013 U.S. App. Lexis 4972 (United States Court of Appeals for the Eighth Circuit, 2013)

4.3 Summary Judgment Yes, Wal-Mart Stores, Inc. should be granted summary judgment. Summary judgment can be granted by a court where there is no dispute as to the material facts of the case. Here, the court of appeals held that there were no issues of material fact that needed to be heard by a jury and that the judge could therefore make a decision in this case. The court held that Wal-Mart did not provide a dangerous display and that the four corners of the display were clearing marked with “Watch Step” warning signs. The court stated that Walmart did not instruct the plaintiff to pick up her watermelon and take several steps around the display with it. The court noted that the safer option was for her to have pushed her shopping cart close to the display and then to have scooped the watermelon into her cart. This option would not have required her to take any steps, thus avoiding the unfortunate incident. The court rejected the contention that Walmart “created a trap” for the plaintiff. Based on the undisputed facts of the case, the court granted summary judgment to Walmart. Primrose v. Wal-Mart Stores, Inc., 127 So.3d 13, 2013 La. App. Lexis 1985 (Court of Appeals of Louisiana, 2013)

4.4 Class Certification Yes, the class should be certified. The homeowners who have installed the Pex home plumbing system manufactured by Zurn Pex, Inc. and Zurn Industries, Inc. (Zurn) allege that the system has a crucial defect in that the brass fitting and crimp that joins the Pex tubing together is defective because it corrodes over time. Many homeowners have experienced water damage because of the corrosion; other homeowners who have installed the Pex system have not yet experienced water leakage but are still covered by the 25-year warranty on the Pex plumbing system. Homeowners in Minnesota who have installed Zurn Pex plumbing, whether they have experienced water damage or not, seek class certification to bring a class action against Zurn to have Zurn repair or replace Pex plumbing systems according to the warranty. The U.S. district

court noted that the class is readily identifiable, the Pex product that is claimed to be defective is the same product that has been installed in all of the covered homes, the defendants are easily identifiable, and all of the homes are covered by a similar warranty. Therefore, the U.S. district court certified the following class: “All persons and entities that own a structure located within the State of Minnesota that contains a Zurn Pex plumbing system with Zurn brass crimp fittings.”

The U.S. court of appeals affirmed the class certification. In re Zurn Pex Plumbing Products Liability Litigation, 644 F.3d 604, 2011 U.S. App. Lexis 13663 (United States Court of Appeals for the Eighth Circuit, 2011)

4.5 Arbitration Yes, the contract dispute between the parties is subject to arbitration. The U.S. Supreme Court held that there was a valid arbitration agreement entered into between Nitro-Lift Technologies, L.L.C. and its former employees, Eddie Howard and Shane D. Schneider. When Howard and Schneider sued Nitro-Lift in Oklahoma state court to have the noncompetition agreement declared null and void, they ignored the arbitration clause contained in the same agreement. The U.S. Supreme Court held that the dispute was subject to the arbitration clause and must be submitted to arbitration. The U.S. Supreme Court held that the contract dispute in the case was to be heard by the arbitrator and not by the Oklahoma state court. The U.S. Supreme Court stated “The Oklahoma Supreme Court must abide by the Federal Arbitration Act (FAA), which is the Supreme Law of the Land.” Nitro-Lift Technologies, L.L.C. v. Howard, 133 S.Ct. 500, 2012 U.S. Lexis 8897 (Supreme Court of the United States, 2012)

Answers to Ethics Cases 4.6 Ethics Case Yes, the issuance of a default judgment against the defendants is warranted in the case. A default judgment may be issued by the court if the defendant does not answer the complaint. A default judgment establishes the defendant’s liability. The plaintiff then has only to prove damages.

BMW North America, LLC and Rolls-Royce Motor Cars NA, LLC and their parent and affiliate companies (plaintiffs) filed a lawsuit in U.S. district court for trademark

infringement against the corporate defendants, DinoDirect Corporation, DinoDirect China Ltd., and B2CForce International Corporation, and the individual defendant Kevin Feng, for selling counterfeit goods bearing the trademark names “BMW” and “Rolls-Royce.” The plaintiffs properly served these defendants with the complaint against them. The defendants replied to the court with many emails but failed to appear in court or to file an answer to the complaint filed against them. After giving the defendants ample opportunities to appear and file an answer, the court issued a default judgment against the defendants holding them liable for trademark infringement. In the default judgment, the court permanently enjoined the defendants from engaging in similar trademark infringement in the future, issued an order for the destruction of any counterfeit goods in the possession of the defendants, and awarded the plaintiffs $1.5 million against the defendants for willful trademark infringement.

Selling counterfeit goods bearing valid trademarks of other companies is unethical behavior.

Here, the brand names BMW and Rolls-Royce are well recognized in the United States and around the world as being those of companies producing luxury automobiles and other products.

The defendants were trying to make illegal profits by selling counterfeit goods bearing these trademarks. Trademark owners lose hundreds of millions of dollars each year from counterfeiters illegally selling knock-off s bearing their trademarks. BMW of North America v. Dinodirect Corporation, 2012 U.S. Dist. Lexis 170667 (United States District Court for the Northern District of California, 2012)

4.7 Ethics Case No, the federal court should not vacate the arbitrator’s award. The agreement signed between Johnson Controls, Inc. and Edman Controls, Inc. gave Edman the exclusive rights to sell Johnson products in Panama. An arbitration agreement provides that disputes between the parties will be decided by an arbitrator and not by the courts. The agreement between the parties in this case stipulated that any dispute arising from the parties’ arrangement would be resolved through arbitration using Wisconsin law. The court upheld the arbitrator’s finding that Johnson breached the agreement by attempting to sell its products directly to Panamanian developers, circumventing Edman. The U.S. district court upheld the arbitrator’s decision, as did the U.S. court of appeals. The court of appeals held that the parties had entered into a binding arbitration agreement and that the dispute between the parties had been properly decided by the arbitrator.

The court noted “Attempts to obtain judicial review of an arbitrator’s decision undermine the integrity of the arbitral process.” The district court and court of appeals affirmed the arbitrator’s decision that Johnson had breached its contract with Edman and upheld the arbitrator’s award $733,341 in lost profits and damages, $252,127 in attorney’s fees, $39,958 in costs, and $23,042 in prejudgment interest against Johnson.

Johnson acted unethically in two regards in this case. First, Johnson breached its agreement with Edman by directly competing with Edman in the Panama building market, violating the express terms of their agreement. Concerning this, the court of appeals stated, “Johnson breached the agreement, circumventing Edman. There was nothing subtle about this.” The second way Johnson acted unethically was by trying to avoid the arbitrator’s decision and award. In regards to Johnson’s attempt to avoid the arbitrator’s award by appealing to the courts, the court of appeals noted “Although arbitration is supposed to be a procedure through which a dispute can be resolved privately, losers sometimes cannot resist the urge to try for a second bite at the apple.

That is what has happened here.” Johnson Controls, Inc. v. Edman Controls, Inc., 712 F.3d 1021, 2013 U.S. Dist. Lexis 5583 (United States Court of Appeals for the Seventh Circuit, 2013)

Chapter 5 Constitutional Law for Business and E-Commerce

Answer to Critical Legal Thinking Cases

5.1 Supremacy Clause Yes. The U.S. Supreme Court held that the Massachusetts’ anti-Myanmar law conflicted with federal law and was therefore preempted by the Supremacy Clause of the U.S. Constitution. The Supreme Court stated, “Within the sphere defined by Congress, then, the federal statute has placed the president in a position with as much discretion to exercise economic leverage against Burma, with an eye toward national security, as our law will admit. It is simply implausible that Congress would have gone to such lengths to empower the president if it had been willing to compromise his effectiveness by deference to every provision of state statute or local ordinance that might, if enforced, blunt the consequences of discretionary presidential action.” The court stated that it was unlikely that Congress intended both to enable the president to protect national security by giving him the flexibility to suspend or terminate federal sanctions and simultaneously to allow Massachusetts to act at odds with the president’s judgment of what national security requires. And that is just what the Massachusetts Burma law would do in imposing a different, state system of economic pressure against the Burmese political regime.

The U.S. Supreme Court held that the Massachusetts anti-Myanmar law conflicted with federal law and was therefore preempted by the Supremacy Clause of the Constitution. The Supreme Court ruled in favor of the National Foreign Trade Council. Crosby, Secretary of Administration and Finance of Massachusetts v. National Foreign Trade Council, 530 U.S. 363, 120 S.Ct. 2288, 2000 U.S. Lexis 4153 (Supreme Court of the United States, 2000)

5.2 Establishment Clause Yes, the display of the Ten Commandments in the courthouses violates the Establishment Clause. The First Amendment’s Establishment Clause mandates governmental neutrality regarding religion, that is, a government cannot promote religion. However, the U.S. Supreme

Court has held that in some instances the display of a religious item may have obtained a secular purpose and therefore does not violate the Establishment Clause. Here, the Ten Commandments were not part of an historical display that may have taken on a secular meaning. Instead, the Ten Commandments were recently hung in the courtrooms, and were hung alone. Although the counties later added historical documents to the display—such as the Declaration of Independence and the Bill of Rights—this did not create a secular purpose. Here, the hanging of the additional material was a sham to hide the real purpose, which was to promote religion. The U.S. Supreme Court held that the Counties’ display of the Ten Commandments violated the Establishment Clause. McCreary County, Kentucky v. American Civil Liberties Union of Kentucky, 545 U.S. 844, 125 S.Ct. 2722, 2005 U.S. Lexis 5211 (Supreme Court of the United States, 2005)

5.3 Supremacy Clause Yes, South Coast’s fleet emission standards are preempted by federal environmental protection law. The Supremacy Clause of the U.S. Constitution stipulates that federal law is the supreme law of the United States, and that any conflicting state or local law is preempted by the relevant federal law. Congress enacted the Clean Air Act, a federal law that sets air pollution standards for vehicles and other sources of pollution. The South Coast Air Quality Management District (South Coast), which is a political entity of the state of California, adopted air pollution standards for fleets of vehicles, such as those operated by trucking companies that were more stringent than federal air pollution standards. The U.S. Supreme Court held that South Coast’s more stringent pollution law conflicted with the federal pollution law and was therefore preempted by the Clean Air Act. The Supreme Court stated, “Clearly, Congress contemplated the enforcement of emission standards. But if one state or political subdivision may enact such rules, then so may any other, and the end result would undo Congress’s carefully calibrated regulatory scheme. What is the use of imposing such a limitation if the states are entirely free to impose their own fleet purchase standards with entirely different specifications?” The U.S. Supreme Court held that the federal Clean Air Act preempted South Coast’s more stringent fleet emission standards. Engine Manufacturers Association v. South Coast Air Quality Management District, 541 U.S. 246, 124 S.Ct. 1756, 2004 U.S. Lexis 3232 (Supreme Court of the United States, 2004)

5.4 Due Process Yes, the Federal Communications Commission (FCC) violated the Fifth Amendment’s due process rights of Fox and ABC. A fundamental principle of the U.S. legal system as stated in the Due Process Clause of the Fifth Amendment is that laws which regulate persons and entities must give fair notice of conduct that is forbidden or required. The Fifth Amendment requires the invalidation of laws that are impermissibly vague. The U.S. Supreme Court held that the FCC failed to give Fox or ABC notice prior to the broadcasts in question that fleeting expletives and momentary nudity could be found actionably indecent and in violation of federal communications law. Therefore, the FCC’s 2004 standards as applied to the broadcasts in 2002 and 2003 were vague. The Supreme Court held that the defendants’ Fifth Amendment’s due process rights had been violated because the FCC had failed to give fair notice to Fox and ABC prior to the broadcasts in question that fleeting expletives and momentary nudity were indecent. Federal Communications Commission v. Fox Television Stations, Inc., 132 S.Ct. 2307, 2012 U.S. Lexis 4661 (Supreme Court of the United States, 2012)

5.5 Free Speech Yes, the Free Speech Clause of the First Amendment shields Phelps and the members of the Westboro Baptist Church from tort liability for their insensitive picketing speech at Lance Corporal Matthew Snyder’s funeral. Here, the Westboro congregation members picketed while standing on public land adjacent to a public street approximately 1,000 feet from the church. They carried placards that read “God Hates the USA/Thank God for 9/11,” “America Is Doomed,” and “Thank God for Dead Soldiers.” The picketers also sang hymns and recited Bible verses. The funeral procession passed within 200 to 300 feet of the picket site. However insensitive the picketing, the U.S. Supreme Court held that it was protected speech under the First Amendment. The Supreme Court stated, “Given that Westboro’s speech was at a public place on a matter of public concern, that speech is entitled to special protection under the First Amendment. Such speech cannot be restricted simply because it is upsetting or arouses contempt. Speech is powerful. It can stir people to action, move them to tears of both joy and sorrow, and—as it did here—inflict great pain. On the facts before us, we cannot react to that pain by punishing the speaker. As a Nation we have chosen a different course—to protect even hurtful speech on public issues to ensure that we do not stifle public debate. That choice requires that we shield Westboro from tort liability for its picketing in this case.”

Snyder v. Phelps, 562 U.S. 443, 131 S.Ct. 1207, 2011 U.S. Lexis 1903 (Supreme Court of the

United States, 2011)

Answers to Ethics Cases 5.6 Ethics Case Yes, under the Supremacy Clause of the U.S. Constitution preemption provision in the federal NCVIA bar state law design-defect product liability claims against vaccine manufacturers? The Supremacy Clause establishes that the U.S. Constitution and federal treaties, statutes, and regulations are the supreme law of the land and that any state or local laws that conflict with valid federal law are preempted and without effect. In this case, Congress passed the National Childhood Vaccine Injury Act of 1986 (NCVIA) which relieved manufactures of vaccines from liability from unavoidable side effects of immunization. The U.S. Supreme Court held that Hanna Bruesewitz’s lawsuit against the vaccine manufacturer Wyeth LLC for state law product liability is preempted by the NCVIA. The public policy for the Supremacy Clause is obvious: without the Clause states could enact laws that overrode federal law, and federal laws could always be ignored and preempted by state law. This would cause havoc to the concept of federalism of our form of government.

Is it ethical for the defendant to rely on the NCVIA to protect it from liability? In this case probably yes, because otherwise Wyeth LLC might not produce the very valuable vaccine against diphtheria, tetanus, and pertussis (DTP). Congress made a public policy choice when it enacted the NCVIA. Bruesewitz v. Wyeth LLC, 562 U.S. 223, 131 S.Ct. 1068, 2011 U.S. Lexis 1085 (Supreme Court of the United States, 2011)

5.7 Ethics Case Yes, unsolicited telemarketing calls is commercial speech that is subject to government regulation and the do-not-call registry restrictions do not violate the free speech rights of the plaintiff telemarketers. Commercial speech covers advertising, including telemarketing.

Commercial speech is provided limited protection under the Free Speech Clause of the U.S. Constitution and is subject to time, place, and manner restrictions. The U.S. Court of Appeals held that the “do-not-call” law is a proper time, place, and manner restriction on telemarketers’ commercial speech and did not did not violate the free speech rights of the plaintiff

telemarketers. The U.S. Court of Appeals stated “The national do-not-call registry offers consumers a tool with which they can protect their homes against intrusions that Congress has determined to be particularly invasive.”

One of the major complaints of consumers, and the impetus for the passage of the do-not-call registry, was that telemarketers were calling people at their homes at dinner time and other inconvenient times. In addition, many telemarketers were overly aggressive, and others used computer generated calling systems. It may have been legal to have used these tactics prior to the enactment of the law, but it seems quite unethical to knowingly bother people at home with unsolicited telemarketing calls. Mainstream Marketing Services, Inc. v. Federal Trade Commission and Federal Communications Commission, 358 F.3d 1228, 2004 U.S. App. Lexis 2564 (United States Court of Appeals for the Tenth Circuit, 2004)

Chapter 6 Torts and Strict Liability Answers to Critical Legal Thinking Cases 6.1 Assumption of the Risk Yes, riding the mechanical bull was an open and obvious danger for which Lilya had voluntarily assumed the risk. The court found the danger stemming from riding the mechanical bull was the open and obvious characteristic of the ride: the possibility of falling off the mechanical bull.

Plaintiff John Lilya had previously seen a patron and his friend be tossed off the mechanical bull, and Lilya himself had been thrown from the mechanical bull prior to boarding the bull for his fateful ride. The supreme court of Alabama stated, “Additionally, the very name of the ride— “Rolling Thunder”—hanging on a banner above the ride, gives a somewhat graphic indication of what is the very nature of bull riding: an extremely turbulent ride, the challenge of which is to hang on and not fall off.” The court concluded “Volenti non fit injuria” (a person who knowingly and voluntarily risks danger cannot recover for any resulting injury). The supreme court of Alabama held that riding a mechanical bull and being thrown and injured by the bull is an open and obvious danger and that Lilya had voluntarily assumed the risk when he rode the bull and was thrown and injured. The state supreme court affirmed the grant of summary judgment in favor of defendant Gulf State Fair. Lilya v. The Greater Gulf State Fair, Inc., 855 So.2d 1049, 2003 Ala. Lexis 57 (Supreme Court of Alabama, 2003)

6.2 Defect in Design Yes, Doncasters, Inc. is strictly liable for the death of the deceased parties of the crash of the Twin Otter airplane because of a defect in design of the blades used in the engine of the crashed airplane. The plaintiffs introduced sufficient evidence through expert witnesses to establish that Doncastors had knowledge that the aluminide coating and base metal alloy used in its engine blades were not safe for use in the engine of the crashed airplane. The jury issued a verdict that held Doncastors strictly liable for the plane crash that killed Victoria Berridge, Robert Cook, Robert Walsh, and Scott Cowan and awarded compensatory damages of $4 million for each

death. The court of appeals upheld the decision that there was sufficient evidence for the jury to have reached its conclusion of liability. In justifying the award of compensatory damages the court stated “Here, substantial evidence was introduced to show that the decedents suffered from pre-impact terror prior to the crash of the Twin Otter.” The jury also awarded $5.6 million of punitive damages for each death. The court of appeals held that the award of punitive damages was justified because the defendant acted with “a complete indifference to or conscious disregard for the safety” of the decedents. Delacroix v. Doncasters, Inc., 407 S.W.3d 13, 2013 Mo. App. Lexis 567 (Missouri Court of Appeals, 2013)

6.3 Negligence Yes. The court held that Clancy was negligent when he fell asleep at the wheel while driving his truck and hit and injured Dianna Goad, who driving a motorcycle on the other side of the road.

The court held that Clancy owed a duty to drive his vehicle safely, and he did not do so by falling asleep at the wheel. Clancy did not mean for the accident to happen, but nonetheless he has been negligent. Clancy was the actual cause and proximate cause of the accident, and of causing the injuries to Dianna. Prior to the accident, Dianna was an active and athletic person.

She was an avid runner, often jogging three-and-a-half miles a day. She belonged to a health club where she regularly trained with free weights. Dianna enjoyed rollerblading, hiking, and cross country skiing. Dianna also worked full-time in a managerial accounting position where she planned to work until she retired.

The court found that the injuries Dianna received in the accident as a result of Clancy’s accident were catastrophic. She spent two weeks in a coma. Surgeries were performed to medically amputate her leg above the knee and to set her broken pelvic bones and her broken elbow. Dianna’s spleen could not be repaired and was inevitably removed, resulting in an increased lifetime risk of infection. Dianna has endured multiple skin graft procedures. At the time of the trial, Dianna had undergone seven surgeries, taken more than 6,800 pills, and her medical expenses totaled more than $368,000. Furthermore, Dianna’s medical expenses and challenges continue and are expected to continue indefinitely. In addition, Dianna has been fitted with a “C-leg,” a computerized prosthetic leg. A C-leg needs to be replaced every three to five years at full cost. The trial court took judicial notice that Dianna’s life expectancy is 35.4 years.

The jury returned a verdict finding Clancy 100 percent at fault for the accident and awarded

Dianna $10 million in compensatory damages. The court of appeals affirmed the judgment of the trial court finding Clancy liable for negligence and upheld the jury verdict awarding Dianna $10 million in damages. Clancy v. Goad, 858 N.E.2d 653, 2006 Ind. App. Lexis 2576 (Court of Appeals of Indiana, 2006)

6.4 Disparagement No, Zagat is not liable for disparagement. Disparagement is an untrue statement of fact made by one person or business about the products, services, property, or reputation of another business.

To prove disparagement, the plaintiff must show that the defendant (1) made an untrue statement of fact about the plaintiff’s products, services, property, or business reputation; (2) published that untrue statement to a third party; (3) knew the statement was not true; and (4) made the statement maliciously (i.e., with intent to injure the plaintiff). Restaurant ratings and reviews almost invariably constitute expressions of opinion. In this case, Zagat’s ratings and comments about Lucky Cheng’s restaurant that appeared in the Zagat guide were not statements of fact. Instead, they were mere opinions and were therefore not actionable as disparagement. Therefore, disparagement did not occur. Themed Restaurants, Inc., Doing Business as Lucky Cheng’s v.

Zagat Survey, LLC, 801 N.Y.S.2d 38, 2005 N.Y. App. Div. Lexis 9275 (Supreme Court of New York, Appellate Division, 2005)

6.5 Negligence Yes. Wilhelm acted negligently by failing to warn Flores of the dangers of working with beehives. The plaintiffs’ allegations of negligence included failure to provide proper instructions.

The plaintiffs established a duty to warn of the dangerousness of bees. Foreseeability is the foremost and dominant consideration. There must be sufficient evidence indicating that the defendant knew or should have known that harm would eventually befall the victim. Bees are probably the number one cause of insect deaths. Defendant Wilhelm testified that he was an expert concerning insects, with a degree in entomology. At the time of this incident, Wilhelm had owned beehives for about five years. The court of appeals held that Wilhelm owed a duty to Flores to warn him of the danger of working with bees and breached that duty by not warning Flores of that danger. The court held that Wilhelm, the person working with the bees, was negligent, and that Black, the owner of a beehive business that contracted to purchase bees from

Wilhelm, was also liable. The court awarded $1,500,000 in damages to the plaintiffs, and apportioned liability fifty percent to Wilhelm and fifty percent to Black. Wilhelm v. Flores, 133 S.W.3d 726, 2003 Tex. App. Lexis 9335 (Court of Appeals of Texas, 2003)

6.6 Defect in Manufacture Yes, Western Manufacturing is strictly liable for Dorel Roman’s injuries based on the defect of manufacture. The court of appeals reviewed the evidence presented at trial and agreed with the jury’s finding that the mobile stucco pump produced by Western was defective in construction.

The jury found that the stucco pumps produced by Western did not contain a design defect but that the stucco pump that Roman was using had a specific defect in construction. Strict liability can be imposed for a defect in manufacturing. Based on the evidence, the jury determined that the individual pump that had been used by Roman and his employee was defective in its construction. Therefore, there was a defect in manufacture for which Western was strictly liable.

The jury and the trial court awarded Roman $653,304 in damages. Roman v. Western Manufacturing, Incorporated, 691 F.3d 686, 2012 U.S. App. Lexis 17353 (United States Court of Appeals for the Fifth Circuit, 2012)

Answers to Ethics Cases 6.7 Ethics Case No. Walmart did not present sufficient evidence to prove that it should be protected by the merchant protection statute. Plaintiff Goodman sued Walmart for damages for false imprisonment when Walmart detained her for alleged shoplifting. Walmart defended, asserting that the merchant protection statute protected it from liability. In order to be shielded from liability under the merchant protection statute, a merchant must prove that there were reasonable grounds for the suspicion, the suspect was detained for only a reasonable time, and the merchant’s investigation was conducted in a reasonable manner. The court rejected Walmart’s defenses, including the shopkeeper’s privilege and its assertion that it had not maliciously prosecuted Goodman. The court awarded Goodman $200,000 in compensatory damages for her

suffering. The court also decided that Walmart had acted so badly that it awarded Goodman $600,000 in punitive damages.

Did Walmart act ethically in this case? It could be argued that Walmart aggressively prosecuted Goodman when there was not sufficient evidence of possible shoplifting. In addition, bringing criminal charges without sufficient evidence violated Goodman’s right to be free from overaggressive acts of a large corporation. The court answered the question of ethics when it imposed punitive damages on Walmart for its conduct. Wal-Mart Stores, Inc. v. Goodman, 789 So.2d 166, 2000 Ala. Lexis 548 (Supreme Court of Alabama, 2000)

6.8 Ethics Case No. Overhead Door Corporation was not liable for strict liability for either design defect or failure to warn. Jolie Glenn could have easily avoided exposing her three-year old daughter Brittany to dangerous levels of carbon monoxide by not leaving her in a car unattended for an extended period of time with the engine running and the garage door down. Proving that a manufacturer did not warn of some potential danger does not, by itself, prove that a defendant is liable. In order to prove failure to warn, the plaintiff must show that the user was ignorant of the danger warned against. Manufacturers and distributors have no duty to warn of dangers that are open and obvious or if the hazard associated with the product is common knowledge to the ordinary observer or consumer. Although Jolie Glenn testified that it never crossed her mind that her daughter could die from carbon monoxide poisoning, she did testify that she knew a person should never leave a child unattended in a car with the engine running. She also testified that she knew and appreciated the danger of carbon monoxide poisoning and that she knew the garage door would not open automatically. She needed no other warning. The court of appeals held that Overhead Door was not strictly liable for design defect or failure to warn.

Did Glenn act ethically in suing Overhead? It would seem that Glenn did not act unethically.

Glenn acted negligently herself, but she could still have a reasonable lawsuit against Overhead.

Maybe this would have been the case where the court imposed a duty on overhead garage door manufacturers to provide some form of alarm that detects carbon monoxide. Glenn v. Overhead Door Corporation, 935 S.2d 1074, 2006 Miss. App. Lexis 60 (Court of Appeals of Mississippi, 2006)

Chapter 7 Criminal Law and Cybercrime Answers to Critical Legal Thinking Cases 7.1 Search and Seizure No. The police officers’ use of the global positioning system (GPS) without first obtaining a search warrant does not constitute an unreasonable search in violation of the Fourth Amendment.

The Fourth Amendment forbids unreasonable searches and seizures. The U.S. Supreme Court has created a presumption that a warrant is required to conduct a search. However, a warrant is not required under certain circumstances. The Supreme Court has insisted that the meaning of a Fourth Amendment search must change to keep pace with the march of science. The police of Polk County, Wisconsin, where the events of this case unfolded, are not engaged in mass surveillance. They use GPS tracking only when they have a suspect in their sights. They had probable cause for suspecting the defendant in this case. The U.S. Court of Appeals held that the warrantless use of a GPS tracking system was not a search and therefore did not violate the Fourth Amendment. United States of America v. Garcia, 474 F.3d 994, 2007 U.S. App. Lexis 2272 (United States Court of Appeals for the Seventh Circuit, 2007)

7.2 Cruel and Unusual Punishment Yes, Alabama’s mandatory sentencing requirement of life imprisonment without the possibility of parole as applied to juvenile defendants constitutes cruel and unusual punishment in violation of the Fifth Amendment. The U.S. Supreme Court held that a mandatory life sentence as applied to a juvenile prevents the sentencer from taking into account a juvenile defendant’s youth as a consideration at sentencing. The Supreme Court noted that juveniles have a greater capacity for reform than adults. The Supreme Court stated that the sentencer should consider several factors, including the possibility of a juveniles lack of maturity and undeveloped sense of responsibility,

the vulnerability of juveniles from negative influences and outside pressures including from peers and family members, and a juvenile’s character that may not be as developed as an adult’s.

The Court stated, “Of special pertinence here, we insist that a sentencer have the ability to consider the mitigating qualities of youth.” The U.S. Supreme Court held that a mandatory life sentence without the possibility of parole for those under the age of 18 at the time of their crimes violates the Eighth Amendment’s prohibition against cruel and unusual punishment. The Supreme Court remanded the case for further proceedings regarding sentencing. Miller v.

Alabama, 132 S.Ct. 2455, 2012 U.S. Lexis 4873 (Supreme Court of the United States, 2012)

7.3 Search Yes, the warrantless search is constitutional. Although in the majority of cases a warrant is necessary to conduct a search, the warrant requirement is subject to certain reasonable exceptions. One well-recognized exception applies when the exigencies of the situation make the needs of law enforcement so compelling that a warrantless search is objectively reasonable under the Fourth Amendment. The Supreme Court permits police officers to enter premises without a warrant when they are in hot pursuit of a fleeing subject and to prevent the imminent destruction of evidence. The U.S. Supreme Court held that these exigent circumstances existed in this case and justified the warrantless search and seizure of the evidence used against King. The Supreme Court held that the evidence obtained by the warrantless search could be used against King at his criminal trial. Kentucky v. King, 131 S.Ct. 1849, 2011 U.S. Lexis 3541 (Supreme Court of the United States, 2011)

7.4 Search Yes, the record amply supports the trial court’s determination that Aldo’s alert gave Wheetley probable cause to search Harris’s truck. If a bona fide organization has certified a dog after testing his reliability in a controlled setting, a court can presume that the dog’s alert provides probable cause to search. The question—similar to every inquiry into probable cause—is whether all the facts surrounding a dog’s alert viewed through the lens of common sense, would make a reasonable prudent person think that a search would reveal contraband or evidence of a crime. The U.S. Supreme Court found that it did. The Court noted “A sniff is up to snuff when it meets that test. And here, Aldo’s did.” The U.S. Supreme Court found that the record amply

supported the trial court’s determination that Aldo’s alert gave Wheetley probable cause to search Harris’s truck. Florida v. Harris, 133 S.Ct. 1050, 2013 U.S. Lexis 1121 (Supreme Court of the United States, 2013)

7.5 Search and Seizure The U.S. Supreme Court held that the use of a thermal-imaging device aimed at a private home from a public street to detect relative amounts of heat within the home was a “search” within the meaning of the Fourth Amendment. The Supreme Court stated, “At the very core of the Fourth Amendment stands the right of a man to retreat into his own home and there be free from unreasonable government intrusion.” The Supreme Court noted that, with few exceptions, the question whether a warrantless search of a home is reasonable and hence constitutional must be answered no. The present case involves officers on a public street engaged in more than nakedeye surveillance of a home. The court framed the issue, “The question we confront today is what limits there are upon this power of technology to shrink the realm of guaranteed privacy.” The Supreme Court found that obtaining by sense-enhancing technology any information regarding the interior of the home that could not otherwise have been obtained without physical intrusion into a constitutionally protected area constitutes a search. This ruling assures preservation of that degree of privacy against government that existed when the Fourth Amendment was adopted. On the basis of this criterion, the Supreme Court held that the information obtained by the thermal imager in this case was the product of a search within the meaning of the Fourth Amendment.

Kyllo v. United States, 533 U.S. 27, 121 S.Ct. 2038, 2001 U.S. Lexis 4487 (Supreme Court of the United States, 2001)

7.6 Search and Seizure Yes, the Indianapolis highway checkpoint program violates the Fourth Amendment to the U.S. Constitution. In the highway checkpoint in this case the police, without individualized suspicion, stopped vehicles for the purpose of discovering illegal narcotics. The Fourth Amendment requires that searches and seizures be reasonable. A search or seizure is ordinarily unreasonable in the absence of individualized suspicion of wrongdoing. In only limited circumstances does this rule not apply. The Fourth Amendment does not approve a checkpoint program whose primary purpose is to detect evidence of ordinary criminal wrongdoing. Because the primary

purpose of the Indianapolis narcotics checkpoint program was to uncover evidence of ordinary criminal wrongdoing, the program contravenes the Fourth Amendment. Of course, certain circumstances might justify a law enforcement checkpoint where the primary purpose would be necessary for some emergency. For example, the Fourth Amendment would permit an appropriately tailored roadblock set up to thwart an imminent terrorist attack or to catch a dangerous criminal who is likely to flee by way of a particular route. But barring such emergencies—which did not exist in this case—the police cannot use a checkpoint program whose primary purpose is to detect evidence of ordinary criminal wrongdoing of possessing or using illegal narcotics. City of Indianapolis, Indiana v. Edmond, 531 U.S. 32, 121 S.Ct. 447, 2000 U.S. Lexis 8084 (Supreme Court of the United States, 2000)

Answers to Ethics Cases 7.7 Ethics Case Yes, the canine investigation was an unreasonable search. The U.S. Supreme Court noted that “When it comes to the Fourth Amendment, the home is first among equals.” At the Fourth Amendment’s very core stands the right of a man to retreat into his own home and there be free from unreasonable governmental intrusion. The Supreme Court held that the area immediately surrounding and associated with the home—what is call curtilage—is part of the home for Fourth Amendment purposes. The front porch is the classic example of an area adjacent to the home to which the activity of home life extends. The U.S. Supreme Court held that the government’s use of a trained narcotics detection dog to investigate the home and its immediate surroundings was an unreasonable search. The Supreme Court affirmed the judgment of the Florida Supreme Court that suppressed the evidence.

The question of whether it is ethical for a defendant to assert the Fourth Amendment to suppress evidence when he knows he is guilty of the crime charged is a close one. Literally, the answer would be no, because the defendant knows that he is getting away with a crime.

However, the privilege to be free from unreasonable searches was placed in the Constitution for a very important reason. So in reality, it could be said that the government is acting unethically when if tries to admit evidence it has unlawfully obtained. Florida v. Jardines, 133 S.Ct. 1409, 2013 U.S. Lexis 2542 (Supreme Court of the United States, 2013)

7.8 Ethics Case No, the search of Rodney Gant’s car was not a reasonable search. A search of a car incidence to an arrest is permissible and the evidence obtained may be admitted into evidence. The issue was whether the warrantless search of Gant’s automobile was justified as a search incident to an arrest. A warrantless search incident to arrest may only include the arrestee’s person and the area “within his immediate control.” Gant clearly was not within reaching distance of his car at the time of the search. Gant was arrested for driving with a suspended license—an offense for which police could not expect to find evidence in the passenger compartment of Gant’s car. Because police could not reasonably have believed either that Gant could have accessed his car at the time of the search or that evidence of the offense for which he was arrested might have been found therein, the U.S. Supreme Court held that the search was unreasonable and that the evidence found in Gant’s automobile must be suppressed.

The Fourth Amendment of the U.S. Constitution protects persons from unreasonable searches. This is a right granted by the highest law of the land. It could be argued that Gant acted unethically by trying to get evidence of his crime—the cocaine found in the passenger compartment of his car—excluded from his trial. However, it would be hard to label his conduct unethical when the U.S. Constitution grants him the right to be secure from unreasonable searches by the government. Arizona v. Gant, 129 S.Ct. 1710, 2009 U.S. Lexis 3120 (Supreme Court of the United States, 2009)

Chapter 8 Intellectual Property and Cyber Piracy Answers to Critical Legal Thinking Cases 8.1 Patent No, the claimed invention is not patentable. To be patentable, the claimed invention must be novel and nonobvious. Laws of nature, physical phenomena, and abstract ideas do not meet these criteria and are therefore not patentable. The concepts covered by laws of nature and abstract ideas are part of the storehouse of knowledge of all men free to all men and reserved exclusively to none. Claims 1 and 4 of the patent application explain the basic concept of hedging, or protecting against risk. The U.S. Supreme Court stated, “Hedging is a fundamental economic practice long prevalent in our system of commerce and taught in any introductory finance class.

Allowing petitioners to patent risk hedging would preempt use of this approach in all fields, and would effectively grant a monopoly over an abstract idea.” The U.S. Supreme Court held that the concept of hedging is an abstract idea that cannot be patented. Bilski v. Kappos, Director, Patent and Trademark Office, 561 U.S. 593, 130 S.Ct. 3218, 2010 U.S. Lexis 5521 (Supreme Court of the United States, 2010)

8.2 Trademark Yes, Zura Kazhiloti is liable for trademark infringement. The store owners testified that they had purchased the counterfeit jewelry from Kazhiloti that contained the trademarks of Cartier International A.G and Van Cleef & Arpels and produced invoices showing the purchase of such jewelry. They also testified that Kazhiloti gave them certificates of authenticity that the jewelry came from Cartier and Van Cleefs & Arpels. The jewelry sold by Kazhiloti to the jewelry stores, which were then sold to unsuspecting customers, and the pieces seized from the jewelry stores, were high-quality counterfeits that contained plaintiffs’ trademarks. The court found that Kazhiloti’s counterfeiting was intentional. The court stated, “Mr. Kazhiloti has simply plead the Fifth Amendment throughout the course of this litigation and has not so much as denied that he

sold the counterfeit jewelry in question.” The court issued a permanent injunction against further infringement of the plaintiffs’ trademarks and awarded the plaintiffs a total of $43 million in total damages. The court also awarded the plaintiffs their attorneys’ fees, costs, and prejudgment interest. Cartier International A.G. and Van Cleef & Arpels S.A. v. Kazhiloti, 2013 U.S. Dist.

Lexis 145278 (United States District Court for the District of New Jersey, 2013)

8.3 Copyright The U.S. Court of Appeals held that the incorporation by the Beastie Boys of a short segment of a copyrighted musical composition of “Choir” into their new musical recording constituted fair use and not copyright infringement. The dispute between Newton and Beastie Boys centered around the copyright implications of the practice of “sampling” a practice now common to many types of popular music. Sampling entails the incorporation of short segments of prior sound recordings into new recordings. For an unauthorized use of a copyrighted work to be actionable, there must be substantial similarity between the plaintiff’s and defendant’s works. This means that even where the fact of copying is conceded, no legal consequences will follow from that fact unless the copying is substantial. The focus on the sample’s relation to the plaintiff’s work as a whole embodied the fundamental question in any infringement action: whether so much is taken that the value of the original is sensibly diminished. The court held that when viewed in relation to Newton’s composition as a whole, the sampled portion was neither quantitatively nor qualitatively significant. Quantitatively, the three-note sequence appeared only once in Newton’s composition. When played, the segment lasted six seconds and was roughly two percent of the four-and-a-half-minute “Choir.” Beastie Boys’ use of the “Choir” composition was de minimis.

The U.S. Court of Appeals held that the Beastie Boys’s de minimis sampling of Newton’s “Choir” composition constituted fair use and not copyright infringement. Newton v. Beastie Boys, 349 F.3d 591, 2003 U.S. App. Lexis 22635 (United States Court of Appeals for the Ninth Circuit, 2003)

8.4 Trademark Yes, Cracker Barrel Old Country Store, Inc. (CBOCS) use of the “Cracker Barrel” name on the food products it proposes to sell in grocery stores infringes on the Kraft Foods Group Brands LLC (Kraft) Cracker Barrel trademark. The words “Cracker Barrel” on both labels might lead

the shopper to think them both Kraft products. The U.S. court of appeals stated “Even savvy consumers might be fooled. A trademark’s value is the saving in search costs made possible by the information that the trademark conveys about the quality of the trademark owner’s brand.”

The particular danger for Kraft of CBOCS’s being allowed to sell food products through the same outlets under a trade name confusingly similar to Kraft’s “Cracker Barrel” trade name is that if CBOCS’s products are inferior in any respect to what the consumer expects — if a consumer has a bad experience with a CBOCS product and blames Kraft, thinking it the producer — Kraft’s sales of Cracker Barrel cheeses are likely to decline. The U.S. court of appeals affirmed the injunction issued by the U.S. district court that prevents CBOLS from selling food products in grocery stores using Kraft’s trademark name Cracker Barrel. Kraft Foods Group Brands LLC v. Cracker Barrel Old Country Store, Inc., 2013 U.S. App. Lexis 23124 (United States Court of Appeals for the Seventh Circuit, 2013)

8.5 Copyright Yes, Cecilia Gonzalez is liable for copyright infringement. The U.S. court of appeals stated, “A copy downloaded, played, and retained on one’s hard drive for future use is a direct substitute for a purchased copy. As file sharing has increased, the sales of recorded music have dropped. The events likely are related. Music downloaded for free from the Internet is a close substitute for purchased music; many people are bound to keep the downloaded files without buying originals.

That is exactly what Gonzalez did. Nor can she defend by observing that other persons were greater offenders; Gonzalez’s theme that she obtained ‘only 30’ (or ‘only 1,300’) copyrighted songs is no more relevant than a thief’s contention that he shoplifted ‘only 30’ compact discs, planning to listen to them at home and pay later for any he liked.” The U.S. district court granted summary judgment in favor of BMG Music, assessed $22,500 in damages against Gonzalez, and issued an injunction against Gonzalez, enjoining her from further copyright infringement. The U.S. court of appeals upheld the decision. BMG Music v. Gonzalez, 430 F.3d 888, 2005 U.S. App. Lexis 26903 (United States Court of Appeals for the Seventh Circuit, 2005)

Answers to Ethics Cases 8.6 Ethics Case

Yes, there was infringement of Intel Corporations trademarks that warranted the issuance of a permanent injunction against Intelsys. Intel Corporation distributes its entire line of products and services under the registered trademark and service mark INTEL and well as under other trademarks that incorporate its INTEL mark, such as the marks INTEL INSIDE, INTEL SPEEDSTEP, INTEL XEON, and INTEL NETMERGE. The defendant uses the mark “Intelsys Software,” which incorporates Plaintiff’s INTEL trademark and adds the generic term “sys”—a common abbreviation for “systems”—and the generic term “software.” The defendant’s unauthorized use of the Intelsys Software name and trademark falsely indicates to consumers that defendant’s products and services are in some manner connected with, or related to, plaintiff Intel. The defendant’s use of the mark allows it to benefit from the goodwill established by Intel and will continue to have an adverse effect on the value of and distinctive quality of the INTEL mark. The U.S. district court granted judgment to Intel Corporation on its trademark infringement claims against Intelsys and issued a permanent injunction prohibiting the defendant from using the name Intelsys as a trade name or name of any products or services.

From the facts of the case it is easy to draw the conclusion that the defendant choose the name Intelsys to play off of the name recognition of the “INTEL” trademark of Intel Corporation. The Intel Corporation used its trademark name Intel and added additional names to that word to create other recognizable trademarks. The defendant took the INTEL trademark and did the same by adding the abbreviated term sys to the mark INTEL. This was an obvious and unethical means of stealing the recognition and goodwill established by Intel Corporation’s INTEL trademark. Intel Corporation v. Intelsys Software, LLC, 2009 U.S. Dist. Lexis 14761 (United States District Court for the Northern District of California, 2009)

8.7 Ethics Case The U.S. Court of Appeals held that Passport’s use of the copyrighted Elvis Presley materials was not fair use but instead constituted copyright infringement. The Court of Appeals stated, “The King is dead. His legacy and those who wish to profit from it remain very much alive.” The Court of Appeals held that Passport’s use of others’ copyrighted materials was for commercial use rather than for a nonprofit purpose. The Court rejected Passport’s claim that the videos consisted of scholarly research that would be protected as fair use. Also, the use of other copyright holders’ materials that made up 5 to 10 percent of the Passport video is not de minimis,

but is significant. The court found that Passport’s use of the copyrighted material caused market harm to the copyright holders because it would act as a substitute for the original copyrights and thus deny the copyright holders of the value of their copyrights. The Court of Appeals denied Passport’s claim of fair use and affirmed the District Court’s judgment that enjoined Passport from distributing its videos containing these copyrighted materials.

Concerning the ethics of Passport Video, it is obvious that Passport knew it was attempting to use copyrighted material for free. The amount of copyrighted material made up a significant portion of its Elvis Presley video. Passport itself would assert copyright protection for its video and would not want someone to copy 5 to 10 percent of the video. The question is whether Passport video could have realistically thought that its use of other parties’ copyrighted material was fair use. Although possible, it is highly unlikely that this would have been the case. Elvis Presley Enterprises, Inc. v. Passport Video, 349 F.3d 622, 2003 U.S. App. Lexis 22775 (United States Court of Appeals for the Ninth Circuit, 2003)

Chapter 9 Formation and Requirements of Contracts

Answers to Critical Legal Thinking Cases 9.1 Gift and Gift Promise No, Cooper cannot recover the gifts that he made to Julie and Janet Smith. The court of appeals held that the gifts made by Cooper to Julie and to Janet were irrevocable gifts that he could not recover simply because his engagement with Julie ended.

Unless the parties have agreed otherwise, the donor is entitled to recover the engagement ring (or its value) if the marriage does not occur, regardless of who ended the engagement. Here, Julie had voluntarily returned the engagement ring to Cooper. Unlike the engagement ring, the other gifts have no symbolic meaning. Rather, they are merely “tokens of love and affection” which the donor bore for the donee. The court stated, “Many gifts are made for reasons that sour with the passage of time. Unfortunately, gift law does not allow a donor to recover/revoke a gift simply because his or her reasons for giving it have soured.” Thus, the gifts are irrevocable gifts and Cooper is not entitled to their return. Cooper v. Smith, 800 N.E.2d 372, 2003 Ohio App. Lexis 5446 (Court of Appeals of Ohio, 2003)

9.2 Mirror Image Rule No. The court of appeal applied the mirror image rule and held that no contract had been created between the parties. The court stated, “Florida employs the ‘mirror image rule’ with respect to contracts. Under this rule, in order for a contract to be formed, an acceptance of an offer must be

absolute, unconditional, and identical with the terms of the offer.” The court examined the facts of the case and found the following. Norma English made an offer to purchase a house owned by Michael and Lourie Montgomery (Montgomery) for $272,000 which included the purchase of some personal property of Montgomery, including paving stones and a fireplace screen worth $100. Montgomery then made a counteroffer whereby they made many changes to English’s offer, including deleting the paving stones and fireplace screen from the personal property that English wanted. When English replied, she accepted all of Montgomery’s changes except that she did not accept Montgomery’s change that deleted the paving stones and fireplace screen from the deal. Therefore, when Montgomery was selling their house to another buyer for $285,000, English sued and asked the court to find that an enforceable contract existed between Montgomery and her and to order Montgomery to specifically perform the contract. However, the court applied the mirror image rule and held that English had not accepted Montgomery’s counteroffer, so no contract existed between them. Montgomery was free to sell their house to another purchaser. The court concluded, “Applying the mirror image rule to these undisputed facts we hold that, as a matter of law, the parties failed to reach an agreement on the terms of the contract and, therefore, no enforceable contract was created.” Montgomery v. English, 902 So.2d 836, 2005 Fla. App. Lexis 4704 (Court of Appeal of Florida, 2005)

9.3 Illegal Contract Yes. The appellate court held that the partnership agreement between Parente and Pirozzoli was an illegal contract and was therefore void and unenforceable. The partnership was formed for an illegal purpose, which was to obtain a liquor license for a bar in Pirozzoli’s name without disclosing to the state liquor commission that issued the license that Parente was also an owner of the business. If Parente’s prior criminal record had been disclosed to the liquor commission the bar would not have been issued a liquor license. The court stated, “Here, the partnership agreement was not offensive on its face, but had an illegal, ulterior purpose, namely, to evade the strictures of the liquor control laws. Because the partnership agreement was made to facilitate, foster, or support patently illegal activity, we conclude that it is illegal as against public policy….” The court found that the partnership contract had an illegal purpose and refused to enforce the contract. The court left the parties where it found them—Pirozzoli had the liquor

license for the business and Parente did not. The court stated, “Although the end result of holding the partnership agreement illegal may be to allow Pirozzoli a windfall at Parente’s expense, this result is common and necessary in many cases in which contracts are deemed unenforceable on the grounds of furthering overriding policies. Knowing that they will receive no help from the courts and must trust completely to each other’s good faith, the parties are less likely to enter an illegal arrangement in the first place.” The appellate court found that Pirozzoli was not liable to Parente, and held that Pirozzoli could keep the $138,000 windfall. Parente v. Pirozzoli, 866 A.2d 629, 2005 Conn. App. Lexis 25 (Appellate Court of Connecticut, 2005)

9.4 Counteroffer No. A contract to convey the real property does not exist between Heikkila and McLaughlin. A written offer does not evidence a completed contract and a written acceptance is required.

Minnesota has applied the “mirror image rule” in analyzing acceptance of offers. Under that rule, an acceptance must be coextensive with the offer and may not introduce additional terms or conditions. Heikkila’s alterations of the Purchase Agreements constituted a rejection of McLaughlin’s offer and constituted a counteroffer. Heikkila withdrew the counteroffer before McLaughlin provided a written acceptance of the counteroffer. Only a written acceptance by McLaughlin of the exact written terms proposed by Heikkila on the Purchase Agreements would have created a binding contract for the sale of land. Without a written acceptance and delivery to the other party to the agreement, no contract was formed. The court of appeals held that because McLaughlin did not sign or otherwise accept in writing Heikkila’s counteroffer, there was no contract for the sale of land between the parties. McLaughlin v. Heikkila, 697 N.W.2d 231, 2005 Minn. App. Lexis 591 (Court of Appeals of Minnesota, 2005)

9.5 Contract Yes. Dees is bound to the contract. The trial court agreed with Saban Entertainment, Inc., finding that the “Work-for-Hire/Independent Contractor Agreement” was an enforceable contract between the parties. The court held that Dees had transferred his ownership interests in the Mighty Morphin Power Rangers’ logo that he designed to Saban pursuant to an enforceable

contract. The Court of Appeals affirmed the judgment in favor of Saban, stating, “The disputed agreement transferred plaintiff’s copyright in the Mighty Morphin Power Rangers’ logo with as much specificity as the law requires.” The Court applied the adage “a contract is a contract is a contract”, at least in this case.

There seems to be is no equity doctrine that Dees can raise in this case to save him from the contract he signed. He was an adult who choose not to obtain legal representation before he negotiated and signed the contract with Saban. Later developments—the success of the Mighty Morphin Power Rangers—cannot be introduced to change his contract. Does Saban owe an ethical duty to pay Dees more money? Probably not. When Saban signed the contract there was no certainty that the Mighty Morphin Power Rangers would be so successful or that the design Dees provided would work. Dees, d/b/a David Dees Illustration v. Saban Entertainment, Inc., 131 F.3d 146, 1997 U.S. App. Lexis 39173 (United States Court of Appeals for the Ninth Circuit)

Answer to Ethics Case 9.6 Ethics An illegal contract is one where the object of the contract is unlawful. Courts have held that where a license is required to practice a profession, a person must have that license before providing services covered by the license. If a person does not have the required license, a contract to provide such services to a client is an illegal contract and therefore void and unenforceable. Here, Elena Sturdza was not licensed to provide architectural services in Washington DC. However, she entered into a contract with the United Arab Emirates (UAE), a country in the Middle East, to provide the architectural design for a new embassy to be built in Washington, D.C., and did provide many architectural services to UAE. Sturdza sued UAE for nonpayment for her architectural services. Here, the court held that Sturdza was not payment from UAE because the contract between Sturdza and UAE was an illegal contract and therefore void. As a decision based on law, it was the correct decision.

The UAE could have voluntarily paid Sturdza for her architectural work. But it did not. Did the UAE act ethically in this case by not paying Sturdza? This is a case where the law is on

UAE’s side and stipulates that UAE does not have to pay Sturdza. However, the UAE selected her to provide architectural services, accepted such services, and worked with Sturdza to modify their design. They received the benefit of her work. It seems unethical for the UAE to hire Sturdza and then use the law to avoid making such payments to her. Sturdza v. United Arab Emirates, 11 A.3d 251, 2011 D.C. App. Lexis 2 (District of Columbia Court of Appeals, 2011)

9.7 Ethics Case No, City Segway Tours of Washington DC, LLC (CST) is not liable to Norman Mero for the injuries he suffered while riding a Segway personal transportation vehicle provided by CST. The court held that the release of liability clause (exculpatory clause) that Mero signed with CST prior to using the Segway vehicle provided by CST for the tour was enforceable. The court found that the release of liability clause was clear and conspicuous. The court held that the release of liability clause waived CST’s liability for negligence. The court found that riding a Segway vehicle did not involve an issue of public interest that would make the release of liability clause ineffectual. The U.S. district court enforced the release of liability clause and granted CST’s motion for summary judgment.

It could be argued that CST, by placing a release of liability clause in its contract, acted unethically. However, release of liability clauses are well recognized by the law, and their use in certain kinds of contracts have been found to be enforceable. Mero did not have to ride the Segway, a personal transportation vehicle, to tour Washington DC. He choose to do so, and signed the release clause. The law provides for not enforcing release of liability clauses if they violate the public interest, but found the clause in this case not to have done so. Mero v. City Segway Tours of Washington DC, 962 F.Supp.2d 92, 2013 U.S. Dist. Lexis 120304 (United States District Court for the District of Columbia, 2013)

Chapter 10 Performance and Breach of Contracts

Answers to Critical Legal Thinking Cases 10.1 Intended or Incidental Beneficiary Ramos/Carson/DePaul (RCD) was an incidental beneficiary of the Phillies-DH agreement. RCD was not an intended beneficiary of the Philadelphia Phillies Agreement with Driscoll/Hunt Joint Venture (DH). The court held that because RCD was merely an incidental beneficiary of the Phillies—DH Agreement, the Phillies could not be held liable to RCD. RCD had not proffered any evidence to show that the Phillies and DH intended to give RCD the right to demand payment directly from the Phillies. There is no evidence showing that either the Phillies or DH intended to benefit RCD or the other subcontractors in drafting the Agreement’s payment provisions. Since RCD has failed to show that it was an intended third—party beneficiary of the Agreement between the Phillies and DH, RCD’s breach of contract claim against the Phillies was dismissed. The court held that RCD was not an intended beneficiary of the Phillies—DH Agreement, but instead was an incidental beneficiary to the Agreement and therefore had no right to sue the Phillies as a third—party beneficiary. Ramos/Carson/DePaul, a Joint Venture v.

The Phillies, L.P., 2006 Phil. Ct. Com. PL Lexis 397 (Common Pleas Court of Philadelphia County, Pennsylvania, 2006)

10.2 Liquidated Damages Yes, the liquidated damage clause is enforceable and 845 UN Limited Partnership (845 UN) may keep the $8 million down payments paid by Cem Uzan and Hakan Uzan for condominiums to be built by 845 UN as liquidated damages because of their breach of the contract. A liquidated damages clause is a clause in a contract that stipulates the damages that will be paid by a breaching party. Here, there was a liquidated damage clause in the contract between the builder

and the buyers that permitted the builder to keep the buyer’s down payment as liquidated damages if the buyer breached the contract and failed to purchase the condominiums sold by 845 UN. The court found the liquidated damage not to be a penalty. The supreme court of New York, appellate division, sided with 845 UN and held that Cem and Hakan had breached their contract with 845 UN and that 845 UN was entitled to keep the 25 percent down payment as liquidated damages. The appellate court of New York affirmed the decision. Uzan v. 845 UN Limited Partnership, 778 N.Y.S.2d 171, 2004 N.Y. App. Div. Lexis 8362 (Supreme Court of New York, Appellate Division, 2004)

10.3 Fraud Yes, Payne engaged in fraudulent conduct. The evidence proved that the sale of the damaged truck was fraudulent and the result of intentional conduct and was not merely an accident. The court found that defendant Payne’s conduct could only be seen as exhibiting a very high degree of reprehensibility. The record clearly supports a finding that Payne acted indifferently to or in reckless disregard of the safety of the Krysas in selling them a vehicle that he knew or should have known was not safe to drive. The jury returned a verdict for the Krysas and awarded them $18,449 in compensatory damages and $500,000 in punitive damages. The court of appeals upheld the finding of fraud and affirmed the award of damages to the Kysas. Krysa v. Payne, 176 S.W.3d 150, 2005 Mo. App. Lexis 1680 (Court of Appeals of Missouri, 2005)

10.4 Parol Evidence

Yes, the parol evidence rule eliminates plaintiff Yarde’s claim of an implied right to purchase Patriots’ season tickets? The purchase of a ticket to a sports or entertainment event typically creates nothing more than a revocable license. The New England Patriots’ ticket specifically stated that “purchase of season tickets does not entitle purchaser to renewal in a subsequent year.” Parol evidence is not generally admissible to vary the unambiguous terms of the contract.

Yarde has articulated no basis on which to ignore the language on the ticket. The appeals court held that there was an express written contract between Yarde and the Patriots, and that the parol evidence rule prevented Yarde’s alleged implied right to purchase season tickets from becoming part of that contract. Yarde Metals, Inc. v. New England Patriots Limited Partnership, 834 N.E.2d 1233, 2005 Mass. App. Lexis 904 (Appeals Court of Massachusetts, 2005)

10.5 Guaranty Contract No. The court of civil appeals held that Mary R. Page’s alleged oral promises to guarantee her husband’s debts to Jerry Sellers were not in writing, as required by the Statute of Frauds, and were therefore not enforceable against her. Glenn A. Page, Mary’s husband owed Sellers money.

Sellers obtained alleged oral promises from Mary to pay her husband’s debts. However, a promise to pay the debt of another is barred by the Statute of Frauds unless it is in writing. It is not disputed that Mary did not sign a note, guaranty, or any other writing promising to pay any part of Glenn’s debts. Therefore, if the purported agreement to pay Glenn’s debt is within the Statute of Frauds, Mary is not liable even if the trial court found Seller’s testimony to be credible. Mary’s alleged oral promises are not enforceable under the Statute of Frauds. The court held that Mary’s alleged promises to guaranty to pay Glenn’s debts fell within the Statute of Frauds, and therefore, because they allegedly oral promises, were not enforceable. Page v. Gulf Coast Motors, 903 So.2d 148, 2004 Ala. Civ. App. Lexis 982 (Court of Civil Appeal of Alabama, 2004)

10.6 Rescission of a Contract Yes. The court of appeal found that Patricia Dianne Hickman’s relatives, including her father Joe Hickman and her cousin Keith Bates, had taken advantage of her and engaged in fraud in getting

her to sign sales contracts by which she sold her interests in the two properties to the Bates. After substantial pressure from her relatives, including her father, she agreed to sell the two pieces of property worth $280,000 to the Keith Bates for $500. The court noted that Patricia’s intellectual abilities are limited, both from her lack of education and from her mental condition that requires medicine. Considering her situation, her youth, she was then 20 years old, and her limited abilities, as well as her lack of prior knowledge of the purpose of the visit, and her father’s illness, and the fact that she trusted her father and her cousin, the court found that Keith had a responsibility to make sure Patricia was informed fully about the transactions and make sure that she understood everything she was doing and the import of everything she was doing, including the fact that she would own nothing, and including the price considerations involved before she signed those documents. The court held that Keith’s failure to inform his young and limited firstcousin was intentional and was done to obtain an advantage over her. That is, of divesting her interest in two pieces of real property “for a pittance.” The court held that Patricia rightfully rescinded the contracts and awarded her attorney’s fees. Hickman v. Bates, 889 So.2d 1249, 2004 La. App. Lexis 3076 (Court of Appeal of Louisiana, 2004)

Answer to Ethics Case 10.7 Ethics Case Yes, the Statute of Frauds bars recovery by Sawyer in this case. According to the Statute of Frauds, an executory contract that cannot be performed by its own terms within one year of its formation must be in writing. Here, Mills’ oral promise to pay Sawyer $1,065,000 as a bonus to be paid in monthly installments over 107 months, approximately a 9-year period, clearly exceeded the one-year rule of the Statute of Frauds. The trial court and Supreme Court of Kentucky held that the Statute of Frauds required the bonus agreement between Sawyer and Mills to be in writing to be enforceable. Because the oral agreement exceeded one year, the courts held that it did not meet the requirements of the Statute of Frauds and was therefore unenforceable.

The application of the Statute of Frauds sometimes reaches unfair results. This is one of those cases. The trial court judge stated, “The end result may not seem ‘fair’ to Sawyer. The Statute of Frauds, by its own terms, can be considered ‘harsh’ in that it will bar oral agreements between parties under certain conditions. This is simply the nature of the beast.” Sawyer v. Mills, 295 S.W.3d 79, 2009 Ky. Lexis 195 (Supreme Court of Kentucky, 2009)

Chapter 11 Digital Law and E-Commerce Answers to Critical Legal Thinking Cases 11.1

Internet Service Provider

No, GTE Corporation, the ISP, is not liable for damages to the plaintiff football players. Part of the federal Communications Decency Act of 1996 provides: “No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.” Just as the telephone company is not liable as an aider and abettor for recordings or narcotics sold by phone, and the Postal Service is not liable for recordings sold and delivered by mail, so a Web host cannot be classified as an aider and abettor of criminal activities conducted through access to the Internet. GTE is not a “publisher or speaker.” Therefore, GTE cannot be liable under any state law theory to the persons harmed by Franco’s material. Thus, GTE Corporation, the ISP, is not liable for the nude video-recordings of the football players transmitted over its system by Franco Productions. John Doe v. GTE Corporation, 347 F.3d 655, 2003 U.S. App. Lexis 21345 (United States Court of Appeals for the Seventh Circuit, 2003)

11.2 Domain Name The Coca-Cola Company wins. Francis Net would be described as a cybersquatter, that is, someone who registers domain names of famous companies or persons who they are not connected with. The U.S. Congress enacted the Anticybersquatting Consumer Protection Act (ACPA), a federal law specifically aimed at cybersquatters. The act has two fundamental requirements: (1) the name must be famous and (2) the domain name must have been registered in bad faith. In this case the first element is met because the name “classic coke” is a famous trademarked brand name used by the Coca-Cola Company. The second issue is whether the

famous name has been registered in bad faith. In determining bad faith, a court may consider the extent to which the domain name resembles the trademark owner’s name or the famous person’s name, the holder’s offer to sell or transfer the name, whether the holder has acquired multiple Internet domain names of famous companies and persons, and other factors. Here, the registered domain name is exactly the same as a product sold by the Coca Cola Company, Francis has offered to sell the domain name to the Coca-Cola Company for $500,000, and Francis has no connection to the domain name. Here, Francis has registered the domain name in bad faith in violation of the ACPA. Francis would be ordered to turn the domain name over to the Coca-Cola Company.

11.3 Email Contract West Coast Steel Company wins. Contracts can be legally negotiated and completed by email as long as they meet the requirements necessary to form a traditional contract. This includes capacity, lawful object, agreement, and consideration. The element of capacity is met because both parties are businesses, and the object of the contract, the purchase of steel, is a lawful object. Consideration exists because the buyer, Little Steel Company, would be paying money and West Coast Steel Company would be delivering steel. An agreement is reached by exchanging emails. Exchanging emails is an acceptable method of negotiating and entering into a sales agreement. Thus, the traditional elements of forming a contract are met by the exchange of emails between the parties. Little Steel Company’s bases its rejection of the shipment of steel by West Coast Steel Company by alleging the defense of the Statute of Frauds. Little Steel Company argues that an email contract, which is electronic, is not in writing according to the Statute of Frauds and is therefore unenforceable. The U.S. Congress has enacted the Electronic Signatures in Global and National Commerce Act (E-SIGN Act). This federal law recognizes that electronic contracts meet the writing requirement of the Statute of Frauds. Thus, the email contract can be enforced against Little Steel Company.

11.4 Electronic Signature Yes. David Abacus’ electronic signature is enforceable against him. David Abacus used the Internet and placed an order to license software for his computer from Inet.License, Inc. (Inet), through Inet’s electronic website ordering system. David received the software program from

Inet and installed it on his computer. When he refused to pay for the license, he justified his refusal by arguing that his electronic signature was not a valid signature under the Statute of Frauds. The U.S. Congress has enacted the Electronic Signatures in Global and National Commerce Act (E-SIGN Act). This federal law stipulates that electronic signatures meet the signature requirement of the Statute of Frauds. The E-SIGN Act recognizes electronic signatures (e-signatures) and gives an e-signature the same force and effect as a pen-inscribed signature on paper. Here, a web license between the parties has been formed and the electronic signature is valid. Therefore, the web license is enforceable against David.

11.5 License iSoftware wins. Most software programs and digital applications are electronically licensed by the owner of the program or application to a user of a computer or digital device. An electronic license, or e-license, is contract whereby the owner of software or a digital application grants limited rights to the owner of a computer or digital device to use the software or a digital application for a limited period and under specified conditions. The owner of the program or application is the electronic licensor, or e-licensor, and the owner of the computer or digital device to whom the license is granted is the electronic licensee, or e-licensee. Here iSoftware, Inc. is the licensor and Tiffany is the e-licensee. The Uniform Computer Information Transactions Act (UCITA) is a model act that establishes a uniform and comprehensive set of rules that govern the creation, performance, and enforcement for computer information transactions. The UCITA provides that e-licenses are enforceable contracts. Therefore, under the UCITA, the e-license can be enforced against Tiffany Pan.

Answers to Ethics Cases 11.6 Ethics Case Macy’s Inc., BP P.L.C., and the General Motors Corporation win. BluePeace.org has used domain names that include all three of these companies trademarked names. Not only has BluePeace used their trademarked names, but it has used additional information in the domain names that tarnish the companies’ names. In addition, the content on the websites significantly disparage the products of these companies. The U.S. Congress enacted the Anticybersquatting

Consumer Protection Act (ACPA), a federal law specifically aimed at parties who misappropriate other’s domain names. The act has two fundamental requirements: (1) the name must be famous and (2) the domain name must have been registered in bad faith. In this case the first element is met because the names “Macy’s,” “BP,” and “General Motors” are famous trademarked names. The second issue is whether the famous names have been registered in bad faith. The registered domain names used the companies’ trademarked names. BluePeace has no connection with these names. Here, BluePeace has registered the domain names in bad faith in violation of the ACPA. BluePeace.org, as an environmental organization, may have its opinion as to the unethical conduct it believes the three companies have engaged in. But it cannot steal the companies’ trademarked names to draw attention its cause. BluePeace may have thought they were doing society a service by pointing out what it thinks is inappropriate conduct by the targeted companies. However, BluePeace cannot break the law in asserting its position. BluePeace can engage in other lawful activities to draw attention to its grievances against the target companies.

11.7 Ethics Case Apricot.com wins. Bates licensed Apricot.com’s software “Match” for a period of five years with a license fee of $200 per month. Bates did not pay Apricot.com the required monthly licensing fee for any of the three months he used the software. After using the Match software but refusing to pay Apricot.com its licensing fee, Apricot.com activated the disabling bug in the software and disabled the Match software on Bates’ computer. The disabling of a software program for nonpayment of license fees is an appropriate self-help remedy that software licensors may use where there has been a breach of the license agreement. However, to be lawfully used, the disabling cannot cause physical harm to a person or cause damage to other software programs and data that the user may have stored on his computer. Here, there is no evidence of such damage. Therefore, Apricot’s disabling of its software on Bates’ computer is lawful.

Bates breached the contract. If he had good reason not to pay for the software program (e.g., it did not work properly, fraud) then his actions would be justified. However, without evidence of any problem with the software or fraudulent or unethical conduct by Apricot.com, Bates has breached the contract and his ethical duty to perform the contract.

Chapter 12 Sales Contracts, Leases, and Warranties

Answers to Critical Legal Thinking Cases 12.1 Good or Service?

The state supreme court held that the provision of services, and not the sale of goods, was the predominant feature of the transaction whereby, during the course of an operation, a medical doctor surgically implanted a ProteGen Sling (sling) into Brandt for treatment of urinary incontinence. The issue was whether the predominate portion of the transaction was the sale of a good or the provision of a service. If the predominate part was the sale of the good—the ProteGen Sling—then the UCC Article 2 (Sales) applied. If the predominate part of the transaction was the provision of medical services, then the UCC does not apply and the Health Center is not liable for the defective sling. In this case, Brandt’s bill from the Health Center reflects that of the $11,174.50 total charge for her surgery, a charge of $1,659.50, or 14.9%, was for the sling and its surgical kit. The remainder of the charges was for various services, including the hospital and operating rooms and various kinds of medical testing and treatment. A charge for the implantation of the sling by the surgeon was not included in the hospital’s bill. A majority of the charges were for services rather than goods. Only a small fraction of the total charge was for the sling, the goods at issue in this case. The court held that because predominate feature of the transaction between Brandt and Health Center was the provision of services and not the sale of goods, then Health Center was not liable under Article 2 (Sales) of the UCC. Brandt v. Boston Scientific Corporation and Sarah Bush Lincoln Health Center, 792 N.E.2d 296, 2003 Ill. Lexis 785 (Supreme Court of Illinois, 2003)

12.2 Implied Warranty of Merchantability

Yes. The court of appeals held that Ford Motor Company had breached the implied warranty of merchantability concerning the use of the Bronco II and awarded Nancy Denny $1.2 million in damages. The court found that the evidence did not support Ford’s claim that the Bronco II was intended as an off-road vehicle and was not designed to be used as a conventional passenger automobile on paved streets. Instead, the court found sufficient evidence that Ford marketed and sold the Bronco II specifically to consumers who were only interested in driving the vehicle on paved streets. Denny produced a Ford marketing manual that predicted many buyers would be attracted to the Bronco II because utility vehicles were suitable to “contemporary lifestyles” and were “considered fashionable” in some suburban areas. According to this manual, the sales presentation of the Bronco II should take into account the vehicle’s “suitability for commuting and for suburban and city driving.” Additionally, the vehicle’s ability to switch between twowheel and four-wheel drive would “be particularly appealing to women who may be concerned about driving in snow and ice with their children.” Plaintiff testified that the perceived safety benefits of its four-wheel drive capacity attracted her to the Bronco II. She was not at all interested in its off-road use. Thus, under the evidence of the case, the court concluded that the vehicle was not safe for the “ordinary purpose” of daily driving for which it was marketed and sold. Denny v. Ford Motor Company, 87 N.Y.2d 248, 662 N.E.2d 730, 639 N.Y.S.2d 250, 1995 N.Y. Lexis 4445 (Court of Appeals of New York)

12.3 Implied Warranty of Fitness for a Particular Purpose Yes. The appellate court held that Massey Motors had made and breached an implied warranty of fitness for a particular purpose but that Jeep Eagle had not. In this case, the service provided by Massey Motors’ sales staff included undertaking the responsibility of checking with the Airstream dealer and thereafter representing that the Jeep Cherokee, with an automatic transmission, was suitable for pulling the Airstream. Massey Motors’ sales manager testified he knew the intended purpose for Mrs. Garnica’s use of the proposed vehicle and that he undertook to investigate the specifications of the Airstream. After having undertaken the inquiry, he recommended the Jeep Cherokee as being suitable for the purposes Mrs. Garnica was seeking— that of towing the Airstream trailer she had on order. The evidence supported the finding that the Jeep Cherokee simply was exceeding its towing capacity and that Massey Motors had

misrepresented the fact that this was the proper vehicle suitable for towing the Airstream trailer.

In light of Massey Motors’ superior knowledge and expertise concerning Mrs. Garnica’s inquiry and reliance, the evidence was sufficient to support the finding that Massey Motors had breached an implied warranty of fitness for a particular purpose when it recommended the Jeep Eagle to Mrs. Garnica for towing the Airstream trailer that she had ordered. Mack Massey Motors, Inc. v.

Garnica, 814 S.W.2d 167, 1991 Tex. Lexis 1814 (Court of Appeals of Texas)

12.4 Firm Offer Coronis wins the lawsuit; the UCC recognizes an acceptance to the common law rule that allows an offeror to revoke his offer any time prior to its acceptance. This exception is known as the firm offer rule. This rule provides as follows: If a merchant offers to buy or sell goods and gives a written and signed assurance on a separate form that the offer will be held open, the offeror cannot revoke the offer for the time stated, or if no time is stated, then for a reasonable time. In this situation, the court held that the firm offer rule did not apply. Although the letter from Coronis to Gordon may have been a signed form sent between merchants, it only quoted a price.

The letter gave no assurance that the bid would be held open. In order for the firm offer rule to apply, the offeror must explicitly state that the offer will be held open. Because they had made no such statements, Coronis had properly revoked its offer on June 1. E. A. Coronis Associates v.

Gordon Construction Co., 216 A.2d 246, 1966 N.J. Super. Lexis 368 (Superior Court of New Jersey)

12.5 Battle of the Forms No, the clauses in the delivery memo were not part of the contract. Because the court found Miller and Newsweek to be merchants in regards to photographs, UCC Section 2 207 applies. If two merchants negotiate a sales contract and then exchange preprinted forms, the additional terms materially alter the original contract. In this case, the court held that a valid contract had been formed between Newsweek and Miller during their phone conversation. The two parties had agreed on the price of the photographs, the delivery date, and the terms, i.e., Newsweek was

to pay for each photo used. The delivery memo contained terms additional to the original contract. The court held that the additional terms materially altered the contract because Newsweek probably would not have agreed to them in the original contract, and they would work a great hardship upon Newsweek. The court did not believe that Newsweek would agree to pay over $100,000 if it accidentally lost the photos. Because the inclusion of this term was a unilateral action by Miller, the court held that it materially altered the original contract. Applying UCC 2 207, additional terms do not become part of contracts between merchants if they materially alter the contract. Therefore, Miller was not able to collect $1,500 a piece for the missing photos. Miller v. Newsweek, Inc., 660 F.Supp. 852, 1987 U.S. Dist. Lexis 4338 (United States District Court for the District of Delaware)

12.6 Risk of Loss Wycombe must return the payment Silver made on the destroyed furniture. If a seller is a merchant, risk of loss does not pass to the buyer until the goods are received. In other words, a merchant seller bears the risk of loss between the time of contracting and the time the buyer picks up the goods from the seller. In this case, there was no question as to whether Wycombe was a merchant of custom furniture. Even though the furniture was to be shipped, and not picked up by the buyer, the same principles apply. When a merchant seller such as Wycombe holds goods for a buyer, it bears the risk of loss. When the custom furniture was destroyed in a fire while it was within Wycombe’s possession, Wycombe bore the risk of loss. Because Wycombe bore the risk of loss, it must return the payment Silver had made on the destroyed furniture.

Silver v. Wycombe, Meyer & Co., Inc., 124 Misc. 2d 717, 477 N.Y.S.2d 288, 1984 N.Y. Misc.

Lexis 3319 (Civil Court of the City of New York).

Answers to Ethics Cases 12.7 Ethics Case Contractual disclaimers are unconscionable and therefore unenforceable. Trial court is affirmed.

Both procedural and substantive unconscionability are evident here. The procedural element

focuses upon “oppression” (unequal bargaining power) and “surprise” (hidden terms in form drafted by party seeking enforcement). In commercial situations, courts also seek to determine whether unbargained-for terms are also “overly harsh” or “one-sided” such that substantive unfairness results. Although courts are generally not sympathetic to commercial entities, the David and Goliath position of these parties invites review. The disputed terms were on the reverse of the preprinted form and plaintiff’s attention was never directed to them. Finally, the attempt to disclaim any responsibility for a product doing what it is supposed to do rises to the level of substantive unconscionability. A&M Produce Co. v. FMC Corp., 135 Cal. App.3d 473, 186 Cal. Rptr. 114, 1982 Cal. App. Lexis 1922 (Court of Appeal of California).

12.8

Ethics Case

Yes, the “as is” disclaimer was conspicuous and therefore properly disclaimed the implied warranty of merchantability in this case. An “as is” disclaimer properly disclaims an implied warranty of merchantability if the disclaimer is conspicuous. A disclaimer is conspicuous if it is so written that a reasonable person against whom it is to operate ought to have noticed it. A printed heading in capital letters is conspicuous. Here, the heading “AS IS” was in capital letters.

Language in the body of a form purchase contract is conspicuous if it is larger than the rest of the contract. Here, the words “THIS USED MOTOR VEHICLE IS SOLD AS IS. THE PURCHASER WILL BEAR THE ENTIRE EXPENSE OF REPAIRING OR CORRECTING ANY DEFECTS THAT PRESENTLY EXIST OR THAT MAY OCCUR IN THE VEHICLE” were all in capital letters in the purchase contract that Mitsch signed. The “as is” disclaimer in the purchase contract was conspicuous and therefore disclaimed the implied warranty of merchantability. Therefore, Rockenbach Chevrolet was granted summary judgment, and Mitsch’s lawsuit was dismissed.

Mitch purchased the vehicle fully aware that the purchase agreement contained an “as is” clause that disclaimed the implied warranty of merchantability. “As is” disclaimers are permitted by law it they are conspicuous, which is was in this case it was. Mitch may have believed that the “as is” disclaimer was unfair, but it was obviously a conspicuous lawful disclaimer. If Mitch did not want to abide by an “as is’ disclaimer then he should not have purchased the vehicle. Mitsch v. Rockenbach Chevrolet, 833 N.E.2d 936, 2005 Ill. App. Lexis 699 (Appellate Court of Illinois)

Chapter 13 Credit, Secured Transactions, and Bankruptcy

Answers to Critical Legal Thinking Cases 13.1 Financing Statement No. The bankruptcy court held that creditor PSC Metals, Inc.’s filing of the financing statement under the debtor’s trade name “Keystone Steel & Wire Co.” rather than under its corporate name “Keystone Consolidated Industries, Inc.” was a defective filing. It is undisputed that under Revised Article 9, PSC’s financing statement would be insufficient as a matter of law. Revised Article 9 requires that a financing statement contain the name of a corporate debtor as indicated on the public record of the debtor’s jurisdiction of organization. Revised Article 9 states that a financing statement that provides only the debtor’s trade name does not sufficiently provide the name of the debtor. In reaching its conclusion the court stated, “One of the mantras espoused by the experts was the necessity of using the debtor’s correct legal name, not a trade name or nickname. PSC knew the debtor’s correct legal name. PSC ignored the correct legal name and filed under the trade name at its own peril.” The bankruptcy court held that PSC’s filing of the financing statement under Keystone’s trade name and not under Keystone’s legal name was a defective filing. Therefore, the bankruptcy court could avoid PSC’s unperfected security interest.

PSC became an unsecured creditor for the debt owed to it by Keystone. In re FV Steel and Wire Company, 310 B.R. 390, 2004 Bankr. Lexis 748 (United States Bankruptcy Court for the Eastern District of Wisconsin, 2004)

13.2 Buyer in the Ordinary Course of Business Yes. The court of appeals held in favor of Randall and Christina Alderson and ordered Indianapolis Car Exchange (ICE) to release the lien it held on the truck. The Indiana Uniform

Commercial Code stipulates “A buyer in ordinary course of business takes free of a security interest created by the buyer's seller, even if the security interest is perfected and the buyer knows of its existence." There is no question that ICE, the creditor, had a perfected security interest in the vehicles on its debtor’s Top Quality Auto Sales used car lot. However, a buyer in the ordinary course of business who purchases vehicles from Top Quality takes the vehicle free of ICE’s perfected security interest in the vehicle. In this case, Chrisman was a buyer in the ordinary course of business when she purchased the vehicle from Top Quality because Top Quality was in the business of selling used cars. When the Aldersons bought the truck from Chrisman, a used car dealer, they too were buyers in the ordinary course of business. Thus, Chrisman took free of ICE's security interest in the truck and had the power to transfer title to the Aldersons free of that security interest. The court ordered ICE to release the lien on the truck.

Indianapolis Car Exchange v. Alderson, 910 N.E.2d 802, 2009 Ind. App. Lexis (Court of Appeals of Indiana, 2009)

13.3 Discharge Yes. A debt arising from a medical malpractice judgment that is attributable to negligence or reckless conduct is dischargeable in bankruptcy. The Bankruptcy Code provides that a debt for willful and malicious injury by the debtor to another is not dischargeable. The U.S. Supreme Court stated, “The question before us is whether a debt arising from a medical malpractice judgment, attributable to negligent or reckless conduct, falls within this statutory exception. We hold that it does not and that the debt is dischargeable.” Thus, the debt arising from the malpractice judgment in this case arose out of the negligence of the doctor and not willful or malicious conduct. The U.S. Supreme Court ruled that a medical malpractice judgment based on negligent or reckless conduct—and not willful conduct—is dischargeable in bankruptcy.

Kawaauhau v. Geiger, 523 U.S. 57, 118 S.Ct. 974, 1998 U.S. Lexis 1595 (Supreme Court of the United States)

13.4 Bankruptcy Estate

No, the debtor’s jewelry does not qualify as necessary and proper wearing apparel and is therefore not exempt property from the bankruptcy estate. Mrs. Lebovitz’s jewelry is part of the bankruptcy estate. The debtor argues that she should be able to exempt all of her jewelry as wearing apparel because the items are worn by the debtor regularly, have sentimental value to her because they were given to her by her husband, and were not purchased for investment.

However, under Tennessee law the debtor is not entitled to claim her jewelry as exempt because the items are neither necessary nor proper wearing apparel for a bankruptcy debtor. Thus, the debtor is not entitled to claim her jewelry as exempt from the bankruptcy estate. As difficult as this case is given the unfortunate illness of Dr. Lebovitz that led to the bankruptcy filing, the law is clear. Whether the debtor’s jewelry is valued at its wholesale value or retail value, the items constitute luxury items. The items constitute luxury items, not necessary or proper wearing apparel. The debtor’s luxury jewelry do not qualify as necessary and proper wearing apparel and are not exempt property from the debtor’s bankruptcy estate. The debtor’s jewelry is property that must be included in the bankruptcy estate. In re Lebovitz, 344 B.R. 556, 2006 Bankr. Lexis 1044 (United States Bankruptcy Court for the Western District of Tennessee, 2006)

13.5 Purchase Money Security Interest Yes, International Harvester’s (IH) security interest in the tractor takes priority over the Bank of California’s security interest in the same collateral. This is because IH had a purchase money security interest in the tractor that takes priority over any general security interest in the same property. A perfected purchase money security interest prevails over a perfected nonpurchase money security interest in after acquired property. If the collateral in question is not inventory, the purchase money security interest must be perfected within ten days of the debtor receiving the collateral to take priority over a perfected nonpurchase money security interest. In this case, both parties had an interest in the Prior Brothers’ after-acquired property, the model 1066 tractor.

IH’s interest was a purchase money security interest because IH had extended credit to the Prior Brothers to purchase the collateral. IH perfected its security interest in the tractor within ten days of the Prior Brothers accepting the tractor. The Court held that such acceptance acts as the starting point for the ten-day deadline for perfecting the interest in a sale on approval. Since IH had a perfected purchase money security interest, their claim took priority over the Bank’s. In the

Matter of Prior Brothers, Inc., 632 P.2d 522, 1981 Wash. App. Lexis 2507 (Court of Appeals of Washington)

13.6 Executory Contract Yes, The Record Company may reject the purchase agreement to buy the record stores from Bummbusiness. The Bankruptcy Code permits a debtor in a Chapter 11 case to reject executory contracts. An executory contract is defined as one under which the obligations of both the debtor and the other party are so far unperformed that the failure of either party to complete performance would constitute a material breach. The Bankruptcy Court held that the purchase agreement in the instant case fit this definition. The Record Company still owed Bummbusiness $10,000 and was obligated to keep paying on the $380,000 trade debt. The performance outstanding of Bummbusiness included not competing with the buyer and using its efforts to obtain extensions of the due dates for the trade debt. The court held that the sum total of the performance outstanding by both parties made the purchase agreement an executory contract. As such, the court permitted The Record Company to reject the purchase agreement. In re The Record Company, 8 B.R. 57, 1981 Bankr. Lexis 5157 (United States Bankruptcy Court for the Southern District of Indiana)

Answers to Ethics Cases 13.7 Ethics Case The bankruptcy trustee wins, and the debtors’ transfer of their house to their daughters may be set aside as a fraudulent transfer. The court held that the bankruptcy trustee could not employ the one-year fraudulent transfer provision of the Bankruptcy Code because the debtors’ transfer of their residence to their daughters took place approximately 1 1/2 years prior to the filing of their bankruptcy petition. However, the trustee can use the six-year limitation period of the New York fraudulent transfer statute because the transfer of the house was made for no consideration, which raised a presumption of insolvency that the debtors did not overcome. The court held that the transfer could therefore be avoided as a fraudulent transfer and that the residence became part

of the bankruptcy estate. The Debtors clearly act unethically in this case by making a fraudulent transfer of their house prior to declaring bankruptcy so that their house would not be part of the bankruptcy estate. In re Tabala, 11 B.R. 405, 1981 Bankr. Lexis 3663 (United States Bankruptcy Court for the Southern District of New York)

13.8 Ethics Case Yes, Mrs. Sales is liable as a guarantor for the payment of the medical services provided to her sister, Mrs. Lynch, by the Forsyth County Hospital. A guaranty is a promise to answer for the payment of some debt in the case of the failure of the person who is primarily liable to pay the debt. A guaranty is a collateral and independent undertaking creating secondary liability, and the creditor’s cause of action against the guarantor ripens immediately upon the failure of the principal debtor to pay the debt at maturity. The court held that Mrs. Sales personally guaranteed the payment of Mrs. Lynch’s medical costs when she signed the form admitting Mrs. Lynch to the hospital. Thus, Mrs. Sales is personally liable for the moneys owed by Mrs. Lynch to the hospital.

There could be some question whether Mrs. Sales acted unethically when she denied liability as the guarantor for Mrs. Lynch’s medical expenses. Mrs. Sales did sign the admission form including the guaranty agreement, but what would have happened to Mrs. Lynch if Mrs. Sales did not sign the agreement? Mrs. Sales probably felt a moral obligation to sign the guaranty agreement so that her sister Mrs. Lynch could obtain the necessary medical services. But Mrs. Sales may not have appreciated the legal ramifications of signing such an agreement under those circumstances. Forsyth County Memorial Hospital Authority, Inc v. Sales., 346 S.E.2d 212, 1986 N.C. App. Lexis 2432 (Court of Appeals of North Carolina)

Chapter 14 Small Business, General Partnerships, and Limited Partnerships

Answers to Critical Legal Thinking Cases 14.1 Sole Proprietorship No. Jerry Schuster is not liable for the warranty made by his father. James Schuster, the father, was a sole proprietor doing business as (d.b.a.) “Diversity Heating and Plumbing” when he made the warranty to Vernon, the purchaser of the boiler. Jerry Schuster, the son, was a sole proprietor when he later operated his sole proprietorship “Diversity Heating and Plumbing.” The court held that James Schuster’s sole proprietorship ended when he died. When Jerry, his son, began a new sole proprietorship, he began a separate business from that of his father. The court stated, “It is well settled that a sole proprietorship has no legal identity separate from that of the individual who owns it. There is generally no continuity of existence because on the death of the sole proprietor, the sole proprietorship obviously ends.” In this case, Diversity Heating has no separate legal existence. Diversity Heating was only a pseudonym for James Schuster. Once he died, Diversity Heating ceased to exist. Now, Diversity Heating is only a pseudonym for Jerry Schuster. James Schuster and Jerry Schuster, one succeeding the other, cannot be the same entity. Even though defendant Jerry Schuster inherited Diversity Heating from his father, Jerry would not have continued his father’s sole proprietorship, but rather would have started a new sole proprietorship. The court held that Jerry Schuster, as a sole proprietor, was not liable for the warranty previously made by his father. Vernon v. Schuster, d/b/a/ Diversity Heating and Plumbing, 688 N.E.2d 1172, 1997 Ill Lexis 482 (Supreme Court of Illinois)

14.2 Liability of General Partners

Yes. Doctor Antenucci is jointly and severally liable for the medical malpractice of his partner, Doctor Pena. Pena was found negligent in treating Elaine Zuckerman during her pregnancy, which caused her son, Daniel, to be born with severe physical problems. Doctor Antenucci and Doctor Pena were partners of a medical practice operated as a general partnership. When a tort is committed by the general partnership, the wrong is imputable to all of the general partners jointly and severally, and an action may be brought against all or any of them in their individual capacities or against the partnership as an entity. Therefore, even though the jury found that defendant Antenucci was not guilty of any malpractice in his treatment of the patient Zuckerman, but that defendant Pena, his partner, was guilty of malpractice in his treatment of the patient, they were then both jointly and severally liable for the malpractice committed by defendant Pena under general partnership law. The fact that Antenucci was not liable for malpractice does not change the result. Zuckerman v. Antenucci, 478 N.Y.S.2d 578, 1984 N.Y. Misc. Lexis 3283 (Supreme Court of New York)

14.3 Tort Liability No, the law firm and the other partners are not liable for McGrath’s tortious conduct in shooting Hayes. The court noted that a master is responsible for the servant’s acts under the doctrine of respondeat superior when the servant acts within the scope of his employment and in the furtherance of the master’s business. Where a servant steps aside from the master’s business in order to affect some purpose of his own, the master is not liable. The court found no evidence to indicate, either directly or by inference that McGrath was acting in the scope of his employment when he shot Hayes. There was no evidence that McGrath transacted law firm business or engaged in any promotional activities on behalf of the law firm, and its other partners were not liable for McGrath’s tortious conduct. Hayes v. Tarbenson, Thatcher, McGrath, Treadwell & Schoonmaker, 749 P.2d 178, 1988 Wash. App. Lexis 27 (Court of Appeals of Washington)

14.4 Liability of Limited Partners

No, the limited partners are not individually liable to Day. A limited partnership is a domestic limited partnership in the state in which it is organized, and a foreign limited partnership in all other states. Under Kentucky law, a foreign limited partnership is required to register with the state before conducting business in that state. If a foreign limited partnership fails to do so, the only loss of right is that it cannot initiate litigation in Kentucky. Failure to register does not, however, impair the validly of any act of the partnership or prevent it from defending itself in any legal proceeding in the state or affect the limited liability status of the limited partners. The court, therefore, held that the limited partners were not individually liable to Day for his injuries.

Virginia Partners, the limited partnership, and its general partners could be held liable to Day. Virginia Partners, Ltd. v. Day, 738 S.W.2d 837, 1987 Ky. App. Lexis 564 (Court of Appeals of Kentucky)

14.5 Liability of Partners Molander can only recover against the assets of the limited partnership and its corporate general and limited partners. He cannot recover against Calvin Raugust personally. Under limited partnership law, a limited partnership is liable on its own contracts; in addition, the general partner is individually liable for the debts and obligations of a limited partnership. Limited partners may be held liable for the obligations of the limited partnership if the limited partnership has been defectively formed. Otherwise, limited partners’ liability is limited to their capital contribution to the limited partnership. The court held that the limited partnership had been defectively formed because the parties had not even executed the limited partnership agreement and a certificate of limited partnership had not been filed with the state as required by law. Thus, because of this defect the limited partners also became liable on Molander’s contract. Thus, Molander can recover against the assets of the partnership, the assets of the corporate general partner, and the assets of the corporate limited partners. However, because all of these entities are corporations, Molander can only recover against the shareholders of these entities. That is, Molander cannot recover against Calvin Raugust, the shareholder of the corporate general partner, individually. If the assets of these defendant corporate entities are insufficient to pay Molander’s claim, he cannot recover against Raugust’s personal assets. In reaching this conclusion, the court stated:

Few people are aware of the organizational intricacies of businesses with which they are dealing and unless there is an agreement to be personally liable, absent fraud or a similar basis, personal liability cannot be imposed just because a person seeks a corporate entity. A professional architect doing business in a complex financial world cannot escape the legal consequences of failure to protect himself by professing ignorances as to corporate and partnership liability. Subjective expectations or postdisaster wishful thinking is not a substitute for legal advice and appropriate contract language. The Court of Appeals overturned the trial court’s $447,011 judgment against Calvin Raugust. Note: If Molander wanted to make Calvin Raugust personally liable for the architectural services, he should have required Raugust to sign a personal guarantee of the performance of the contract. Molander v. Raugust-Mathwig, Inc., 722 P.2d 103, 1986 Wash. App. Lexis 2992 (Court of Appeals of Washington)

Answers to Ethics Cases 14.6 Ethics Case Yes, the limited partners of Cosmopolitan are individually liable on the contract between the partnership and Dwinell’s Central Neon. Partnership law provides that if a limited partnership “substantially complies” with the legal requirements for organizing a limited partnership, the limited partners are not individually liable for the debts of the partnership, and are only liable up to the extent of their capital contribution to the limited partnership. However, if substantial compliance is not met, the partnership is a general partnership, and the purported limited partners are individually liable as general partners.

The court held that Cosmopolitan had not substantially complied with the legal requirements for the organization of a limited partnership at the time it had entered into the contract with Dwinell’s. This was because the certificate of limited partnership had not been filed with the state until several months after the contract was signed. Obviously, the purpose of the filing requirement is to acquaint third persons, such as Dwinell’s, of the existence of the limited partnership and the limited liability of the limited partners. In this case, no filing was made at the time Dwinell’s entered into the contract, so it had no way of appraising itself of the asserted

limited liability. Further, the contract only identified Cosmopolitan as a “partnership,” not as a limited partnership. The court held that there was a defective formation of Cosmopolitan as a limited partnership, and that it was a general partnership at the time the contract was signed with Dwinell’s. Therefore, the court held the purported limited partners individually liable as general partners on the debt due Dwinell’s. It could be concluded that the limited partners acted unethically in denying liability on the contract because the law was quite clear that there was no limited partnership because of the defective formation and therefore they were general partners liable on the contract with Dwinell’s. Dwinell’s Central Neon v. Cosmopolitan Chinook Hotel, 587 P.2d 191, 1978 Wash. App. Lexis 2735 (Court of Appeals of Washington)

Chapter 15 Limited Liability Companies, Limited Liability Partnerships, and Special Forms of Business Answers to Critical Legal Thinking Cases 15.1 Liability of a Franchisor Yes. The court held that McDonald’s negligent and was therefore liable to Martin’s parents and Dudek and Kincaid. This was so even though a third party, the burglar, Peter Logan, actually killed Martin and injured Dudek and Kincaid during his burglary of the McDonald’s franchise.

The court determined that McDonald’s Corporation had a duty to protect plaintiffs Laura Martin, Maureen Kincaid, and Therese Dudek from harm. The court held that based on the facts of the case, McDonald’s Corporation voluntarily assumed a duty to provide security to plaintiffs and protect them from harm. This was because McDonald’s established a corporate division to deal with security problems at franchises, prepared a manual for restaurant security operations and required its franchisees to adhere to these procedures which included the rules that no one should throw garbage out the backdoor after dark, and that trash and grease were to be taken out the side glass door at least one hour prior to closing, and that a McDonald’s inspector inspected the franchise store and notified the franchisee of numerous violations of the rules but never returned to determine if the violations had been corrected.

Once McDonald’s Corporation assumed the duty to provide security and protection to plaintiffs, it had the obligation to perform this duty with due care and competence, and any failure to do so would lead to a finding of breach of duty. There was ample evidence that McDonald’s had breached its assumed duty to plaintiffs. The court held that McDonald’s was negligent for not following up and making sure that the security deficiencies it had found at the Oak Forest franchise had been corrected. The court held McDonald’s liable for negligence and awarded damages of $1,003,445 to the Martins for the wrongful death of their daughter and awarded $125,000 each to Dudek and Kincaid. Martin v. McDonald’s Corporation, 572 N.E.2d 1073, 1991 Ill. App. Lexis 715 (Court of Appeals of Illinois)

15.2 Liability of a Franchisee No. The Costa Mesa 7-Eleven franchisee was not an agent of the franchisor, the Southland Corporation. Also, the doctrine of apparent agency does not apply to the facts of the case.

Therefore, Southland is not liable for the alleged tortious conduct of its franchisee. In the field of franchise agreements, the question of whether the franchisee is an independent contractor or an agent depends on whether the franchisor exercises complete or substantial control over the franchisee. The Southland agreement recites that the franchisees are independent contractors, and provisions in the agreement give the Trujillos, the franchisees, the right to make all inventory, employment and operational decisions. As provided under the franchise agreement, the franchisee exercised full and complete control over the store’s employees, including the hiring, firing, disciplining, compensation, and work schedules. The franchisee could purchase whatever inventory it chose and from whatever supplier it want to purchase them from. It was the sole decision of the franchisee to sell clove cigarettes. Southland did not advertise, promote or merchandise the clove cigarettes sold at the franchisee’s store. Therefore, the Costa Mesa 7Eleven franchisee was not an express or apparent agent of Southland, but was an independent contractor. The Southland Corporation, the franchisor, is not liable for the franchisee’s alleged tortious conduct in this case. Cislaw v. Southland Corporation, 4 Cal. App.4th 1284, 6 Cal. Rptr.2d 386, 1992 Cal. App. Lexis 375 (Court of Appeal of California)

15.3 Limited Liability Company Fuzzy Toys, LLC and its insurer, Allied Insurance Company, are liable. Angela, Yoko, Cherise, and Serena are not liable. The LLC is liable for the $10 million judgment because it produced the defective doll that injured Catherine, the 7-year old child who was severely injured by the toy.

The LLC’s insurance company, Allied Insurance Company, is also liable. So, Allied must pay the $800,000 of insurance to Catherine, but after that its obligation is over. Fuzzy Toys, LLC, is also liable, but only has $200,000 of assets at the time of the injury. The LLC is obligated to pay $200,000 to Catherine. In total, Catherine has collected $1 million. There is still $9 million of unpaid judgment. Angela, Yoko, Cherise, and Serena, as owner members of the LLC, are not personally liable for any of the judgment. One of the reasons for forming and operating as an LLC is to shield the owners from personal liability. And that is what happens here. So the injured

Catherine can recover $800,000 liability insurance from Allied and can recover the $200,000 that Fuzzy Toys, LLC has, but she cannot recover anything from the owner members of the LLC. Do persons act ethically by forming an LLC knowing that they cannot be held personally liable for the debts and obligations of the LLC? This is a difficult question to answer. By permitting members of LLCs to avoid personal liability, commerce is greatly facilitated. Without such a limited liability shield, many people would not start or invest in LLCs, and business in this country would be severely hampered. When balancing competing interests, the social benefit of permitting limited liability to LLC owners outweighs the reason for holding the owners personally liable. The ethical thing for owners of LLCs to do is to acquire sufficient liability insurance to pay most claims. That way, injured parties will be compensated for injuries and the owners will not be subject to personal liability.

15.4 Liability of Members Only Microhard.com, LLC is liable. Harold, Jasmine, Caesar, and Yuan, the owners Microhard.com, LLC, are not liable. Heather, the LLC’s employee who caused the accident is personally liable to Singer, the pedestrian she negligently injured. An LLC is liable for any loss or injury caused to anyone as a result of a wrongful act or omission by a member, a manager, an agent, or an employee of the LLC who commits the wrongful act while acting within the ordinary course of business of the LLC or with authority of the LLC. Thus, the LLC is liable for the negligence of its employee. However, the debts, obligations, and liabilities of an LLC, whether arising from contracts, torts, or otherwise, are solely those of the LLC. The general rule is that members of an LLC are not personally liable to third parties for the debts, obligations, and liabilities of an LLC beyond their capital contribution. Therefore, the owners of Microhard.com, LLC—Harold, Jasmine, Caesar, and Yuan—are not personally liable to the pedestrian injured by the LLC’s employee.

15.5 Member-Managed LLC Big Apple, LLC and Jennifer are liable to the injured pedestrian. Martin and Edsel, the other owners of Big Apple, LLC are not personally liable. The LLC was a member-managed LLC and not a manager-managed LLC. This difference does not affect the liability of the members of the LLC for the debts and obligations of the LLC. The owners are not liable for the tort liability of

an LLC whether the LLC is a member-managed or manager-managed LLC. The choice to be a manager-managed LLC or a member-managed LLC does affect which owners can bind the LLC to contracts. Here, no contracts are involved. As for tort liability for negligence in this case, Jennifer is personally liable to the injured pedestrian because she negligently caused the accident.

The LLC is liable because Jennifer is an agent of the LLC and was acting within the scope of LLC business when she caused the accident. However, Martin, and Edsel are not personally liable for the accident because they are protected by the LLC shield from personal liability.

Answers to Ethics Cases 15.6 Ethics Case Yes. Melony is liable. A member of a member-managed LLC and a manager of a managermanaged LLC owe a fiduciary duty of loyalty to the LLC. This means that these parties must act honestly in their dealings with the LLC. A major breach of the duty of loyalty occurs where a member sells the LLC’s secrets to another party. The member who sells the secrets is doing so for personal gain and not for the benefit of the LLC that she is member of. Here, Melony sold the plans and drawings for a valuable secret asset of the LLC to another party. Melony has breached her duty of loyalty and is liable to the LLC for any damages her breach of loyalty causes the LLC. In this case, there is no question that Melony acted unethically. Not only the law but also ethical principles were violated by her actions. She owed a fiduciary duty to her co-owners to not reveal secrets to any other party. She acted unethically by breaching this duty of trust.

15.7 Ethics Case No, Southland is not legally liable for the tortious acts of its 7-11 franchisee Campbell, who sold liquor to a minor, who then caused an automobile accident that killed one person and severely injured two other persons.. Campbell, as a franchisee, was not an agent of Southland. Only Campbell managed the day-to-day activities of the store: she hired and fired employees, and set their wages; and the franchise agreement provided that the relationship was one of independent contractor. The only evidence of agency is the fact that the liquor license was issued to “Campbell Valerie Southland #13974,” but this is simply an identification of the licensee as a

franchisee of Southland and did not create an agency relationship. Here, Southland and Campbell were independent contractors of each other. There was no agency relationship between them.

Only Campbell, the franchisee, is liable to the plaintiffs who were harmed in the automobile accident. Under the facts of this case it seems that Southland is not morally responsible for the harm caused by the under aged drinker. If Southland, and all other franchisors, were compelled by moral duty to pay for the harm caused by their franchisees, there would be no reason to operate franchises as separate operations. Wickham v. The Southland Corporation, 168 Cal. App.3d 49, 213 Cal. Rptr. 825, 1985 Cal. App. Lexis 2070 (Court of Appeal of California)

Chapter 16 Corporations and Corporate Governance

Answers to Critical Legal Thinking Cases 16.1 Piercing the Corporate Veil Veil Northeast Iowa Ethanol, LLC (Northeast Iowa) wins. The court held that the doctrine of piercing the corporate veil applied in this case, thus allowing the plaintiffs to pierce the corporate veil of Global Syndicate International, Inc. (GSI) and reach the personal assets of Drizin, the shareholder of GSI. Generally, a corporation is a distinct entity from its shareholders. Therefore, shareholders are no personally liable for the debts and obligations of the corporation. However, in certain circumstances the court will “pierce the corporate veil” and hold shareholders personally liable for the debts and obligations of the corporation. The court found that facts existed to pierce the corporation’s veil in this case. The corporation was severely undercapitalized, having only $250 capital yet holding over $3 million of the plaintiffs’ money.

In addition, Drizin, the shareholder of GSI, commingled the corporation’s funds with his personal funds. Without question, this case presents exceptional circumstances warranting the piercing of GSI’s corporate veil and finding Mr. Drizin personally liable for GSI’s misdeeds, as the sole purpose of establishing GSI was to perpetuate fraud. GSI engaged in no legitimate business transactions whatsoever. The $250 initial capitalization of GSI was, in fact, trifling compared with the business to be done and the risk of loss. Justice and equity call for piercing the corporate veil. The U.S. District Court held that the corporate veil of GSI could be pierced to reach its shareholder Drizin. The court awarded the plaintiff compensatory damages of $3.8 million and punitive damages of $7.6 million against Drizin. Northeast Iowa Ethanol, LLC v.

Drizin, 2006 U.S. Dist. Lexis 4828 (United States District Court for the Northern District of Iowa, 2006)

16.2 Shareholder Resolution Yes, the Medical Committee’s proposed shareholder resolution could be stated in terms to meet the requirements of Section 14(a) to be included in Dow Chemical’s proxy materials. If a shareholder meets the ownership requirements of Section 14(a) (which the Committee met), he has a right to place a proposal in the proxy materials of the corporation if the proposal relates to the corporation’s business, concerns a policy issue and not the day-to-day operations of the corporation, and does not solely relate to a social or religious purpose.

In this case, Dow Chemical was manufacturing napalm, a chemical substance that was used as a defoliant in Vietnam during the Vietnam conflict. Napalm, which was often dropped from airplanes, caused damage to humans who were burned by it and those who were exposed to it.

There was substantial public criticism and demonstration against Dow for making napalm. In addition, many young people of college age refused to work for Dow because of its manufacture of napalm.

These reasons—the bad publicity and inability to recruit young professionals—were sufficient to support the Committee’s request to include its shareholder proposal in Dow’s proxy materials. In addition, the Committee could have also asserted that Dow’s manufacture of napalm made it susceptible to product liability lawsuits by those injured by it. All of these are reasons that the Committee could have asserted to support the inclusion of its shareholder proposal in Dow’s proxy materials. Merely stating that the making of napalm violated the Commission’s credo for the concern for human life would not be sufficient to require the proposal to be included in Dow’s proxy materials. Medical Community for Human Rights v.

Securities and Exchange Commission, 432 F.2d 659, 1970 U.S. App. Lexis 8284 (United States Court of Appeals for the District of Columbia Circuit)

16.3 Promoters’ Contracts Jacobson is incorrect, since a novation of the contract between the two parties did not occur. A corporation can become liable on a promoter’s contract by executing a novation. A novation is a three-party agreement whereby one party (the corporation) agrees to assume the contractual

liability of another party (the promoter) with the consent of the original contracting party (the third party). When a novation is executed, the promoter is released from liability on the contract.

In this case, Jacobson was the promoter who formed a contract for architectural services with Stern. Jacobson later formed a corporation, Lake Enterprises, to own and operate the new casino for which Stern was drawing plans. Although the corporation may have adopted this promoter’s contract, Stern, the third party, never gave his consent for a novation. Thus, Jacobson remains liable for the contract with Stern, since a novation cannot occur without the consent of the third party. Jacobson v. Stern, 605 P.2d 198, 1980 Nev. Lexis 522 (Supreme Court of Nevada)

16.4 Duty of Loyalty Hellenbrand wins since he can obtain an injunction to prevent Berk from leasing the club.

Directors and officers of corporations owe the corporation a duty of loyalty. This duty requires that officers and directors subordinate their own personal interests to those of the corporation and its shareholders. The duty of loyalty prevents officers and directors from competing with the corporation and usurping corporate opportunities. Berk was an officer of a corporation, and a vice president of Comedy Cottage, Inc. Berk usurped a corporate opportunity when he arranged for the Comedy Cottage’s lease to be drawn in his own name. When this action was discovered, Berk used his former position to retain the lease and open his own Comedy Club. This new club was in direct competition with his old corporation. Because of these two actions, the court held that Berk had breached his duty of loyalty to the Comedy Cottage, and granted Hellenbrand the injunction he sought. Comedy Cottage, Inc. v. Berk, 495 N.E.2d 1006, 1986 Ill. App. Lexis 2486 (Appellate Court of Illinois)

16.5 Piercing the Corporate Veil Yes, Walters can be held personally liable, because Wildhorn Ranch, Inc., was merely his alter ego. When a shareholder dominates a corporation and does not maintain any separation between himself and the corporation, that corporation is merely his alter ego. When this occurs, the shareholder may be held personally liable for the corporation’s debts and obligations. A

shareholder may be held liable if the corporation fails to follow the necessary formatting required by applicable statutes, such as holding shareholders meetings, and keeping minutes of these meetings. In this case, Walters dominated the affairs of Wildhorn Ranch, Inc., and ran the corporation without observing any of the necessary corporate formalities. Walters paid Wildhorn’s debts with money from his other corporations, kept no minutes of shareholders meetings, and held the meetings in his living room. Because Walters failed to separate himself from the corporation, he was found liable for the corporation’s torts and other debts. Geringer v, Wildhorn Ranch, Inc., 706 F.Supp. 1442, 1988 U.S. Dist. Lexis 15701 (United States District Court for the District of Colorado)

Answers to Ethics Cases 16.6 Ethics Case Chelsea wins and can recover from Gaffney and his partners. Directors and officers of a corporation owe a duty of loyalty to the corporation. Part of this duty is to not compete with the corporation, unless full disclosure of the competing activity is made, and a majority of the disinterested shareholders approve of the activity. Directors and officers cannot use the facilities, personnel, or funds of the corporation for their own benefit. The corporation can recover any profits made by the nonapproved competition and any other damages caused to the corporation.

Gaffney and his partners were all officers of Ideal. Gaffney and the others set up a competing business without informing the corporation or its shareholders. They also used Ideal’s assets and facilities to build their own business and recruit customers for it. These actions by Gaffney and the other officers constituted a breach of their duty of loyalty to Ideal, and the corporation was able to recover damages from them. Gaffney definitely acted unethically in this case. He owed and substantially breached the duty of loyalty that he owed to his employer. Chelsea Industries, Inc. v. Gaffney, 449 N.E.2d 320, 1983 Mass. Lexis 1413 (Supreme Judicial Court of Massachusetts)

16.7 Ethics Case

Yes, Goodman can be held personally liable for the renovation contract with DDS. A corporation becomes liable for a contract entered into by a promoter before the corporation was formed if it agrees to be bound by ratification, adoption, or novation. Liability for the contract does not automatically transfer because the promoter was acting as the agent of a nonexistent principal when the contract was entered into. In this case, ratification of the promoter’s contracts was not allowed in the state of Washington, and no novation had occurred place. Therefore, if the newly formed corporation chose to be bound by the renovation contract, it would have to be by adoption. Upon adoption, the corporation becomes liable for the contract. However, the promoter remains personally liable on the contract, unless the third party agrees to release him. Since DDS did not agree to release Goodman from liability on the renovation contract, he remained personally liable with the newly formed corporation. It probably was unethical for Goodman to deny liability because the law states that a promoter is liable on contracts unless the third party releases the promoter from the contract. Here, DDS did not relieve Goodman, the promoter, from liability. Goodman v. Darden, Doman & Stafford Associates, 670 P.2d 648, 1983 Wash. Lexis 1776 (Supreme Court of Washington)

Chapter 17 Investor Protection and Securities Transactions

Answers to Critical Legal Thinking Cases 17.1 Definition of a Security The notes issued by the Co-Op are “securities.” In order for the defendant, Ernst & Young, to be subject to federal securities laws in this case, the instrument at issue must be found to be a security. The U.S. Supreme Court found the note issued by the Co-Op to be a security, thus subjecting the Co-Op’s auditor, Ernst & Young, to a securities lawsuit. The Supreme Court applied a “family resemblance test” in finding the note a security. The Court reasoned that the notes were securities because (1) the Co-Op sold them to raise capital, (2) there was common trading in the notes, (3) the public reasonably perceived from advertisements for the sale of the notes that they were investments, and (4) there was no risk-reducing factor that would make the application of the Securities Acts unnecessary. Thus, the notes are securities that are subject to federal securities laws. Reeves v. Ernst & Young, 494 U.S. 56, 110 S.Ct. 945, 1990 U.S. Lexis 1051 (Supreme Court of the United States).

17.2 Definition of Security Yes, the Dare sales scheme is a security that should have been registered with the Securities and Exchange Commission (SEC). In SEC v. W.J. Howey Co., the U.S. Supreme Court defined an “investment contract” as a scheme that involves (1) an investment of money (2) in a common enterprise (3) with the profits to come solely from the efforts of others. The Supreme Court stated that this definition should be broadly and flexibility construed.

The court applied the Howey test in the instant case and held that the Dare multilevel sales scheme was an investment contract. There was obviously an investment of money in a common enterprise. The only difficult issue was whether the Dare plan derived profits for the investors from the efforts of others. The court held that the word “solely” should not be read literally. The court held although investors must exert some effort—mainly convincing friends, neighbors, and others to attend the Adventure Meetings—primarily their profits came from the efforts of others, i.e., from the efforts of the Dare people at the meetings to convince the attendees to sign up and pay money for one of the Adventure levels.

The court held that the Dare multilevel sales scheme was an “investment contract” and therefore a security that had to be registered with the SEC before it was sold. The court held that Turner had sold unregistered securities in violation of securities laws and granted an injunction against Turner from selling any more Dare plans. Previous purchasers could sue to rescind the purchase agreement and recover the money they paid. Securities and Exchange Commission v.

Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 1973 U.S. App. Lexis 11903 (United States Court of Appeals for the Ninth Circuit)

17.3 Intrastate Offering Exemption No, the issue of securities by McDonald Investment Company (McDonald) does not qualify for the intrastate offering exemption from registration. The company met most of the requirements for an intrastate offering exemption, such as (1) the company was a resident of Minnesota, i.e., it was incorporated in Minnesota; (2) its principal place of business was in Minnesota; (3) it was doing business in Minnesota with over 80 percent of its assets located in the state and over 80 percent of its revenues derived from within the state; and (4) the purchasers of the securities were all residents of the state. However, to qualify for the exemption, at least 80 percent of the proceeds from the offering must be invested in the state. Here, the entire proceeds from the securities issue were invested in loans on real estate and other assets located outside the state of Minnesota. Because of this fact, the Court held that the transaction did not qualify for an intrastate offering exemption from registration and issued an injunction prohibiting the continued sale of the securities. Note: Investors who purchased the securities could also rescind their

purchase agreement. Securities and Exchange Commission v. McDonald Investment Company, 343 F.Supp. 343, 1972 U.S. Dist. Lexis 13547 (United States District Court for the District of Minnesota)

17.4 Transaction Exemption No, the sale of the Continental securities by Wolfson and his family and associates does not qualify for an exemption from registration as a sale “not by an issuer, underwriter, or dealer.”

The Court held that an issuer includes any person who directly or indirectly controls the issuer.

In this case, Wolfson controlled Continental. He was its largest shareholder, made the policy decisions for the corporation, and controlled and directed the company’s officers.

The court found that the defendants had tried to conceal the sale of the securities by selling them over an 18-month period through many different brokers. The court held that these sales constituted a major “distribution” of Continental securities that should have been registered with the Securities Exchange Commission if the sales did not qualify for an exemption from registration. The court held that the securities sales did not qualify as a sale “not by an issuer” because Wolfson had been found to have been in control of the issuer of the securities— Continental. The court held that Wolfson and his family and associates should have registered the securities with the SEC, and that they had violated Section 5 of the Securities Act of 1933 because they had not registered the securities. United States v. Wolfson, 405 F.2d 779, 1968 U.S. App. Lexis 4342 (United States Court of Appeals for the Second Circuit)

17.5 Section 10(b) The plaintiff investors win and may sue the defendants for the alleged violations of Section 10(b) of the Securities Exchange Act of 1934. The defendants had asserted that the common-law defense of in pari delicto (“unclean hands”) prohibited the plaintiffs from suing because they had participated in the fraud with the defendants, i.e., the plaintiffs thought they were trading on “inside information” when they purchased the TONM securities. Under the in pari delicto theory, if two parties to illegal conduct are mutually or equally at fault, they cannot use the court

system to sue the other party to the illegal conduct. The issue in the instant case is whether the in pari delicto theory should be applied to securities laws.

The U.S. Supreme Court held that the in pari delicto theory does not apply to actions brought for alleged violations of securities laws. Thus, the plaintiffs in this case who had participated in the insider-trading scheme with the defendants could sue the defendants for disclosing false inside information to them. The Supreme Court stated: “We conclude that the public interest will most frequently be advanced if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders and broker dealers to full public view for appropriate sanctions.”

The court held that the in pari delicto theory did not apply to suits alleging violations of Section 10(b) and that the plaintiffs could maintain their lawsuit against the defendants. Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct. 2622, 1985 U.S. Lexis 95 (Supreme Court of the United States)

Answer to Ethics Case 17.6 Ethics Case The misappropriation theory stipulates that a person commits fraud in connection with a securities transaction when he or she misappropriates confidential information for securities in breach of a duty owed to the source of the information and uses that information to trade in the securities of another company. Basically, the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate “outsider in breach of a duty owed not to a trading party, but to the source of the information.

Here, O’Hagan violated the misappropriation theory and is guilty of violating securities law.

He is the classic outsider to which the misappropriation theory applies. O’Hagan was a lawyer hired by one company, Grand Metropolitan PLC (Grand Met), to prepare documents for the possible tender offer by Grand Met for the shares of Pillsbury Company. O’Hagan used the inside information he knew about the tender offer and purchased shares and options on Pillsbury stock. O’Hagan made a profit of more than $4 million when the tender offer was announced. In this case, O’Hagan breached his fiduciary duty to Grand Met when he misappropriated that

information and purchased the shares and options on Pillsbury stock. O’Hagan is guilty of securities fraud under the misappropriation theory.

O’Hagan acted unethically in this case. He used proprietary confidential information from a client to make a profit by trading in the securities of another corporation. He violated his fiduciary duty to his client Gran Met when he used secret information for his own personal benefit. O’Hagan would have acted unethically even if his conduct had not been made illegal.

But the U.S. Supreme Court, in applying the misappropriation theory, judged that his unethical conduct was also illegal. United States v. O’Hagan, 521 U.S. 642, 117 S.Ct. 2199, 1997 U.S. Lexis 4033 (Supreme Court of the United States)

17.7 Ethics Case Yes, the defendant executives Crawford and Coates are each liable for engaging in insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934. The insiders here were not trading on an equal footing with the outside investors. They alone were in a position to evaluate the probability and magnitude of what seemed from the outset to be a major ore strike.

Crawford telephoned his orders to his Chicago broker about midnight on the day before the announcement and again at 8:30 in the morning of the day of the announcement with instructions to buy at the opening of the stock exchange that morning. Crawford sought to, and did, “beat the news.” Before insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to ensure its availability to the investing public. Here, where a formal announcement to the entire financial news media had been promised in a prior official release known to the media, all insider activity must await dissemination of the promised official announcement. Crawford, an insider, traded while in the possession of material nonpublic information and is therefore liable for violating Section 10(b).

Coates’s telephone order was placed shortly before 10:20 A.M. on the day of the announcement, which occurred a few minutes after the public announcement. When Coates purchased the stock, the news could not be considered already a matter of public information.

Insiders should keep out of the market until the established procedures for public release of the

information are carried out instead of hastening to execute transactions in advance of, and in frustration of, the objectives of the release. Assuming that the contents of the official release could instantaneously be acted upon, at a minimum, Coates should have waited until the news could reasonably have been expected to appear over the media of widest circulation, rather than hastening to ensure an advantage to himself and his broker son-in-law.

Both Crawford and Coates, insider executives of Texas Gulf Sulphur Company, engaged in illegal insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934.

It is not difficult to conclude that Crawford act unethically in this case. As an insider he had knowledge of the substantial and valuable ore strike of the company, and telephoned his orders to buy the company’s stock to his Chicago broker about midnight on the day before the announcement and again at 8:30 in the morning of the day of the announcement. This way he beat the market. His actions were both unethical and illegal. Coates, who purchased securities of the company just minutes after the public announcement was made, knew that he was going to beat most of the market. He too acted unethically in making these purchases. Securities and Exchange Commission v. Texas Gulf Sulphur Company, 401 F.2d 833, 1968 U.S. App. Lexis 5797 (United States Court of Appeals for the Second Circuit)

Chapter 18 Agency Law

Answers to Critical Legal Thinking Cases 18.1 Independent Contractor or Agent Joel Glenn was an independent contractor and not an agent of Frankie and Trena Gibbs at the time of his death from a fall from a ladder when he was trimming branches on a tree on the Gibbs’ property. When Glenn engaged in the work to cut the tree limbs for his friends the Gibbs, Glenn decided where to place the ladder, and never asked for Gibbs’s assistance in operating the chainsaw. Gibbs had no training or experience in operating a chainsaw and did not direct Glenn in the use of the chainsaw or in positioning the ladder. Gibbs did not tell Glenn how to cut the limbs. Glenn brought his own chainsaw and ladder to trim the limbs. Gibbs merely pointed out to Glenn which limbs he wanted trimmed. The evidence showed that Glenn decided the manner, method, and means of trimming the limbs; there was no evidence that Gibbs retained the right to control these factors. The trial court held that Glenn was an independent contractor and not an agent of Gibbs and granted summary judgment to Gibbs. The court of appeals upheld the trial court’s judgment in favor of Gibbs. Glenn v. Gibbs, 746 S.E.2d 658, 2013 Ga. App. Lexis 639 (Court of Appeals of Georgia, 2013)

18.2 Scope of Employment No. The court held that James Goldick, an employee of Lapp Roofing and Sheet Metal Company, Inc., was not acting within the scope of his employment when, after drinking at a bar, he injured several persons while driving a vehicle that had been placed in his possession by Lapp Roofing. The court stated, “There comes a point in every litigation where common sense will make some conclusions obvious.” The court noted that obviously a crew who is assigned for several days or weeks to a remote location will need to utilize the company vehicle to get meals

or other necessities associated with that stay. The court stated, “Therefore, if this event had occurred as the employees were leaving Happy Harry’s after they obtained a needed prescription or from Denny’s Restaurant after a meal, the court believes these foreseeable and logical consequences of a lengthy stay away from home would bring the conduct within the scope of employment under the dual purpose rationale.” The court continued, “However, no reasonable person could conclude this limitation on available transportation would provide the mechanism to expand the coverage to a drunken brawl that occurred after hours and was unassociated with the employee’s work or associated with his stay.” The court found that such conduct is so adverse to the employer that no conceivable benefit could be derived. It is completely unrelated to the employer’s business and does not advance the work for which the employees were sent to this location. This incident did not occur during working hours and Goldick decided to go to Gators Bar and become intoxicated for purely personal reasons and not to serve Lapp Roofing’s interests whatsoever. The court held that Goldick was not acting within the course and scope of his employment when his negligent conduct occurred. The court granted summary judgment to Lapp Roofing on this issue. Keating v. Goldick and Lapp Roofing and Sheet Metal Company, Inc., 2004 Del. Super. Lexis 102 (Superior Court of Delaware, 2004)

18.3 Frolic and Detour No. The court held that Spires was not acting within the scope of his employment at the time of the accident that injured Siegenthaler, and therefore his employer, Johnson Welded Products, was not liable for Spires’s negligent conduct. Spires was on a lunch break, and he had left the premises of his employer, and was therefore on a frolic and detour at the time of the accident.

The court noted that under the doctrine of respondeat superior, an employer will be held liable for the negligent act of its employee if the employee was acting within the course and scope of his employment. The court concluded that “No reasonable finder of fact could find from this evidence that Spires was subject to the direction and control of Johnson Welded Products as to the operation of his truck at the time of the collision, while he was on his way to a friend’s house for lunch. We can see no reason why Johnson Welded Products would have any desire to control the manner in which its employees drive to or from work.” The court held that Spires was not acting within his scope of employment when he collided with and injured Siegenthaler. The

court of appeals affirmed the grant of summary judgment to Johnson Welded Products.

Siegenthaler v. Johnson Welded Products, Inc., 2006 Ohio App. Lexis 5616 (Court of Appeals of Ohio, 2006) 18.4 Agent No. The court of appeal held that the coming and going rule did not apply in this case. The undisputed evidence was that at the time of the accident, Brandon, an employee of Warner Bros.

Entertainment, Inc., was traveling from the airport to his home, with no intention of going to his office. Brandon's route from the airport coincidentally passed his office, which happened to be on his return route home. A special errand continues for the entirety of the trip. The court stated, “It would be nonsensical to base the employer's liability on whether the employee coincidentally chose a route that passed the workplace.” Brandon intended to return to his home, and there were no intervening personal deviations to remove him from the course and scope of employment.

Therefore, the special errand continued until such time as he arrived at his destination. The court noted that an offshoot of the doctrine of respondeat superior is the so-called “going and coming rule.” Under this rule, an employee is not regarded as acting within the scope of employment while going to or coming from the workplace. However, exceptions will be made to the going and coming rule where the trip involves an incidental benefit to the employer, not common to commute trips by ordinary members of the work force. When an employee is engaged in a special errand or a special mission for the employer it will negate the going and coming rule. The court held that the coming and going rule did not apply and did not grant summary judgment to Warner Bros. Entertainment. Jeewarat v. Warner Bros. Entertainment, Inc., 177 Cal. App.4th 427, 98 Cal. Rptr.3d 837, 2009 Cal. App. Lexis 1478 (Court of Appeal of California, 2009)

18.5 Tort Liability Yes, the Newspaper Agency Corporation (NAC) may be held liable to the Johnsons for the negligence of its employee-agent, Donald Rogers. An agent is always liable for his own negligence caused when acting on behalf of his principal, and the principal is liable for the negligence of its agent if the agent was acting within the scope of his employment when the accident occurred. The court also held that the Johnsons could recover punitive damages from

NAC. Punitive damages may be imposed for conduct that is willful and malicious or that manifests a knowing and reckless indifference and disregard toward the rights of others. It is the extreme, outrageous, and shocking behavior that justifies their imposition in drunken driving cases. The state Supreme Court rejected NAC’s motion for summary judgment on the issue of punitive damages. Johnson v. Rogers, 763 P.2d 771, 1988 Utah Lexis 81 (Supreme Court of Utah)

18.6 Independent Contractor Sanchez wins. Generally, a principal is not liable for the negligent or intentional conduct of an independent contractor it hires. However, there is an exception to this rule that provides that a principal is liable for negligent or intentional conduct of an independent contractor if it hired the independent contractor to perform an inherently dangerous activity. The law prohibits the repossession of a vehicle if a breach of peace would occur. The court held that MBank, the principal, was liable for the tortious conduct of El Paso Recovery Service, its independent contractor. The court found that El Paso was involved in an inherently dangerous activity while acting on behalf of MBank. The court held that the act of repossessing an automobile from a defaulting debtor is an inherently dangerous activity and a nondelegable duty. The court concluded that El Paso had breached the peace in repossessing the car from Sanchez and caused her physical and emotional harm. Therefore, MBank, the principal, could not escape liability by hiring an independent contractor to repossess the car. The court found MBank liable to Sanchez.

MBank El Paso, N.A. v. Sanchez, 836 S.W.2d 151, 1992 Tex. Lexis 97 (Supreme Court of Texas)

Answers to Ethics Cases 18.7 Ethics Case D. Hays Trucking, Inc. an independent contractor of Hercules, Inc. Therefore, Hercules, Inc. is not liable for the negligence of Mr. Hays of D. Hayes Trucking, Inc. when he negligently drove his large truck into the car driven by Phyllis Lewis, killing her. D. Hays Trucking, Inc. delivered

tree trunks to Hercules, Inc.’s processing plant, but did so as an independent contractor. Hays owns its own equipment and delivery vehicles, hires its own truckers and other employees, pays for its employees’ workers’ compensation coverage, and withholds federal and state taxes from employees’ paychecks. Hays directed the work of its employees who pulled stumps from the ground and the truckers who delivered the stumps to Hercules. The U.S. district court stated “It is Hays who determined the time, manner, and method of his work. Therefore no reasonable jury could determine that Hays is an employee and not an independent contractor.” The U.S. district court held that Hays was an independent contractor, and not an employee, of Hercules, Inc. The court granted Hercules’s motion for summary judgment.

It is doubtful that Lewis acted unethically when she sued Hercules for the accident caused by Hays. In most lawsuits of this sort, the plaintiff sues all of the parties involved. In this case it included Mr. Hays, who caused the accident, his company D. Hayes Trucking, Inc., and Hercules, Inc. However, Hercules had to spend money on lawyer’s fees and other costs of defending the lawsuit. Lewis v. D. Hays Trucking, Inc., 701 F.Supp.2d 1300, 2010 U.S. Dist.

Lexis 28035 (United States District Court for the Northern District of Georgia, 2010)

18.8 Ethics Case Yes, the real estate listing agreement was terminated when the Hagues sent the termination letter to Hilgendorf, the real estate agent, prior to the expiration of the listing agreement. Since an agency is a consensual relationship, a principal has the power to terminate an agency although the contract is for a period that has not yet expired. The agent’s authority to bind the principal ceases. Thus, the Hagues had the power to terminate the exclusive listing agreement with Hilgendorf.

However, absent some legal ground, the principal does not have the right to terminate an unexpired agency contract, and may subject himself to damages by doing so. The court held that the Hagues had no legal ground for terminating their agency agreement with Hilgendorf and were liable for wrongful termination of the agreement. Where the principal terminates an exclusive agency listing within the term, the agent may show that he would, but for the termination, have sold the property within the unexpired period at the listing price, and then he

can recover his lost profits as ordinarily measured by the commission he would have earned. The court held the Hagues liable for terminating the listing agreement and awarded the amount of the commission that Hilgendorf would have received had he sold the Hagues property. Here, the Hagues acted unethically when they terminated the exclusive agency agreement with Hilgendorf prior to the expiration of the listing agreement. Hilgendorf v. Hague, 293 N.W.2d 272, 1980 Iowa Sup. Lexis 882 (Supreme Court of Iowa)

Chapter 19 Equal Opportunity in Employment Answers to Critical Legal Thinking Cases

19.1 Sexual Harassment Yes. An employer can be held liable when the sexual harassment conduct of its employees is so severe that the victim of the harassment resigns. The U.S. Supreme Court stated “To establish hostile work environment, plaintiffs like Suders must show harassing behavior sufficiently severe or pervasive to alter the conditions of their employment.” The very fact that the discriminatory conduct was so severe or pervasive that it created a work environment abusive to employees because of their gender offends Title VII’s broad rule of workplace equality.

Essentially, Suders presents a “worse case” harassment scenario, harassment ratcheted up to the breaking point. Harassment so intolerable as to cause a resignation may be effected through coworker conduct, unofficial supervisory conduct, or official company acts. Unlike an actual termination, which is always effected through an official act of the company, a constructive discharge need not be. A constructive discharge involves both an employee’s decision to leave and precipitating conduct. The U.S. Supreme Court held that an employer can be held liable when the sexual harassment conduct of its employees is so severe that the victim of the harassment resigns. Pennsylvania State Police v. Suders, 542 U.S. 129, 124 S.Ct. 2342, 2004 U.S. Lexis 4176 (Supreme Court of the United States, 2004)

19.2 Sexual Harassment Teresa Harris wins. When the workplace is permeated with discriminatory intimidation, ridicule, and insult that are sufficiently severe or pervasive to alter the conditions of the victim’s employment and create an abusive working environment, Title VII is violated. A discriminatorily abusive work environment, even one that does not seriously affect employees’ psychological well-being, can and often will detract from employees’ job performance, discourage employees

from remaining on the job, or keep them from advancing in their careers. Certainly Title VII bars conduct that would seriously affect a reasonable person’s psychological well-being, but the statute is not limited to such conduct. So long as the environment would reasonably be perceived, and is perceived, as hostile or abusive, there is no need for it also to be psychologically injurious. The U.S. Supreme Court held that Title VII does not require a victim to prove that the challenged conduct seriously affected her psychological well-being in order to bring a Title VII lawsuit. Harris v. Forklift Systems Incorporated, 510 U.S. 17, 114 S.Ct. 367, 1993 U.S. Lexis 7155 (Supreme Court of the United States)

19.3 National Origin Discrimination Yes. The court held that Baccarat had engaged in national origin discrimination in violation of Title VII. Under Equal Employment Opportunity Commission (EEOC) regulations, national origin discrimination includes the denial of employment opportunity because an individual has the linguistic characteristics of a national origin group. The court stated “Accent and national origin are obviously inextricably intertwined in many cases.” Thus, unless any employee’s accent materially interferes with her job performance, it cannot legally be the basis for an adverse employment action. In this case, Ms. Rivera testified that during her one face-to-face meeting with Mr. Negre, he specifically stated that he did not like her accent. It is a statement by the president of the company who himself made the decision to terminate Ms. Rivera. Mr. Negre’s criticism of Ms. Rivera’s accent, his statement that he did not want Hispanic sale employees, and the fact that two Hispanic sales representatives were discharged while the nonHispanic salesperson was retained, all buttress the finding of liability. The court held that Baccarat had engaged in national origin discrimination in violation of Title VII and awarded Ms. Rivera $104,373 in damages, attorneys’ fees of $102,437, and prejudgment interest. Rivera v.

Baccarat, Inc., 10 F.Supp.2d 318, 1998 U.S. Dist. Lexis 9099 (United States District Court for the Southern District of New York)

19.4 Bona Fide Occupational Qualification (BFOQ) Johnson Controls’ fetal-protection policy is not a bona fide occupational qualification (BFOQ).

The U.S. Supreme Court ruled that Johnson Controls’ fetal-protection policy did not qualify as bona fide occupational qualification (BFOQ), and therefore constituted sex discrimination in

violation of Title VII. The U.S. Supreme Court stated, “The bias in Johnson Controls’ policy is obvious. Fertile men, but not fertile women, are given a choice as to whether they wish to risk their reproductive health for a particular job. Johnson Controls’ fetal-protection policy explicitly discriminates against women on the basis of their sex.” The Supreme Court stated that it had no difficulty concluding that Johnson Controls could not establish a BFOQ, stating, “We have no difficulty concluding that Johnson Controls cannot establish a BFOQ. Fertile women, as far as appears in the record, participate in the manufacture of batteries as efficiently as anyone else.

Johnson Controls’ professed moral and ethical concerns about the welfare of the next generation do not suffice to establish a BFOQ of female sterility. Decisions about the welfare of future children must be left to the parents who conceive, bear, support, and raise them rather than to the employers who hire those parents.” The U.S. Supreme Court held that Johnson Controls’s fetalprotection policy did not qualify as a BFOQ, but was instead sex discrimination in violation of Title VII. International Union, United Automobile, Aerospace and Agricultural Implement Workers of America, UAW v. Johnson Controls, Inc., 499 U.S. 187, 111 S.Ct. 1196, 1991 U.S. Lexis 1715 (Supreme Court of the United States)

19.5 Religious Discrimination No, TWA is not liable for religious discrimination in violation of Title VII. The Supreme Court held that TWA had taken all actions necessary to reasonably accommodate Hardison’s religious preference. The court held that TWA could not force other employees to work in place of Hardison without violating the collective bargaining agreement with the union that would be a violation of federal labor law. The Supreme Court also held that TWA did not have to meet Hardison’s request to work only a four-day workweek. The court reasoned that this would give Hardison an employment benefit that would be based on religion, which would itself be religious discrimination against the other employees of TWA. Further, the court held that this would cause an undue hardship on TWA by requiring it to hire and train a part-time employee to work Saturdays only or to incur the additional cost of paying overtime wages to a current employee to work overtime on Saturdays. Thus, TWA did not violate Title VII. Trans World Airlines v.

Hardison, 432 U.S. 63, 97 S.Ct. 2264, 1977 U.S. Lexis 115 (Supreme Court of the United States)

Answers to Ethics Cases

19.6 Ethics Case Yes, the residency requirement of the town of Harrison constitutes race discrimination in violation of Title VII of the Civil Rights Act of 1964. Evidence showed that the town of Hudson is part of a larger, more diverse cosmopolitan area. The town of Hudson is within Hudson County, New Jersey, and abuts the city of Newark. By reason of the geographical location and the flow of transportation facilities, the town of Harrison could reasonably be viewed as a component of the city of Newark and a part of Essex County. The city of Newark’s population is approximately 60 percent African American. Essex County’s civilian labor force totals 391,612, of which 130,397 (or 33.3 percent) are African American. The town of Harrison could draw employees from its own county of Hudson as well as Bergen, Essex, and Union counties. These four counties have a total civilian labor force of 1,353,555, of which 214,747 are African American. Thus, the town of Harrison could easily draw employees from a four-county area. It would be hard to conclude that among the very substantial number of African Americans in the four-county labor market there are not large numbers of persons qualified to serve as managers, police officers, firefighters, clerks, and laborers.

For all practical purposes, Harrison has no African American residents. Thus, to limit employment to residents effectively excludes African Americans from employment by the town of Harrison. If the residency requirement were removed, qualified African Americans would seek positions with the town of Harrison’s municipal government. Thus, the town of Harrison’s residency requirement is a facially neutral policy that has a disproportionate discriminatory impact on African Americans. Because of this discriminatory effect, the town of Harrison’s residency ordinance constitutes disparate-impact race discrimination, in violation of Title VII of the Civil Rights Act of 1964. The U.S. court of appeals decided that an injunction against the enforcement of the residency requirement should be issued.

The town of Harrison would have easily understood that its neutral-looking residency requirement was excluding African Americans from employment by the city. The city’s rational for having the residency requirement could have been based on a determination that if only residents could be city employees they therefore may more likely spend their earnings in the city, whereas persons residing elsewhere may not. The ethics of the city’s adoption of the residency requirement may not have been unethical. National Association for the Advancement of Colored

People, Newark Branch v. Town of Harrison, New Jersey, 907 F.2d 1408, 1990 U.S. App. Lexis 11793 (United States Court of Appeals for the Third Circuit)

19.7 Ethics Case Yes. The U.S. Supreme Court held that the Americans with Disabilities Act (ADA) requires the PGA Tour, Inc., to accommodate Casey Martin, a disabled professional golfer, by permitting him to use a golf cart while playing in PGA-sponsored golf tournaments. The U.S. Supreme Court noted that golf carts started appearing with increasing regularity on American golf courses in the 1950s and that today they are everywhere. The Supreme Court stated, “As an initial matter, we observe that the use of carts is not itself inconsistent with the fundamental character of the game of golf. From early on, the essence of the game has been shot-making—using clubs to cause a ball to progress from the teeing ground to a hole some distance away with as few strokes as possible.” The Supreme Court continued, “The force of petitioner PGA Tour’s argument is, first of all, mitigated by the fact that golf is a game in which it is impossible to guarantee that all competitors will play under exactly the same conditions or that an individual’s ability will be the sole determinant of the outcome. A lucky bounce may save a shot or two. Whether such happenstance events are more or less probable than the likelihood that a golfer afflicted with Klippel-Trenaunay-Weber Syndrome would one day qualify for the PGA Tour, they at least demonstrate that pure chance may have a greater impact on the outcome of elite golf tournaments than the fatigue resulting from the enforcement of the walking rule.” The Supreme Court affirmed the judgment of the U.S. Court of Appeals that held that the ADA required that the PGA Tour, Inc., to accommodate Casey Martin, a disabled professional golfer, by allowing him to use golf carts while competing in PGA-sponsored professional golf tournaments. It would seem that the PGA did not have unethical motives when it instituted the cart rule and held that Martin did not meet this rule. PGA Tour v. Martin, 532 U.S. 661, 212 S.Ct. 1879, 2001 U.S. Lexis 4115 (Supreme Court of the United States, 2001)

Chapter 20 Employment Law and Worker Protection

Answers to Critical Legal Thinking Cases

20.1 Workers’ Compensation Yes. Medrano’s actions at the time of the automobile accident were within the course and scope of his employment, thus entitling his heirs to workers’ compensation benefits. MEC argued that it received no benefit from Medrano’s attendance at the apprenticeship class and the death claim was not compensable. However, the court held that there was substantial and competent evidence to support a finding that the classroom instruction was beneficial to Medrano and his employer.

Mike Mills, the owner and president of MEC, testified: “The training made the employees more valuable to MEC by improving the quality of service to customers.” The court stated that the record was sufficient to show that MEC derived substantial benefit from having its employees travel from Marshall to Sedalia to fully participate in the apprenticeship program. MEC encouraged employees to attend the classroom instruction and covered the costs of tuition. Even though employees like Medrano obtained personal benefits in formalizing their education, MEC mutually benefited from the program as a convenient way for MEC to train its employees and ultimately provide a better quality of service to its customers. The court of appeals held that Medrano was acting within the course and scope of his employment when he was fatally injured in the car crash and that his family was entitled to receive workers’ compensation death benefits.

Medrano v. Marshall Electrical Contracting Inc., 173 S.W.3d 333, 2005 Mo. App. Lexis 1088 (Court of Appeals of Missouri, 2005)

20.2 Occupational Safety The Occupational Safety and Health Review Commission prevails because an employer is required to furnish a safe place of employment for its employees. The court stated that to violate the Occupational Safety and Health Act, the secretary must prove that (1) the employer failed to render its workplace “free” of a hazard that was (2) recognized, and (3) causing or likely to cause death or serious physical harm. In this case, the failure to pressure test a pressure vessel before activation was an apparent and obvious hazard that was likely to cause serious injury.

Furthermore, it created an extremely high probability of rupture and ensuing harm. Thus, the court stated that it is clear the hazard at issue here was both “recognized” and likely to cause serious harm, as well as preventable by the simple expedient of pressure testing. Getty Oil Company v. Occupational Safety and Health Review Commission, 530 F.2d 1143, 1976 U.S. App. Lexis 11640 (United States Court of Appeals for the Fifth Circuit)

20.3 Occupational Safety Yes. Corbesco, Inc. violated an Occupational Safety and Health Administration (OSHA) safety standard. The court held that Corbesco had violated OSHA’s safety standard that requires that safety nets be provided when workers are more than 25 feet above the ground. Here, the building on which Roger Matthew, a Corbesco employee, was working was 60 feet above the ground.

When Matthew was on his knees installing insulation on the roof, he lost his balance and fell 60 feet to the concrete below and died from the fall. In this working situation, the OSHA standard required Corbesco to provide safety nets in case a worker were to fall off such a high building.

Because Corbesco did not have such safety nets installed, it violated the OSHA safety standard.

The court rejected Corbesco’s defense that the flat roof upon which Matthew was working constituted the required “safety net.” The court stated, “The purpose of the safety devices listed in the regulation is to provide fall protection, and a roof cannot provide fall protection if workers must operate along the perimeter.” The court held that Corbesco had violated OSHA’s rules by not providing a safety net below its employees who were working more than 25 feet above the ground. Corbesco, Inc. v. Dole, Secretary of Labor, 926 F.2d 422, 1991 U.S. App. Lexis 3369 (United States Court of Appeals for the Fifth Circuit)

Answers to Ethics Cases 20.4 Ethics Case The intentional tort exception did not apply in this case. The undisputed evidence compels no other conclusion than that there was no intentional tort. Though a number of employees had received shocks from the apparatus, there is no evidence that anyone, except for the decedent, suffered a similar electrocution. All of those employees who previously received the shocks suffered no more than a transient physical buzz or numbing. These minor incidents occurred over a period where there was a continuous, daily use of the apparatus at a busy manufacturing assembly line. Given these circumstances, an electrocution could not have been envisioned as a certain danger.

Moreover, it is undisputed that the Nordyne’s management, once aware of the apparatus’s problem, took measures, however effective they may have been, to repair the apparatus.

Nordyne’s management also took another safety measure: warning the employees of the possibility of shocks. If anything, these remedial measures would have diminished the likelihood of any future electrical shocks. These measures would not have made an electrocution a certainty.

To be sure, there was a risk of an injury arising from the use of the testing apparatus. Some, such as the plaintiff’s expert, may even assert that the risk was quite high because the apparatus was defectively designed and built. However, given the record presented here, including the pleadings, briefs, affidavits, and deposition testimony of Bryson and Kendra, there is simply no evidence indicating that the electrocution injury was certain to occur at Nordyne’s manufacturing plant in Holland, Michigan, on April 20, 1988. Glockzin v. Nordyne, Inc., 815 F. Supp.1050, 1992 U.S. Dist. Lexis 8059 (United States District Court for the Western District of Michigan)

20.5 Ethics Case

Yes, employees can engage in self-help under certain circumstances under OSHA regulations.

The secretary of labor has promulgated a regulation providing that an employee may choose not to perform his assigned tasks if he has a reasonable apprehension of death or serious injury coupled with a reasonable belief that no less drastic alternative is available, without being subject to subsequent discrimination. The issue here is whether that regulation is valid. The fundamental purpose of OSHA is to prevent occupational deaths and serious injuries. This legislation is broad in nature. It would be anomalous to construe this act as to not allowing the employee to withdraw from a dangerous workplace. Further, there is an affirmative duty on all employers to provide a safe workplace. Since an OSHA inspector cannot be present all the time, this regulation allows the employee to get the benefit of a safe workplace in all circumstances. The regulation is valid.

The Whirlpool plant supervisor acted unethically by ordering the two employees to work doing the dangerous job of crawling onto an unstable wire-mess screen suspended 20 feet above the plant floor to retrieve objects that had fallen from equipment onto the screens. One employee had previously fallen to his death doing this job. Therefore, Whirlpool had notice that this a death-threatening job that it was asking the employees to do. Whirlpool was engaging in extremely unethical behavior in this case. Whirlpool also acted unethically by not correcting the method of retrieving the objects by constructing safer equipment to conduct this job. Whirlpool Corp. v. Marshall, Secretary of Labor, 445 U.S. 1, 100 S.Ct. 883, 1980 U.S. Lexis 81 (Supreme Court of the United States)

Chapter 21 Labor Law and Immigration Law Answers to Critical Legal Thinking Cases 21.1 Unfair Labor Practice Yes, the president of the Sinclair Company violated federal labor law by unlawfully interfering with the union election. The Supreme Court held that although an employer is free to communicate to his employees his general views about unionism or his specific views about a particular union his statements may not contain a threat of reprisal, force, or coercion. He may make predictions of the effects he believes unionization will have on his company. The court held that the president’s statements were not cast as predictions but rather as threats of retaliatory action if the employees elected a union. The court concluded that the intended and understood import of the president’s messages was to threaten to throw the employees out of work if the union won the election. The Supreme Court held that the president of the Sinclair Company interfered with the election and ordered that the election be set aside. N.L.R.B. v. Gissel Packing Co., 395 U.S. 575, 89 S.Ct. 1918, 1969 U.S. Lexis 3172 (Supreme Court of the United States)

21.2 Right-to-Work Law The union wins and its agency shop agreement is legal and enforceable. The U.S. Supreme Court held that Texas’ right-to-work law did not apply to the workers in this case. The court held that the predominant job situs was the controlling factor in determining whether a state’s right-to-work law applies. Here, the court reasoned that because most of the employees’ work is done on the high seas and outside the territorial bounds of the state of Texas, Texas’ right-to-work law did not apply to these workers. The court commented that it is immaterial that Texas may have more contacts than any other state with the workers, and that there is no reason to require every employment situation to be subject to some state’s law with respect to union security agreements. Oil, Chemical & Atomic Workers International Union, AFL-CIO v. Mobile

Oil Corporation, 426 U.S. 407, 96 S.Ct. 2140, 1976 U.S. Lexis 106 (Supreme Court of the United States)

21.3 Unfair Labor Practice Yes, the Carpenters’ Union’s refusal to hang the prefabricated doors at the job site was a lawful work stoppage and does not violate federal labor law. The object of the union’s action was to preserve work traditionally done by its members. The Supreme Court held that the preservation of work traditionally done by union members is a proper subject of collective bargaining, and therefore the union’s “will not handle” rule that had been bargained for and agreed to by the employer was lawful. The Supreme Court upheld the NLRB’s decision to dismiss the charges.

National Woodwork Manufacturers Association v. N.L.R.B., 386 U.S. 612, 87 S.Ct. 1250, 1967 U.S. Lexis 2858 (Supreme Court of the United States)

21.4 Illegal Strike No, Bownds and the employees who engaged in the walkout cannot get their jobs back. Bownds, who was discharged for his actions in cutting the bags of flour, was properly discharged for his conduct. The court found that the other employees had engaged in an illegal “wildcat strike” that was not sanctioned by their union. The National Labor Relations Act indicates a preference for collective bargaining. Since the employer is required to bargain with the representative of the workers, it must have some assurance as to the identity of that agent and that it can deal with that agent as a responsible spokesperson for the employees of the unit. There cannot be bargaining in any splinter groups. The court held that because this was an illegal wildcat strike, then the workers were illegal strikers who could be discharged without the right to reinstatement.

N.L.R.B. v. Shop Rite Foods, Inc., 430 F.2d 786, 1970 U.S. App. Lexis 7613 (United States Court of Appeals for the Fifth Circuit)

21.5 Replacement Workers No, the company’s offer of 20-years’ superseniority for layoff and recall purposes is not lawful and constitutes an unfair labor practice in violation of federal labor law. The Supreme Court held that the superseniority award had the effect of offering individual benefits to certain employees who were induced to abandon the strike and operated to the detriment of those who participated

in the strike. The court held that the company unlawfully discriminated between workers in violation of the National Labor Relations Act. The court upheld the NLRB’s finding of an unfair labor practice.

Note: Under the Supreme Court’s ruling in Trans World Airlines, Inc. v. Independent Federation of Flight Attendants, 489 U.S., 109 S.Ct. 1225 (1989), today the company could offer the crossovers the seniority they had prior to the strike. N.L.R.B. v. Erie Resistor Company, 373 U.S. 221, 83 S.Ct. 1139, 1963 U.S. Lexis 2492 (Supreme Court of the United States)

Answers to Ethics Cases 21.6 Ethics Case Yes, American Ship Building can lawfully lay off the employees in what is called an employer lockout. Federal labor law permits an employer to lockout employees if it reasonably anticipates a strike or has reached an impasse in collective bargaining negotiations and there is a threat of damage to the employer’s property. In this case, evidence showed an impasse had been reached in collective bargaining; there was a threat of an impending strike by the unions that would shut the shipyard down for the winter months.

The Supreme Court held that the use of a temporary layoff of employees by the employer in this case solely as a means to bring economic pressure to bear in support of its bargaining position was lawful under the National Labor Relations Act. The court held that an employer can engage in a lockout and preempt the threatened strike by the unions, and that in this case the lockout was a reasonable response to the threatened strike. American Ship Building Company v.

N.L.R.B., 380 U.S. 300, 85 S.Ct. 955, 1965 U.S. Lexis 2310 (Supreme Court of the United States)

Chapter 22 Antitrust Law and Unfair Trade Practices Answers to Critical Legal Thinking Cases 22.1 Price Fixing The State of Arizona wins. The U.S. Supreme Court held that the defendants, the Medical Society, Foundation, and its members, engaged in price fixing in violation of Section 1 of the Sherman Act. The Supreme Court held that price fixing is a per se violation of Section 1 of the Sherman Act, i.e., once price fixing is found, no defenses may be raised to try to justify the price fixing. The defendants argued that Section 1 only prohibited the fixing of minimum prices and did not prohibit the fixing of maximum prices, as set by the doctors in this case. The Supreme Court rejected this argument, holding that the setting of a maximum price is really the setting of a minimum price if all doctors agreed to charge the maximum price. The court reaffirmed that all price fixing, whether the setting of minimum or maximum prices, is judged by the per se rule and not the rule of reason. Therefore, the Supreme Court refused to consider evidence of the procompetitive effects alleged by the doctors to justify their price fixing. The Supreme Court held that the doctors’ price fixing was a per se unreasonable restraint of trade that violated Section 1 of the Sherman Act. Arizona v. Maricopa County Medical Society, 457 U.S. 332, 102 S.Ct. 2466, 1982 U.S. Lexis 5 (Supreme Court of the United States)

22.2 Tying Arrangement Metrix Warehouse, Inc. wins. The court held that Mercedes-Benz of North America (MBNA) engaged in an illegal tying arrangement when it required its franchised dealers to purchase their replacement parts for Mercedes-Benz automobiles from MBNA. A tying arrangement occurs when a seller refuses to sell one product or service (the tying item) unless the customer purchases another product or service (the tied item). In this case, the court held that the Mercedes-Benz franchise granted by MBNA to dealers was the tying product and the replacement parts it required the dealers to purchase were the tied products.

Although some tying arrangements are considered so anticompetitive as to be per se illegal, in this case the court did not find the tie to rise to this level of unlawfulness. Instead, the court applied the rule of reason and examined the procompetitive and anticompetitive nature of the tying arrangement. The court concluded that the anticompetitive aspects outweighed the procompetitive aspects. The court rejected MBNA’s claims that the tie was necessary as a device to regulate quality control. The court found that there were less anticompetitive methods for assuring quality control, such as setting published quality control standards that must be met by all manufacturers of Mercedes-Benz replacement parts. Applying the rule of reason, the court held that the tying arrangement in this case was an unreasonable restraint of trade that violated Section 1 of the Sherman Act. Metrix Warehouse v. Mercedes-Benz of North America, Inc., 828 F.2d 1033, 1987 U.S. App. Lexis 12341 (United States Court of Appeals for the Fourth Circuit)

22.3 Merger The proposed merger between Lipton Tea Co. (Lipton) and Celestial Seasonings would be a horizontal merger. A horizontal merger occurs when two or more firms in the same line of commerce (product market) serving the same section of the country (geographical market) merge. The relevant “line of commerce” in this case was the production and distribution of herbal teas nationally; the relevant “section of the country” was the nation. Since both firms were in the same line of commerce and served the same section of the country, their proposed merger would be a horizontal merger.

If Lipton and Celestial Seasonings were to merge, the resulting firm would control 84 percent of the national market for herbal teas. The next largest competitor, plaintiff Bigelow, would only have a 13 percent market share. The remaining 3 percent of the market was comprised of “trace” competitors. The merger of Lipton, the second largest competitor with 32 percent market, and Celestial Seasonings, the largest competitor with 52 percent market share, would create a merged firm that would have “monopoly power” over the marketplace. The size of the resulting firm and increase in concentration that it would cause would violate the “presumptive illegality” test announced by the U.S. Supreme Court in Philadelphia National Bank.

Although the presumption of illegality is rebuttable, the court held that it is unlikely to be rebutted in this case because of the market shares controlled by Lipton and Celestial Seasonings and the monopoly power that would result from their proposed merger. Based upon the alleged

deliberate acquisition of monopoly power in the herbal tea market, the court found that there may be a substantial lessening of competition in that market if the merger were consummated. The court ordered that the proposed horizontal merger between Lipton and Celestial Seasonings be enjoined. R.C. Bigelow, Inc. v. Unilever, N.V., 867 F.2d 102, 1989 U.S. App. Lexis 574 (United States Court of Appeals for the Second Circuit)

Answers to Ethics Cases 22.4 Ethics Case Yes, Corn Products engaged in price discrimination in violation of Section 2(a) of the Robinson-Patman Act. The U.S. Supreme Court held that the “base-point pricing” system, whereby every purchaser paid the freight charges from Chicago even if the glucose was shipped from Kansas City, constituted indirect price discrimination. This pricing scheme created a favorable zone around Chicago and vicinity. The “phantom freight” paid by nonfavored buyers not located in the favored zone caused them to pay a higher price for glucose than did the favored buyers located in the favored price zone. Evidence showed that this difference in price was important enough to cause several manufacturers of low-priced candy to move their plants to the Chicago area to avoid having to pay the phantom freight charge. The Supreme Court held that Corn Products had engaged in “indirect” price discrimination in violation of Section 2(a) of the Robinson-Patman Act, and upheld the trial court’s judgment against Corn Products.

Corn Products acted unethically in adopting its base point pricing system. It engaged in intentional conduct whereby it charged phantom freight to some customers, thereby overcharging them. Corn Products adopted its base-point pricing system to willfully engage in price discrimination favoring certain customers, thereby violating antitrust law. Corn Products Refining Company v. Federal Trade Commission, 324 U.S. 726, 65 S.Ct. 961, 1945 U.S. Lexis 2749 (Supreme Court of the United States)

Chapter 23 Consumer Protection Answers to Critical Legal Thinking Cases 23.1 Food Regulation Yes, Engel and Gel Spice violated the section of the Federal Food Drug and Cosmetic Act that concerns adulterated foods. The FDA prohibits the shipment, distribution, or sale of adulterated food. Under the act, a food is deemed adulterated if it consists in whole or in part of any “filthy, putrid, or decomposed substance,” or if it is otherwise “unfit for food.” The court found that Gel Spice was in the business of shipping, distributing, and selling spices that were used as food. Gel Spice had allowed rodents to infest their McDonald Avenue warehouse, and these rodents had caused the spice to become adulterated. The presence of rat droppings, rodent urine, and insects in the spice meant that the spice consisted in part of “filthy and putrid substances” and was, therefore, “unfit for food.” Because Engel and Gel Spice had allowed food to become adulterated, the court found that Engel and his company had violated the FDA. United States v.

Gel Spice Co., Inc., 601 F.Supp. 1205, 1984 U.S. Dist. Lexis 21041 (United States District Court for the Eastern District of New York)

23.2 Cosmetics Regulation The government wins the case and has the right to seize the French Bronze Tablets. Under the Food, Drug, and Cosmetic Act of 1938, the Federal Drug Administration is empowered to regulate the composition of cosmetics. Cosmetics include substances and preparations for cleaning, altering the appearance of, and promoting the attractiveness of a person. The Color Additives Amendment to the FDA requires the approval of the FDA before color additives can be used in cosmetics. The court held that French Bronze Tablets were cosmetics within the definition of the FDA. The French Bronze Tablets were a substance used both to alter the appearance of and to promote the attractiveness of the consumer. Because the tablets were a cosmetic, the FDA had to approve the use of any color additive in them. Because canthaxanthin

had never been approved for use as a color additive in cosmetics, the French Bronze Tablets violated the FDA and could be seized and condemned. U.S. v. Eight Unlabeled Cases of an Article of Cosmetic, 888 F.2d 945, 1989 U.S. App. Lexis 15589 (United States Court of Appeals for the Second Circuit)

Answer to Ethics Case 23.3 Ethics Case Yes. The defendants have engaged in false and deceptive advertising in violation of Section 5 of the Federal Trade Commission Act (FTC Act). The U.S. Supreme Court held that the undisclosed use of Plexiglas in the commercial was a material deceptive practice. The Supreme Court stated, “The defendants claimed that it would be impractical to inform the viewing public that it is not seeing an actual test, experiment or demonstration, but we think it inconceivable that the ingenious advertising world will be unable, if it so desires, to conform to the Federal Trade Commission’s insistence that the public be not misinformed.” If it becomes impossible or impracticable to show simulated demonstrations on television in a truthful manner, this indicates that television is not a medium that lends itself to this type of commercial. If the inherent limitations of a method do not permit its use in the way a seller desires, the seller cannot by material misrepresentation compensate for those limitations. The U.S. Supreme Court held that defendants Colgate-Palmolive Company (Colgate) and its advertising agency Ted Bates & Company had engaged in false and deceptive advertising in violation of Section 5 of the FTC Act. Colgate and Bates engaged in unethical conduct. They engaged in deceptive advertising without informing the public that what it was seeing in the television commercial was not actually what the defendants claimed it to be. The defendants had the intent to deceive the public by its false advertising. It is difficult to justify the defendants’ acts in this case. Federal Trade Commission v. Colgate-Palmolive Company, 380 U.S. 374, 85 S.Ct. 1035, 1965 U.S. Lexis 2300 (Supreme Court of the United States)

Chapter 24 Environmental Protection Answers to Critical Legal Thinking Cases 24.1 Wetlands The Army Corps of Engineers (Army Corps) prevail pursuant to the Clean Water Act (CWA).

The CWA provides that the Secretary of the Army may issue permits for the discharge of dredged or fill material into the navigable waters at specified disposal sites. Furthermore, before any discharge or fill is carried out, a permit must be granted or such discharging or filling is unlawful. In this case, the court held that the Army Corps could require Leslie Salt to obtain a permit before draining and filling the land since the property had also acquired some natural “aquatic characteristics,” such as fish, wildlife, and migratory birds. Leslie Salt Co. v. United States, 896 F.2d 354, 1990 U.S. App. Lexis 1524 (United States Court of Appeals for the Ninth Circuit)

24.2 Clean Water Act The United States prevails. The court held that the dumping of approximately 67,000 tons of carcinogenic waste into Lake Superior polluted the public water supplies in violation of its state discharge permit. In reaching this outcome, the court relied on the evidence that the discharges were causing discoloration of the surface waters outside of the zone of discharge. Since Reserve Mining was in violation of their permit, Reserve was fined for each day that the violation occurred. United States v. Reserve Mining Co., 543 F.2d 1210, 1976 U.S. App. Lexis 6503 (United States Court of Appeals for the Eighth Circuit)

24.3 Hazardous Waste The United States prevails. In this case, the Environmental Protection Agency (EPA) determined that the paint drums that were buried were hazardous materials and can only be disposed of at facilities with EPA permits. No such permit had been obtained by Hoflin. The court stated that

those individuals who handle hazardous waste are required to provide information to the EPA in order to secure permits. Placing this burden on those handling hazardous waste materials makes it possible for the EPA to know who is handling hazardous waste, monitor their activities, and enforce compliance with the statute. Thus, since Hoflin failed to inform the EPA of its disposal of the paint, he was liable for the dumping of hazardous waste. United States v. Hoflin, 880 F.2d 1033, 1989 U.S. App. Lexis 10169 (United States Court of Appeals for the Ninth Circuit)

Answer to Ethics Case 24.4 Ethics Case The U.S. Supreme Court held that there were not sufficient reasons to prevent the reopening of the nuclear power plant. The National Environmental Policy Act (NEPA) requires that the Nuclear Regulatory Commission (NRC) evaluate the potential psychological health effects of reopening the nuclear power plant. The court indicated that the renewed operation may well cause psychological health problems. Although such problems include anxiety, tension, and fear, the court held that this harm is simply too remote from the physical environment to justify requiring the NRC to investigate the psychological health damage by the reopening the nuclear plant. Thus, the court held that the NRC does not need to consider the allegations made by the group People Against Nuclear Energy (PANE).

Whether it is socially responsible for the federal government to permit the operation of nuclear power plants is an extremely complex issue. On the one hand, nuclear power can provide a source of energy that replaces the use of oil, burning of coal, and the use other sources of energy that pollute the environment. The use of nuclear power in the United States also makes the country less dependent upon foreign sources of oil. However, the tradeoff is that the use of nuclear power presents risks if something should go wrong, which could cause immediate harm to humans, animals, other creatures, and the environment. Metropolitan Edison Co. v. People Against Nuclear Energy, 460 U.S. 766, 103 S.Ct. 1556, 1983 U.S. Lexis 21 (Supreme Court of the United States).

Chapter 25 Real Property and Land Use Regulation Answers to Critical Legal Thinking Cases 25.1 Recording Statute No. Howard Savings Bank’s mortgage on the property was not properly recorded and indexed and therefore did not give notice of its existence to subsequent parties. The fundamental purpose of the Recording Act is to provide notice to subsequent parties in interest and the protection of purchasers and encumbrancers of real property against undisclosed titles and liens. Mortgagors and lenders would hesitate to be involved in commercial transactions where they could not be confident that a reasonable search of the record would reveal prior interests or where they feared being held liable for a clerk’s misindexing error. Obviously, one effect of finding a duty in the mortgagee to see that his instrument is properly indexed will be that the mortgagee will be required to conduct a search or to employ some other similar mechanism for ensuring that his interest is properly indexed. Furthermore, placing the burden upon the mortgagee to ensure that the requisite notice has been given is not out of step with the equitable maxim that where a loss must be borne by one of two innocent parties, equity will impose the loss on the party whose first act would have prevented the loss. The court held that the Howard Saving Bank’s mortgage was not properly recorded as to give the necessary notice to subsequent parties because it was not indexed. The Howard Savings Bank v. Brunson, 582 A.2d 1305, 1990 N.J. Super. Lexis 436 (Superior Court of New Jersey)

25.2 Reversion The school board wins. A reversion is a right of possession that returns to the grantor after the expiration of a limited or contingent event. In this case, the court held that the site was still being used for “school purposes” where the property was being used as a warehouse for storage of school supplies and materials. The court found that in order to accommodate changing school populations, storage facilities are necessary to house surplus equipment and supplies and to replace worn out and damaged items over time. Accordingly, the court held that having such

equipment and supplies on hand clearly furthers the ultimate goal of educating students and that the property does not revert back to the Mahrenholzes. Mahrenholz v. County Board of School Trustees of Lawrence County, 544 N.E.2d 128, 1989 Ill. App. Lexis 1445 (Appellate Court of Illinois)

25.3 Adverse Possession The Naabs win. In West Virginia the doctrine of adverse possession enables one who has been in possession of a piece of real property for more than ten years to bring an action asserting that he is now the owner of that piece of property even when title rests in another. One who asserts title under the doctrine of adverse possession must prove that (1) he has held the tract adversely; (2) the possession has been actual; (3) it has been open and notorious; (4) possession has been exclusive; (5) possession has been continuous; and (6) possession has been under color of title.

In this case, the record revealed that the predecessors in title of both the Naabs and the Nolans accepted the erection of the concrete garage sometime before 1952. The record also indicated that when the Naabs’ predecessors built the garage no complaint was registered by the Nolans’ predecessors. Accordingly, because the owner of the burdened premises is bound by the actions or inactions of his predecessors in title, the court held that the evidence was sufficient to establish title by adverse possession in that portion of the Nolans’ lot occupied by the Naabs’ garage. Naab v. Nolan, 327 S.E.2d 151, 1985 W.Va. Lexis 476 (Supreme Court of Appeals of West Virginia)

25.4 Americans with Disabilities Act Yes. Cinemark’s wheel-chair seating arrangement in its stadium-style theaters violates Standard 4.33.3 and Title III of the Americans with Disabilities Act (ADA). The regulation at issue appears plainly to require that wheelchair patrons have something more than a merely unobstructed view in seating adjacent to other patrons. The regulation requires more than “lines of sight” for wheelchair patrons, it requires comparable lines of sight. The regulation thus is plain in its requirement that the wheelchair lines of sight be similar, or at least roughly similar, to those of other patrons. The U.S. Court of Appeals concluded that the term lines of sight comparable to those for members of the general public requires that wheelchair users be afforded comparable viewing angles to those provided for the general public. Only then will wheelchair

users have “equal enjoyment” with the general public. The U.S. Court of Appeals ruled that Title III of the ADA and the Department of Justice’s Standard 4.33.3 required Cinemark to provide lines of sight for wheelchair-using patrons comparable to those offered to the general public and that its current seating configuration for wheelchair-using patrons violates the law. The court of appeals remanded the case to the U.S. District Court to determine how to remedy the situation.

United States of America v. Cinemark USA, Inc., 348 F.3d 569, 2003 U.S. App. Lexis 22757 (United States Court of Appeals for the Sixth Circuit, 2003)

Answers to Ethics Cases 25.5 Ethics Case Garber acquired title to the land up to the old fence line by adverse possession. Adverse possession occurs when there is actual open, notorious, exclusive, and continuous possession of another’s property for the statutory period of ten years. There is no question that the Garbers met this criterion of possession because the fence line had been in place for over 50 years at the time the Garbers acquired their property. Unbeknownst to the Garbers, the placement of the fence gave them 3 extra acres from the adjoining property. When the Doentzes bought the adjacent property and had a survey done, they discovered that the old fence line gave the Garbers the 3 extra acres. The Garbers acquired the 3 acres through adverse possession. All of the elements of adverse possession existed. Therefore, the Garbers have acquired the land by adverse possession.

The question of ethics in an adverse possession claim is sometimes difficult to answer. The Garbers, who did not have a survey done and relied on the old fence line, end up acquiring 3 acres that they would not have acquired if the old fence line had been constructed properly. The Garbers did not act unethically in claiming title to property that was on their side of the legal lot line. Courts tend to like old fence lines, however. Doentz v. Garber, 665 P.2d 932, 1983 Wyo. Lexis 339 (Supreme Court of Wyoming)

Chapter 26 International and World Trade Law Answers to Critical Legal Thinking Cases 26.1 Act of State Doctrine The United States government owns the depository account. The U.S. Supreme Court held that the United States government, which has the power to deal in foreign affairs, properly recognized the government of the Soviet Union. Thus, the government entered into a valid international compact with the Soviet Union that covered the Petrograd Metal Work’s (Petrograd) deposit with August Belmont & Co. (Belmont) in the United States. The Soviet Union had confiscated Petrograd’s deposit with Belmont and then assigned this deposit to the United States in settlement of claims between the two countries. Under the Act of State Doctrine, which is recognized by the United States, an act of government in its own country is not subject to suit in another country’s court. Therefore, the act of the Soviet Union in confiscating the property of Petrograd is not subject to suit in the courts of the United States. The Supreme Court reasoned that although the U.S. Constitution provides that private property shall not be taken without payment of just compensation, under the Act of State Doctrine, the United States must recognize the Soviet Union’s right to confiscate property in its own country without payment of compensation. Therefore, Petrograd’s original deposit account with Belmont now belongs to the United States government pursuant to the international compact entered into with the Soviet Union. United States v. Belmont, 301 U.S. 324, 57 S.Ct. 758, 1937 U.S. Lexis 293 (Supreme Court of the United States)

26.2 Act of State Doctrine The private United States lending bank wins. The borrowing bank, Banco National de Costa Rica that was wholly owned by the government of Costa Rica, is not protected by the Act of State Doctrine, even though the government of Costa Rica has enacted a law prohibiting the repayment of foreign debt. The United States District Court held that the Act of State Doctrine did not preclude the court from hearing and deciding the case. The Act of State Doctrine

provides that judges of one country cannot question the validity of an act committed by another country within that country’s own borders. This restraint is based upon the doctrine of separation of powers, that only the executive branch of government, and not the judicial branch, may arrange affairs with foreign governments. However, in the instant case, the court held that the source of the debt was in New York, not Costa Rica, since the court considered where the loan and promissory notes were signed and where the money was to be repaid. Thus, the U.S. District court can hear and decided the case. Libra Bank Limited v. Banco Nacional de Costa Rica, 570 F.Supp. 870, 1983 U.S. Dist. Lexis 14677 (United States District Court for the Southern District of New York)

26.3 Forum-Selection Clause Unterweser Reederei GMBH (Unterweser) is correct that the forum selection clause in its contract with Zapata Off-Shore Company (Zapata) is enforceable. A forum selection clause (or choice of forum selection) is a clause in a contract that designates which nation’s courts have jurisdiction to hear cases or disputes that arise concerning the performance of the contract. In the instant case, the contract between Unterweser, a German corporation, and Zapata, a United States corporation, contained a clause that provided that “Any dispute arising must be treated before the London Court of Justice.” The United States Supreme Court stated that a forum selection clause should be specifically enforced unless it is clearly shown that such enforcement would be unreasonable or unjust or that the clause was obtained by fraud or overreaching. In the instant case, the Supreme Court found that the forum selection clause had been agreed to by sophisticated companies who conducted international business. The court found no unfairness in the clause, fraud, or overreach in its inclusion in the Unterweser-Zapata contract. Therefore, the Supreme Court held that the forum selection clause designating the London Court of Justice as the tribunal to hear the dispute between Unterweser and Zapata was valid and enforceable. M/S Bremen and Unterweser Reederei, GMBH v. Zapata Off-Shore Company, 407 U.S. 1, 92 S.Ct. 1907, 1972 U.S. Lexis 114 (Supreme Court of the United States)

Answers to Ethics Case 26.4 Ethics Case

Texas Trading and Milling Corporation (Texas Trading) wins. The U.S. district court held that the Federal Republic of Nigeria (Nigeria) could not raise the doctrine of sovereign immunity to avoid paying for the cement it had ordered from Texas Trading. The doctrine of sovereign immunity provides that countries are immune from lawsuits in the courts of another country. The United States has enacted the Foreign Sovereign Immunities Act of 1976 (FSIA), which provides an exception to this general rule where a foreign nation is involved in a “commercial activity” that is carried on in the United States, but causes a “direct effect” in the United States. The district court found that Nigeria was carrying on a “commercial activity” when it signed the contract to purchase cement from Texas Trading to be used in building roads, dams, and other infrastructure in the country. The court also held that this commercial activity had a “direct effect” in the United States because many U.S. companies contracted to sell Nigerian cement.

The district court held that the contract in the instant case fell within the “commercial activity” exception of the FSIA, and therefore that the doctrine of sovereign immunity did not protect the country of Nigeria from lawsuit in the court of the United States. Texas Trading & Milling Corp. v Federal Republic of Nigeria, 647 F.2d 300, 1981 U.S. App. Lexis 14231 (United States Court of Appeals for the Second Circuit)

Chapter 27 Accountants’ Duties and Liability

Answers to Critical Legal Thinking Cases

27.1 Auditor’s Liability to Third Party No, Ernst & Whinney is not liable for either fraud or negligence in this case. To be held for fraud, a party must have participated in the fraudulent activity or acted with recklessness or gross negligence. The court found that Ernst & Whinney had no knowledge of the fraudulent activity, and did not act recklessly or with gross negligence. There was no evidence that the work done by Ernst & Whinney was done to defraud or deceive Hutton, or with reckless disregard of Hutton’s interest. Therefore, the court held that Ernst & Whinney was not liable to Hutton for fraud.

With regards to the negligence claim, the court held that Ernst & Whinney was not liable for negligence to Hutton either. This was because the court found that any negligence by Ernst & Whinney was not the proximate cause of Hutton’s losses. The court found that Hutton’s losses were caused solely by the massive fraud of Mr. Cotts and by Hutton’s own negligence in not discovering the fraud by not investigating the loans more cautiously before purchasing them from FAMCO. Therefore, the court dismissed Hutton’s petition against Ernst & Whinney for fraud and negligence. E.F. Hutton Mortgage Corporation v. Pappas, 690 F.Supp. 1465, 1988 U.S. Dist. Lexis 6444 (United States District Court for the District of Maryland)

27.2 Accountant’s Liability to Third Party Following is a discussion of Touche’s liability under the three major theories of accountants’ tort liability to third parties:

1. The Ultramares Doctrine. Under the Ultramares doctrine, an accountant is only liable for his negligence to third parties who are in privity of contract or a privity-type relationship with the accountant. Here, the Rosenblums are not in privity of contract or a privity-type relationship with Touche. Touche is only in privity of contract with Giant, who employed it to conduct the audit. The Rosenblums had no involvement with Giant when Touche conducted the audit. Therefore, under the Ultramares doctrine, Touche owes no duty to the Rosenblums and is not liable to them for its negligence.

2. Section 552 of the Restatement. (Second) of Torts. Under Section 552, an accountant may be held liable for his negligence to any member of a limited class of intended users for whose benefit the accountant has been employed to audit the company and prepare its financial statements. Here, Touche was not employed to conduct the audit of Giant for the Rosenblums’ benefit. In fact, Touche had no knowledge of the Rosenblums when it conducted the audit, and had no knowledge that Giant’s audited financial statements would be used by the Rosenblums to assist them in their sale of their business to Giant.

The Rosenblums did not qualify as “intended users” of the financial statements.

Therefore, Touche did not owe a duty to the Rosenblums and is not liable to them for accounting malpractice under Section 552 of the Restatement (Second) of Torts.

3. The Foreseeability Standard. The foreseeability standard stipulates that accountants are liable for their negligence to any foreseeable user of the client’s financial statements. This is the broadest standard of liability for accounting malpractice. Under this standard, Touche would be liable to the Rosenblums. This is because it is foreseeable that the client would provide its audited financial statements to third parties, including parties like the Rosenblums who are contemplating selling a business to the client in exchange for stock of the client.

The Supreme Court of New Jersey adopted the foreseeability standard for judging an accountant’s negligence liability to third parties. The court stated: When the independent auditor furnishes an opinion with no limitation in the certificate as to whom the company may disseminate the financial statements, he has a duty to all those whom that auditor should reasonably foresee as recipients

from the company of the statements for its proper business purposes, provided that the recipients rely on the statements pursuant to those business purposes.

The court found that the Rosenblums were foreseeable recipients of the financial statements and that they relied on the statements when they made their decision to sell their business to Giant.

The court held Touche liable to the Rosenblums for accounting malpractice. Rosenblum v. Adler, 93 N.J. 324, 461 A.2d 138, 1983 N.J. Lexis 2717 (Supreme Court of New Jersey)

27.3 Accountant’s Liability to a Third Party Following is a discussion of Cooper’s liability under the three major theories of accountants’ tort liability to third parties: 1. The Ultramares Doctrine. Under the Ultramares doctrine, an accountant is only liable for his negligence to third parties who are in privity of contract or a privity-type relationship with the accountant. Here, the Lindner Funds were not in privity of contract or a privity-type relationship with Coopers. Coopers was only in privity of contract with Texscan, its client who employed it to conduct the audit. The Lindner Funds had no involvement with Texscan when Coopers conducted the audit. Under the Ultramares doctrine, Coopers owes no duty to the Lindner Funds and cannot be held liable to them for its alleged negligence.

2. Section 552 of the Restatement (Second) of Torts. Under Section 552, an accountant may be held liable for his negligence to any member of a limited class of intended users for whose benefit the accountant has been employed. Here, Coopers was not employed to conduct the audit of Texscan for the benefit of the Lindner Funds. Coopers did not have knowledge that Texscan’s audited financial statements would be used by the Lindner Funds in making their decision to invest in the company. The Lindner Funds do not belong to a very small group of persons for whose guidance Coopers prepared the financial statements. Therefore, under Section 552 of the Restatement (Second) of Torts, Coopers did not owe a duty to the Lindner Funds and is not liable to them for their alleged negligence.

The Missouri Court of Appeals took this middle ground and chose to apply a balancing test to determine whether Coopers could be held liable to the Lindner Funds.

The court held that the Lindner Funds did not state a cause of action against Coopers and dismissed the complaint.

3. The Foreseeability Standard. The foreseeability standard stipulates that accountants are liable for their negligence to any foreseeable user of the client’s financial statements. This is the broadest standard of liability for accounting malpractice. Under this standard, Coopers could be held liable to the Lindner Funds for its alleged negligence in preparing the audited financial statements of Texscan. This is because it is foreseeable that potential investors—such as the Lindner Funds—would obtain, review, and rely on the audited financial statements of a company before investing in that company. Thus, under the foreseeability standard, Coopers could be held liable to the Lindner Funds for its alleged negligence in conducting the audit of the Texscan Corporation.

Lindner Fund v. Abney, 770 S.W.2d 437, 1989 Mo. App. Lexis 490 (Court of Appeals of Missouri)

27.4 Section 10(b) Yes, Laventhol is liable for violating Section 10(b) of the Securities Exchange Act of 1934.

Section 10(b) and Rule 10b-5 prohibit deceptive and manipulative practices in connection with the sale of securities. However, to be held liable under Section 10(b) and Rule 10b-5, a person must have acted with scienter; negligent conduct is not sufficient to find a violation. After reviewing the evidence in this case, the court held that Laventhol had acted with scienter, and not just negligently.

The court held that the recordation of the profit from the sales transaction of the nursing homes was a materially misleading statement that distorted the financial figures of Firestone. The court further found that Hersfeld and the other investors relied on the audited financial statements and might not have purchased Firestone’s securities if they had known the truth about that sale. The court found that Laventhol’s labeling of the $1,750,000 as “deferred gross

profit”—as opposed to “unrealized gross profit”—gave the erroneous impression that the profit was cash in hand that only had to be recorded in the future. Here, the court held that Laventhol acted with scienter and had violated Section 10(B) and Rule 10b-5. The court affirmed the trial court’s judgment against Laventhol. Herzfeld v. Laventhol, Krestein, Horwath & Horwath, 540 F.2d 27, 1976 U.S. App. Lexis 8008 (United States Court of Appeals for the Second Circuit)

27.5 Accountant–Client Privilege Roberts, the client, wins. Chaple, the accountant, was bound by Georgia’s accountant-client privilege. A state’s accountant-client privilege prevents an accountant from disclosing information about a client or becoming a witness against the client in state court proceedings.

The court held that the purpose of the state’s accountant-client privilege is to insure an atmosphere wherein the client will transmit all relevant information to his accountant without fear of any future disclosure in subsequent litigation. The court held that Chaple’s voluntary disclosure of the confidential information about Roberts to the Internal Revenue Service (IRS), without waiting for a subpoena, violated Georgia’s accountant-client privilege.

However, no accountant-client privilege exists under federal law. Thus, Georgia’s accountant-client privilege is inapplicable to federal proceedings not involving state law claims.

In this case, the IRS, an agency of the federal government, is investigating Roberts for violation of the Internal Revenue Code, a federal law. Therefore, if the IRS issued an administrative summons or subpoena to Chaple requesting the confidential information about Roberts, the Georgia accountant-client privilege could not be asserted to prevent disclosure of this information to the IRS. Because the IRS could eventually issue such a summons or subpoena in this case, the court held that Roberts suffered minimal, if any, damages. The court reversed the trial court’s grant of summary judgment in favor of Chaple. Roberts v. Chaple, 369 S.E.2d 482, 1988 Ga. App. Lexis 554 (Court of Appeals of Georgia)

Answers to Ethics Cases

27.6 Ethics Case Yes, Coopers & Lybrand (Coopers) is liable to the Archdiocese of Miami for the amount of the defalcations of the insurance premiums by McGee. Accountants are liable for their negligence in performing audit services for the client. The court held that Coopers was negligent in failing to adhere to the audit program by not obtaining a copy of the stop-loss policy from Lloyd’s and not verifying the existence of the insurance. If Coopers had done so, the court found, McGee’s defalcations would have been discovered and reported to the Archdiocese. An accounting expert testified that Coopers’ conduct violated General Accepted Auditing Standards (GAASs). The court held that Coopers was negligent and therefore liable to its client. The court remanded the case for a determination of the losses suffered by the Archdiocese. Coopers & Lybrand v.

Trustees of the Archdiocese of Miami, 536 So.2d 278, 1988 Fla. App. Lexis 5348 (Court of Appeal of Florida)

27.7 Ethics Case Yes, Howard is criminally liable for violating Section 24 of the Securities Act of 1933. Section 24 makes it a crime for any person to “willfully” violate any provision of the 1933 Act. The court found that Howard, as the accountant for American Equities, made false and misleading statements in the pro forma accounting reports he prepared for the company. The evidence was sufficient to find that (1) Howard knew that his reports were going to be used by brokers to sell American Equities’ securities to investors, (2) the accounting reports were little more than a regurgitation of materially misleading statements requested by Mende to be included in the accounting reports, and (3) Howard acted willfully and had the state of mind required for criminal conviction. The Court of Appeals affirmed Howard’s conviction. The willful and knowing commission of a crime definitely qualifies as unethical conduct. United States v.

Howard, 328 F.2d 854, 1964 U.S. App. Lexis 6343 (United States Court of Appeals for the Second Circuit)