Legal Environment of Business and Online Commerce, The, 6E Henry R Cheeseman Solution Manual

Instructor’s Manual Gregory Cermignano Widener University

The Legal Environment of Business and Online Commerce Sixth Edition

Henry R. Cheeseman

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CONTENTS Chapter 1: Legal Heritage and the Information Age

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Chapter 2: Business Ethics and Social Responsibility

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Chapter 3: Court Systems and Administrative Law

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Chapter 4: Alternative, Judicial, and E-Dispute Resolution

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Chapter 5: Constitutional Law for Business and E-Commerce

33

Chapter 6: Torts and Strict Liability

43

Chapter 7: Criminal Law and Cyber Crimes

57

Chapter 8: International and World Trade Law

65

Chapter 9: Formation of Traditional and E-Contracts

72

Chapter 10: Performance of Traditional and E-Contracts

89

Chapter 11: Cyber Law and E-Commerce

107

Chapter 12: Sales, Leases, and Warranties

116

Chapter 13: Credit, Secured Transactions, and Bankruptcy

137

Chapter 14: Entrepreneurship and Small Businesses

156

Chapter 15: LLCs, LLPs, and Global Forms of Business

167

Chapter 16: Corporations and the Sarbanes-Oxley Act

182

Chapter 17: Investor Protection and E-Securities Transactions

199

Chapter 18: Agency Law

212

Chapter 19: Equal Opportunity in Employment

222

Chapter 20: Employment Compensation and Worker Protection Law

232

Chapter 21: Labor and Immigration Law

238

Chapter 22: Intellectual Property and Cyber Piracy

247

Chapter 23: Antitrust Law and Unfair Trade Practices

257

Chapter 24: Consumer Protection and Global Product Safety

269

Chapter 25: Environmental Protection and Global Warming

275

Chapter 26: Estates, Leaseholds, and Regulation of Property

284

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PREFACE I am proud to be part of the team that supports the Cheeseman business law texts. Professor Cheeseman has done a wonderful job in writing The Legal and Regulatory Environment of Business and Online Commerce, Sixth Edition. In the supplements, I strive to add value to the tremendous amount of material already contained in the text. The Instructor’s Resource Manual has been divided into five parts.

I. Teacher-to-Teacher Dialogue This portion of the manual allows me to personally communicate what I believe are some of the overriding teaching issues in each chapter and how teaching those issues have worked for me.

I bring well over 20 years of teaching experience to this project, but know that I do not have all the answers about how material should be presented in class. By continuing this dialogue format, I want to encourage further exchange of information—teaching information, philosophies, and pedagogies. Each of us has unique contributions to bring to undergraduate law teaching, and this is my attempt to stimulate an exchange of viewpoints among our colleagues. I welcome your suggestions. I can be contacted at gpcermignano@mail.widener.edu. Some teaching tips have also been added throughout the text indicated by an→. These tips add even more value to the material to which they are attached. They include suggestions that have worked for some.

II. Topic Outlines These are outlines that can be used by the professor as a point of reference or as part of a presentation. They are in boxed format so they can be used as an outline or as part of a power point presentation. They cover most of the main topics in a chapter and are meant to supplement an individual professor’s presentation.

III. Text Materials Text materials are arranged in the order they appear in the text. So, for example, there might be a box, a case, a landmark statute, etc. Hopefully this will make the manual easier to work with as it exactly follows the text.

The Cheeseman texts are famous for its boxes that include Contemporary Trends, Business Ethics, International Law, and Internet Laws & On-Line Commerce.

Another feature of the Cheeseman text is current cases. These cases are briefed in this manual for reference purposes.

IV. Answers to Legal Environment Cases At the end of each chapter, Professor Cheeseman has a number of critical legal thinking cases. Answers to these appear in section IV. If the cases are based on scenarios that are not actually decided cases, that information is also indicated.

V. Answers to Business Ethics Cases At the end of each chapter, Professor Cheeseman has a number of business ethics cases.

Answers to these appear in Section V. If these cases are based on scenarios that are not actually decided cases, that information is also indicated. ..

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 exacerbated 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 U.S. 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.

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Legal Heritage and the Information Age

II.

Topic Outline

What Is Law? ❖ The 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 ❖ The law forbids persons from engaging in certain undesirable activities ❖ It is often fair (but not always) ❖ The Law must be flexible

Functions of Law (1 of 3) ❖ Keeping the peace ❖ Including 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

Functions of Law (2 of 3) ❖ 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 ❖ Providing a basis for compromise ❖ approximately 90 percent of all lawsuits are settled prior to trial

Functions of Law (3 of 3) ❖ Facilitating planning ❖ e.g., well-designed commercial laws allow businesses to plan their activities, allocate their resources, and assess their risks ❖ Maximizing individual freedom ❖ e.g., the rights of freedom of speech, religion, and association granted by the First Amendment to the U.S. Constitution

Landmark U.S. Supreme Court Case: ❖ Brown v. Board of Education (1954) ❖ Supreme Court reversed prior precedent of Plessy v. Ferguson (1896) ❖ Court held that the separate but equal doctrine violated the Equal Protection Clause of the Fourteenth Amendment to the Constitution ❖ The case demonstrates that one Supreme Court can overrule prior Supreme Court cases to promote justice

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Chapter 1

Schools of Jurisprudential Thought (1 of 3) ❖ Natural Law School ❖ Postulates that law is based on what is “correct” ❖ 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

Schools of Jurisprudential Thought (2 of 3) ❖ 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

Schools of Jurisprudential Thought (3 of 3) ❖ 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

English Common Law (1 of 2) ❖ 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

English Common Law (2 of 2) ❖ The English common law can be divided into cases decided by the: ❖ Law courts ❖ Equity courts (Court of Chancery) ❖ Merchant courts

International Law: The Civil Law System (1 of 2) ❖ 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

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Legal Heritage and the Information Age

International Law: The Civil Law System (2 of 2) ❖ In some civil law countries, court decisions do not have the force of law ❖ A contrast to Anglo-American common law where laws are created by the judicial system as well as by congressional legislation Sources of Law in the United States (1 of 5) ❖ 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 Sources of Law in the United States (2 of 5) ❖ Codified law: statutes and ordinances ❖ Statutes are enacted by Congress and state legislatures ❖ Ordinances are enacted by municipalities and local government agencies ❖ They establish courses of conduct that must be followed by covered parties Sources of Law in the United States (3 of 5) ❖ Treaties ❖ The president, with the advice and consent of the Senate, may enter into treaties with foreign governments ❖ Executive orders ❖ Issued by the president and governors of states ❖ They regulate the conduct of covered parties Sources of Law in the United States (4 of 5) ❖ Administrative agency regulations and orders ❖ 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 Sources of Law in the United States (5 of 5) ❖ Judicial decisions ❖ Federal and state courts decide controversies ❖ In doing so, they issue decisions that state the holding of each case and the reasoning used by the court in reaching its decision The Doctrine of Stare Decisis (1 of 2) ❖ Based on the common law tradition, past court decisions become precedent for deciding future cases ❖ Lower courts must follow the precedent established by higher courts

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Chapter 1

The Doctrine of Stare Decisis (2 of 2) ❖ Thus, all federal and state courts in the U.S. must follow the precedents established by U.S. Supreme Court decisions ❖ Adherence to precedent is called stare decisis

Priority of Law in the United States (1 of 2) ❖ The U.S. Constitution and treaties take precedence over all other laws ❖ Federal statutes take precedence over federal regulations ❖ Valid federal law takes precedence over conflicting state or local law

Priority of Law in the United States (2 of 2) ❖ State constitutions rank as the highest state law ❖ State statutes take precedence over state regulations ❖ Valid state law takes precedence over local laws

III.

Text Materials

*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.

Landmark Law: Brown v. Board of Education This box discusses the application of law where the Supreme Court overturned the “separate but equal” doctrine that condoned separate schools for black children and white children. *An historical underpinning can be further reinforced with some discussion of the tie-ins between our own country’s political history with that of the legal traditions of England and other countries.

This portion of the chapter material can be used to introduce students to a broad overview of the roles that the world’s major legal systems play in the world economy. For example, the role of the Law Merchant and its influence on international trade is critical to understanding most international rules on import/export laws today. The origins of the Law Merchant, in turn, are traceable in large part to the Roman civil law. In the end, we have ingredients from English common law, Roman civil law, and Judeo-Christian canon law all thoroughly processed into our law. The individual ingredients are all present, but each is no longer independently identifiable.

Contemporary Environment: Immigration to the United States of America A history of U.S. immigration and discussion of the Oath of Citizenship are covered in this box.

International Law: Adoption of English Common Law in America Common Law is discussed.

International Law: The Civil Law System This box discusses the history of civil law. *Another key objective of this chapter is to introduce students to the sources of the law in the U.S as specific emphasis is placed on role of the U.S. Constitution and its pivotal role in the ultimate 5 ..

Legal Heritage and the Information Age

distribution of powers between the federal government and the states vis-à-vis the control of business conduct in the U.S. This aspect of the chapter will introduce students to key terms that they will be using throughout the rest of the course such as substantive and procedural due process and the like. Emphasis will also be placed on the sources of the law. *Constitutional principles are given living meaning through the critical legal thinking process of using stare decisis on a case-by-case basis. Our system is admired around the world. Yet it is in constant need of updating and definition based on the geopolitical and technological changes taking place in our global environment.

IV. Answers to Legal Environment Case Problems 1.1. Most 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 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, 91 N.E. 695, 1910 Ill. Lexis, 1958 (Ill.) 1.2 The Court said, in light of the facts, it could be assumed that the defendant bullied the plaintiff. Thus the decision was unfair. Baileyv. Eminem, 2005 Mich. App. Lexis 930(Ct. of Appeals of Mich., 2005).

V. Answers to Business Ethics Cases 1.3 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 Lexis 126 (U.S. Sup. Ct.) 1.4 1) Mitnick stole secret information from his victim, computer systems.

2) Yes. What he did hurt many others and there was no legitimate purpose.

3) Yes. This was given on an ability to pay criteria.

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Chapter 2 Business Ethics and Social Responsibility

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, Professor Cheeseman 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. Topical Outlines Introduction ❖ 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 Law and Ethics ❖ 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 ❖ The law may permit something that would be ethically wrong

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Chapter 2

Theories of Ethics – Summary (1 of 2) Theory ❖ Ethical fundamentalism ❖ Utilitarianism ❖ Kantian ethics

Description ❖ Persons look to an outside source or ❖ central figure for ethical guidelines. ❖ Persons choose the alternative that would provide the greatest good to society. ❖ A set of universal rules establishes ethical duties. The rules are based on reasoning and require (1) consistency in application and (2) reversibility.

→Note Kant’s categorical imperative → “Do unto others as you would have them do unto you.” This is duty ethics or deontology.

Theories of Ethics – Summary (2 of 2) Theory ❖ Rawls’s social justice theory

Description ❖ Moral duties are based on an implied social contract. Fairness is justice. Rules are established from an original position.

❖ Ethical relativism

❖ Individuals decide what is ethical

based on their own feelings as to what is right or wrong.

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

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Business Ethics and Social Responsibility

Theories of Social Responsibility – Summary Theory Responsibility ❖ Maximizing profits ❖ To maximize profits for stockholders. ❖ Moral minimum ❖ To avoid causing harm and to compensate for harm caused. ❖ Stakeholder interest ❖ To consider the interests of all stakeholders, including stockholders, employees, customers, suppliers, creditors, and local community. ❖ Corporate citizenship ❖ Corporate citizenship To do good and solve social problems The Corporate Social Audit (1 of 2) ❖ Corporate audits should be extended to include the moral health of the corporation ❖ Corporations that conduct social audits will be more apt to prevent unethical and illegal conduct by managers, employees, and agents The Corporate Social Audit (2 of 2) The audit would examine how well: ❖ Employees have adhered to the company’s code of ethics; and ❖ The corporation has met its duty of social responsibility Such audits would focus on the corporation’s efforts to: ❖ Promote employment opportunities for members of protected classes ❖ Worker safety ❖ Environmental protection ❖ Consumer protection III. Text Materials 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 morally based methodology is sought as a guidepost for 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 as teachers is to help students prepare for these challenges in both their professional and personal ethical lives.

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Chapter 2

Ethics Spotlight: Wal-Mart Pays Big for Meal Break Violations This box deals with the alleged denial of meal breaks by Wal-Mart. The employees won.

Landmark Law: The Whistle Blower Statute This discusses Bayer and its fraud with Cipro and Medicaid. Many interesting issues can be used in the classroom.

Case 2.1: Pizza Hut, Inc. v. Papa John’s International, Inc. Facts: Pizza Hut filed a lawsuit charging Papa John’s with false advertising violating the Lanham Act. The Suit involved Papa John’s slogan, “Better Ingredients, Better Pizza”, and its claim to have a superior sauce and dough to Pizza Hut. The district court found the slogan was just “puffery” but the other claims were misleading and tainted the slogan because of association with these statements.

Issue: Is Papa John’s slogan, “Better Ingredients, Better Pizza” false advertising?

Decision: No. The court of appeals reversed and remanded for entry of judgment for Papa John’s.

Reason: The slogan was a statement of opinion and not fact. The other claims were not material without a showing of potential influence on the purchasing decision of consumers.

Case 2.2: Wal-Mart v. Samara Brothers Facts: Wal-Mart was selling knockoff clothes exactly like those being sold by Samara at a price lower then Samara’s retailers were paying Samara for its clothes. The suit was filed alleging violation of the Lanham Trademark Act. The district court ruled for Samara without finding a secondary meaning for Samara’s clothes. The court of appeals affirmed.

Issue: Must a product’s design have acquired a secondary meaning before it is protected as trade dress?

Decision: Yes. The Supreme Court reversed the decision of the court of appeals.

Reason: The Lanham Act requires a showing of the likeliness of causing confusion with the product for which protection is sought. The Supreme Court requires showing of a secondary meaning to protect a product’s design.

Ethics Spotlight: Social Audit of a Corporation The value of corporate social audits is examined.

Landmark Law: Sarbanes-Oxley Act Prompts Public Companies to Adopt a Code of Ethics. This box discusses the requirement for a code of ethics found in the Sarbanes-Oxley Act. A typical code is shown.

See Law Case with Answer in the text.

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Business Ethics and Social Responsibility

IV. Answers to Legal Environment Cases Fraud 2.1. Whether or not Listerine 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 was probably not guilty of fraud but guilty of false advertising. WarnerLambert Co. v. FTC, 562 F.2d 749 (D.C. Cir. 1979).

Liability 2.2. 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 Johns-Manville Corporation, 36 B.R. 727, 1984 Bank v. Lexis 6384 (Bankr. S.D.N.Y.) V. Answers to Business Ethics Cases 2.3. The Sullivan Principles propose commitments that fit the Corporate Citizenship model. Its precepts include more than ethical positions within the company (e.g., provide equal and fair employment practices), it embraces company action toward improving the lot of the black in South Africa (e.g., assist in schooling, housing, etc.). A company that acts according to the Sullivan Principles is behaving as a Corporate Citizen, a standard somewhat above the ethical duty of business organizations under several approaches.

Duties are owed when they are clear answers to problems. Not all problems have clear solutions. The Utilitarian, for example, might reach a different conclusion regarding the need for a company to withdraw from South Africa. Indeed, this was the strong argument made by those companies who failed to commit to such a plan. The position of these companies was that more bad would come to the region and the affected people than good by their pullout.

Where these speculations have validity, the consequentialist could argue that the pressure from withdrawal has less worth than the misery unintentionally caused by the withdrawal of business, and, accordingly, jobs for the needy.

Universities on the other hand could defend their divestment of holdings in companies who failed to withdraw much easier and with less ill effect on the parties they wish to assist. To the extent that the stock investment manifests a vote for present policies, a divestiture would provide further moral stature to the position regarding apartheid. The duty-based examiner 11 ..

Chapter 2

must ask the question as to whether investment is a vote for willing evil by the company’s participation in the business of South Africa. Here, the principle of proportionality requires that the extent to which such holdings contribute to the company would be invoked, a major issue in determining to decide to discontinue stock ownership.

2.4. 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. Steelworkers v. Weber, 443 U.S. 193 (1979).

2.5. Here again one must determine under what standards the business behavior of the corporation are to be judged. If the appropriate ethical component requires only that corporate agents do no harm to the community, the issue turns on the quality of the behavior toward animals.

While the moral position is generally that man may use the resources of the world as long as it does not injure society or the environment, the level of behavior toward animals is the question. However, cruelty by itself is immoral, and when practiced on a living thing, albeit an animal, it is considered improper. Being truly human, according to the Kantian view, is to practice those virtues that elevate man and do not demean or hurt. Accordingly, the strongest argument against the corporate practice is having its agents acting inhumanely.

A refusal to permit the stockowners an opportunity to express their view about the function of a corporation and the behavior it wished to accept would be ethically wrong under certain approaches.

In this case, the shareholder wins the right to put the issue on the proxy. The ethical and social significance of plaintiff’s proposal and the fact that it implicates significant levels of sales, supports the likelihood of prevailing on the merits with regard to the issue of whether his proposal is “otherwise significantly related” to Iroquois/Delaware’s business. The result would be different if plaintiff’s proposal was ethically significant in the abstract but had no meaningful relationship to the business of Iroquois/Delaware as Iroquois/Delaware was not engaged in the business of importing pate de foie gras. Lovenheim v. Iroquois Brands, Ltd., 618 F.Supp. 554 (D.C. 1985).

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Chapter 3 Court Systems and Administrative Law

See you in Court!

I. Teacher to Teacher Dialogue Twenty-first Century technological advances have provided our students with all kinds of instant access to information. These devices have provided the 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 Court TV. This is not all bad. Current media focus on numerous law related 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 that 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) mechanisms. 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. 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 three million civilian employees working as of 1988. 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

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Chapter 3

authorized to act, and what controls have been put in place so as to protect the rights of both the citizenry 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 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 executive, legislative, and judicial 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 that 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. Topical Outline There are two major court systems in the U.S.: ❖ The federal court system ❖ The court systems of the 50 states and the District of Columbia ❖ Each of these systems has jurisdiction to hear different types of lawsuits

Dispute Resolution Litigation ❖ The process of bringing, maintaining, and defending a lawsuit ❖ Difficult ❖ Time-consuming ❖ Costly ❖ Complex procedural rules

Alternative Dispute Resolution ❖ Nonjudicial dispute resolution developed in response to the expense and difficulty of bringing a lawsuit ❖ Being used more often to resolve commercial and ecommerce disputes

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The State Court Systems (1 of 4) 1. Limited- Jurisdiction Trial Courts 2. General- Jurisdiction Trial Courts 4. State Supreme Court 3. Intermediate Appellate Courts

The State Court Systems (2 of 4) Limited-Jurisdiction Trial Court (hears matters of a specialized nature) ❖ Traffic courts ❖ Juvenile courts ❖ Justice-of-the-peace courts ❖ Probate courts ❖ Family law courts ❖ Small claims courts ❖ Courts that hear misdemeanor criminal law cases and civil lawsuits under a certain dollar amount

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The State Court Systems (3 of 4) General – Jurisdiction Trial Court ❖ Hears 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 Court ❖ An intermediate court that hears appeals from trial courts ❖ Reviews 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

Factors to consider in deciding to bring or settle a lawsuit: (1 of 2) ❖ The probability of winning or losing ❖ The amount of money to be won or lost ❖ Lawyers’ fees and other costs of litigation ❖ Loss of time by managers and other personnel ❖ The long-term effects on the relationship and reputation of the parties ❖ The amount of prejudgment interest provided by law

Factors to consider in deciding to bring or settle a lawsuit: (2 of 2) ❖ The aggravation and psychological costs associated with a lawsuit ❖ The unpredictability of the legal system and the possibility of error ❖ Other factors peculiar to the parties and lawsuit

The Federal Court System (1 of 8) 1. Special Federal Courts 2. U.S. District Courts 3. U.S. Courts Of Appeals 4. U.S. Supreme Court The Federal Court System (2 of 8) ❖ Special Federal Courts Special Federal Courts ❖ Federal courts that hear matters of specialized or limited jurisdiction ❖ They include: ❖ U.S. Tax Court ❖ U.S. Claims Court ❖ U.S. Court of International Trade ❖ U.S. Bankruptcy Courts

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The Federal Court System (3 of 8) U.S. District Courts U.S. District Courts ❖ The federal court system’s trial courts of general jurisdiction ❖ They are empowered to: ❖ Impanel juries ❖ Receive evidence ❖ Hear testimony ❖ Decide cases ❖ Most federal cases originate in federal district court

The Federal Court System (4 of 8) ❖ U.S. Courts of Appeals 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

The Federal Court System (5 of 8) U.S. Courts of Appeals U.S. Courts of Appeals (continued) ❖ 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

The Federal Court System (6 of 8) ❖ U.S. Supreme Court U.S. Supreme Court ❖ The Supreme Court was created by Article III of the U.S. Constitution ❖ The Supreme Court is the highest court in the land and is located in Washington, D.C.

The Federal Court System (7 of 8) U.S. Supreme Court U.S. Supreme Court (continued) ❖ The Supreme Court hears appeals from federal circuit courts of appeals and, under certain circumstances, from federal district courts, special federal courts, and the highest state courts ❖ No new evidence or testimony is heard ❖ Petitioner must file a petition for certiorari and will be granted a writ of certiorari if the case will be reviewed

The Federal Court System (8 of 8) ❖ U.S. Supreme Court U.S. Supreme Court (continued) ❖ The lower court record is reviewed to determine whether there has been an error that warrants a reversal or modification of the decision ❖ The Supreme Court’s decision is final

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The Federal Court System

Jurisdiction of Federal and State Courts

Federal Question –case arising under U.S. Constitution, treaties or federal statutes and regulations.

Diversity – no plaintiff is a citizen of the same state as that of any defendant.

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The Jurisdiction and Venue of Courts 1)Standing to Sue 2)Subject Matter Jurisdiction 3)In personam jurisdiction(or personal jurisdiction) 4)In rem jurisdiction 5)Quasi in rem jurisdiction 6)Long-arm statutes 7)Venue 8)Forum selection clause(see Contemporary Environment box)

Subject Matter Jurisdiction in Federal Courts - Federal question - Diversity of Citizenship (case between citizens of different states)

Long-Arm Statute ❖ Statute that extends a state’s jurisdiction to nonresidents who were not served with a summons within the state – usually defines necessary minimum contacts Forum-Selection Clause ❖ Contract provision that designates a certain court to hear any dispute concerning nonperformance of the contract

III. Text Materials Contemporary Environment: Business Courts This box discusses the relatively new trend toward specialized commercial courts that handle complex commercial lawsuits.

Contemporary Environment: The Process of Choosing a Supreme Court Justice This box discusses the process for choosing and approving a Supreme Court Justice.

Contemporary Environment: Types of Cases Heard by the U.S. Supreme Court This box discusses the process necessary to win a review by the U.S. Supreme Court. Only at most 100 cases are usually heard per year.

Contemporary Environment: Forum-Selection and Choice of Law Clause This discusses what court will hear and decide the case.

Internet Law & Online Commerce: Obtaining Jurisdiction in Cyberspace The Zippo case and its application to the concept of “minimum contacts” and eventually jurisdiction are discussed.

Administrative Law: substantive and procedural law that governs the operation of administrative agencies.

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Administrative Agencies ❖ Agencies that the legislative and executive branches of federal and state governments establish. ❖ Rules and Regulations – adopted by administrative agencies to interpret the statuses that they are authorized to enforce.

Federal Administrative Agencies ❖ Administrative agencies that are part of the executive or legislative branch of government. ❖ The majority of federal administrative agencies are part of the executive branch of government. ❖ Administrative agencies created by Congress are independent of the executive branch. o They have broad regulatory powers over key areas of the national economy.

State Administrative Agencies ❖ Administrative agencies that states create to enforce and interpret state law o Also have a significant effect on business ❖ Local governments and municipalities create administrative agencies to administer local law. o e.g., zoning commissions Landmark Law: Administrative Procedure Act (APA) of 1946 ❖ Establishes certain administrative procedures that federal administrative agencies must follow in conducting their affairs. o e.g., notice and hearing requirements o e.g., rules for conducting agency adjudicative actions o e.g., procedures for rule making Administrative Procedure Act (continued) ❖ Most states have enacted administrative procedural acts that govern state administrative agencies. ❖ Administrative Law Judges (ALJs) – preside over administrative proceedings. o Decide questions of law and fact concerning the case. o No jury o The ALJ is an employee of the administrative agency Administrative Law ❖ Administrative Law is a combination of substantive and procedural law. ❖ Each federal administrative agency is empowered to administer a particular statute or statutes. o These statutes are the substantive law that is enforced by the agency

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Delegation Doctrine ❖ When an administrative agency is created, it is delegated certain powers. o Legislative powers o Executive powers o Judicial powers ❖ If an administrative agency acts outside the scope of its delegated powers, it is an unconstitutional act.

Legislative Powers of Administrative Agencies ❖ Substantive Rule Making ❖ Interpretive Rule Making ❖ Licensing ❖ Statement of Policy Substantive Rules ❖ Government regulation that has the force of law. ❖ Must be adhered to by covered persons and businesses ❖ Violators may be held civilly or criminally liable ❖ All substantive rules are subject to judicial review.

Interpretive Rules ❖ Rules issued by administrative agencies that interpret existing statutory language ❖ Such rules do not establish new laws. ❖ Neither pubic notice nor pubic participation is required Statement of Policy ❖ A statement issued by administrative agencies ❖ It announces a proposed course or action that an agency intends to follow in the future. ❖ Such statements do have the force of the law. ❖ Public notice and participation are not required Licensing Powers of Administrative Agencies ❖ Statutes often require the issuance of a government license before a person can enter certain types of industries or professions ❖ Most administrative agencies have the power to determine whether to grant licenses to applicants. o Power to suspend or revoke licenses. ❖ The administrative agency’s decision is subject to judicial review.

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Executive Powers of Administrative Agencies ❖ Powers that administrative agencies are granted. o i.e., such as the investigation and prosecution of possible violations of statutes, administrative rules, and administrative orders. ❖ Administrative subpoena ❖ Administrative searches Judicial Powers of Administrative Agencies ❖ Many administrative agencies have the judicial authority to adjudicate cases through an administrative proceeding. ❖ Initiated when an agency serves a complaint on a party the agency believes has violated a statute or administrative rule or order. ❖ In adjudicating cases, an administrative agency must comply with the Due Process Clause of the U.S. Constitution Procedural Due Process ❖ Due process that requires the respondent to be given: 1. Proper and timely notice of the allegations or charges against him or her, and 2. An opportunity to present evidence on the matter Substantive Due Process Due process that requires that the statute or rule that the respondent is charged with violating be clearly stated.

Procedures for Administrative Adjudication ❖ Administrative Law Judges (ALJs) – preside over administrative proceedings. o Decide questions of law and fact concerning the case. o No jury. o The ALJ is an employee of the administrative agency ❖ The administrative agency and the respondent may be represented by counsel. ❖ The ALJ’s decision is issued in the form of an order. o Must state the reasons for the ALJ’s decision. ❖ The order becomes final if it is not appealed. ❖ An appeal consists of a review by the agency. ❖ The agency review can result in new findings of fact and law. ❖ Further appeal can be made to the appropriate federal or state court.

Judicial Review of Administrative Agency Actions ❖ Many federal statutes expressly provide for judicial review of administrative agency actions. ❖ The Administrative Procedure Act (APA) authorizes judicial review of federal agency actions. o Where an enabling statute does not provide for review. ❖ Petitioner – the party appealing the decision of an administrative agency. ❖ Decisions of federal administrative agencies are appealed to the appropriate federal court. ❖ Decisions of state administrative agencies may be appealed to the proper state court

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Conditions for Judicial Review 1. The case must ripe for review.

2. The petitioner must have exhausted all administrative remedies.

3. The decision of the administrative agency must be final before judicial review can be sought o Final Order Rule Questions of Law ❖ If the administrative agency has decided a question of law the reviewing court is free to substitute its own judgment for that of the administrative agency. ❖ e.g., interpretation of statutory language Questions of Fact ❖ Questions of fact are not easily overturned. ❖ Reviewing court usually defers to the agency’s fact-finding ❖ APA specified standards for review of fact finding: o The arbitrary, capricious abuse of process test. o The substantial evidence test. o The unwarranted by the facts test.

Immunity of Agency Employees ❖ Federal administrative agency employees are immune from lawsuits for personal liability regarding the actions and decisions they make while performing their agency duties. o Similar to immunity of judges and legislators.

Public Disclosure of Agency Actions ❖ Freedom of Information Act ❖ Government in the Sunshine Act ❖ Equal Access to Justice Act ❖ Privacy Act Freedom of Information Act ❖ Requires that documents of federal administrative agencies be open to the public. ❖ There are certain exemptions from this requirement. ❖ Requires agencies to publish their proceedings, rules, regulations, and other information in the Federal Register.

Government in the Sunshine Act ❖ Requires that meetings of federal administrative agencies be open to the public. ❖ There are certain exemptions to this requirement.

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Equal Access to Justice Act ❖ Gives a private party who was subject to an unjustified federal administrative agency action the right to sue and recover attorneys’ fees and costs.

Privacy Act ❖ Requires that federal administrative agencies maintain only information about an individual that is relevant and necessary to accomplish a legitimate agency purpose ❖ Gives individuals access to these records and a right to correct the records Government Regulation Versus Compensable “Taking” of Property ❖ The government may use its powers of eminent domain to acquire private property for public purposes ❖ The Due Process Clause of the U.S. Constitution requires the government to allow the owner to make a case for keeping the property. o State constitutions where applicable ❖ Just Compensation Clause of the U.S. Constitution – mandates that the government must compensate the property owner when it exercises the power of eminent domain. ❖ Anyone who is not satisfied with the compensation offered by the government can bring an action to have the court determine the compensation to be paid.

Law Case with Answer: Carnival Cruise Lines, Inc. v. Shute Facts: Mrs. Shute sued Carnival Cruise Lines, Inc., (Carnival) for injuries suffered while she was a passenger aboard one of its ships. The suit was filed in Washington. However, the trial court dismissed the suit on a motion for summary judgment that argued that the contract of the parties specified that defendant could only be sued in Florida courts. The Washington appellate court reversed the trial court and the defendant appealed to the United States Supreme Court.

Issue: Is the forum selection clause in the contract enforceable?

Decision: Reversed. The forum clause is fundamentally fair.

Reason: Several advantages flow from recognizing the validity of this nonnegotiated forum clause freely entered into by both parties: (1) The cruise line would not risk having to defend actions brought simultaneously in several jurisdictions.

(2) Litigation expense is reduced for both parties if they both know where suits can be brought.

(3) Passengers who purchase tickets can expect to benefit from reduced prices due to the savings generated by reasonable and fair clauses.

It, therefore, seems better to permit the reasonable inclusion of a forum selection clause whenever its benefits outweigh its dangers.

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IV. Answers to Legal Environment Federal Question 3.1. Yes, the federal courts have the jurisdiction to hear Nutrilab’s case. Federal courts have limited jurisdiction, granted to them by the Constitution and Congress. Part of this limited jurisdiction is to hear cases involving federal questions. Federal question cases are cases arising under the U.S. Constitution, treaties, and federal statutes and regulations. Federal courts have original jurisdiction to hear federal question cases. Nutrilab was disputing the FDA’s application of a federal statute to stop their distribution of Starch Blockers. The Starch Blockers case was therefore one arising under a federal statute, and this gave the federal court original jurisdiction to hear the case. Any lawsuit, such as this one brought by Nutrilab, that involves a federal question must be brought in a federal court. Nutrilab, Inc. v. Schweiker, 713 F. 2d 335, 1983 U.S. App. Lexis 25121 (7th Cir.).

Jurisdiction 3.2. Yes, the case can be removed to a federal court on the basis of diversity of citizenship. If a case over which the federal courts have concurrent jurisdiction is brought in a state court, the case can be removed to a federal court. Federal courts have concurrent jurisdiction over cases involving parties with diverse citizenship. Diversity of citizenship is defined as a case involving (1) citizens of different states, (2) a citizen of a state and a citizen of a foreign country, (3) a citizen of a state and a foreign country where the foreign country is the plaintiff.

A corporation is considered to be a citizen of the state in which it is incorporated. A case that is brought must involve more than $50,000. The lawsuit between Allison and ITE involved a citizen of the state of Mississippi, and a citizen of a foreign country, Japan. The amount Allison was suing for was greater than $50,000. This meant that the case could be removed from Mississippi State Court to a federal court. The federal court had concurrent jurisdiction over the case, based upon the diversity of citizenship between Allison and ITE. Allison v. ITE Imperial Corp., 729 F. Supp. 45, 1990 U.S. Dist Lexis 607 (S.D. Miss.)

Administrative Regulation 3.3. Yes, the Federal Communications Commission’s (FCC) regulation and censoring of Pacifica Foundation (Pacifica) in this case was lawful and constitutional. The U.S. Supreme Court held that Congress had asserted the Federal Communications Act which specifically forbids the use of any “obscene, indecent, or profane language by means of radio communications.” The Supreme Court held that the FCC did not exceed its delegated power when it found George Carlin’s “Filthy Words” monologue to be indecent and thereby not proper to be broadcast by a radio station.

The Supreme Court also addressed the First Amendment Freedom of Speech issue that was raised by Pacifica. The court held that all forms of communication broadcasting has the most limited First Amendment protection. The court stated that radio stations were subject to “time, place, and manner” restrictions regarding broadcasts. Thus, the Communications Act’s prohibition against “indecent” broadcasts was justified because (1) the broadcast media have a uniquely pervasive presence in the lives of all Americans and (2) broadcasting is uniquely accessible to children. Based on this reasoning, the Supreme Court upheld the FCC’s order against Pacifica Foundation.

Justice Brennan wrote a dissenting opinion in which he stated that the government’s regulation of the content of broadcasting isolated the Free Speech Clause of the First Amendment.

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children, conflicts with the time-honored right of a parent to raise a child as he sees fit, and could lead to a banning from radio of a myriad of literary works, novels, poems, and plays by the likes of Shakespeare, Joyce, and Hemingway. Brennan argued that if people were offended by what was on the radio they could turn it off with a minimum of effort. Federal Communications Commission v. Pacifica Foundation, 438 U.S. 726, 98 S.Ct. 3026,1978 U.S. Lexis 135 (U.S.Sup. Ct.).

IV. Answers to Business Ethics Cases 3.4. No. Based on the de minimis theory, i.e., “the law disregards trifles,” the trial court was correct in dismissing the case. Justice King believed that this lawsuit is an absurd waste of the resources of the courts and of the taxpayers’ money. The courts are already too heavily burdened to be used to punish advertisers who use junk mail. Harris v. Time, 191 C.App. 3d 449, 237 Cal. Rptr. 584, 1987 Cal. App., Lexis 1617 (Cal. App.).

3.5 This is a case dealing with minimum contacts and attempts to avoid jurisdiction. There were obviously minimum contacts because of the amount of business done there and it was not fair that the National Enquirer try to avoid suit in California. They derived benefit from their California business and need to abide by rules. The Court held they were subject to suit in California. There was sufficient minimum contacts. Calder v. Jones, 465 U.S. 783, 104 S.Ct. 1482.

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Why don’t I want to see you in court?

I. Teacher to Teacher Dialogue Twenty-first Century technological advances have provided our students with all kinds of instant access to information. These devices have provided the 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 Court TV. This is not all bad. Current media focus on numerous law related 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 that 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) mechanisms. 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.

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II. Topic Outline The Pretrial Litigation Process 1.Pleadings 2. Discovery 3. Dismissals and Pretrial Judgments 4. Settlement Conference

1) Complaint is filed with the Court or served on the Defendant.

2) Summons is and order directing the defendant to appear.

3) Answer is mandatory. No answer could result in a no fault judgment.

4) Statute of limitations establishes period for bringing a lawsuit.

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Discovery ❖ 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.

Dismissals and Pretrial Judgments ❖ Motion for judgment on the pleadings – motion that alleges that if all the facts are 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 that asserts 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 Phases of a Trial 1. Jury Selection – voir dire 2. Opening Statements 3. The Plaintiff’s Case – plaintiff bears the burden of proof (direct and cross examination) 4. The Defendant’s Case 5. Rebuttal and Rejoinder 6. Closing Arguments 7. Jury Instructions 8. Jury Deliberation 9. Entry of Judgment The 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 Alternative Dispute Resolution (ADR) ❖ 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 Types of ADR ❖ Arbitration – courts usually give deference to arbitrator’s decision ❖ Judicial Referee ❖ Mediation – no decision ❖ Conciliation – interested 3rd party ❖ Minitrial ❖ Fact-Finding ❖ Judicial Referee + E-Dispute Resolution – ADR on-line

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Key ADR Legislation ❖ Federal Arbitration Act -Arbitration agreements involving commerce are valid, irrevocable, and enforceable contracts (Landmark Law) ❖ Uniform Arbitration Act - Adopted by half of the states. Promotes the arbitration of disputes at the state level

III. Text Materials Internet Law & Online Commerce: E-Filings in Court This box discusses the “virtual courthouse” where all filings are done electronically. Some courts have instituted this procedure.

Contemporary Trend: Cost-Benefit Analysis of a Lawsuit This box helps students do real world analysis of how the decision is made to go forward with a suit.

Ethics Spotlight: Frivolous Lawsuit Some state have statutes against frivolous lawsuits See Law Case with answer in the text.

Case 4.1: Ferlito v. Johnson Products, Inc. Facts: Plaintiffs Susan and Frank Ferlito, husband and wife, attended a Halloween party in 1984 dressed as Mary (Mrs. Ferlito) and her little lamb (Mr. Ferlito). Mrs. Ferlito had constructed a lamb costume for her husband by gluing cotton batting manufactured by defendant Johnson & Johnson Products to a suit of long underwear. She had also used defendant’s product to fashion a headpiece, complete with ears. The costume covered Mr. Ferlito from his head to his ankles, except for his face and hands, which were blackened with Halloween paint. At the party Mr. Ferlito attempted to light his cigarette by using a butane lighter. The flame passed close to his left arm, and the cotton batting on his left sleeve ignited. Plaintiffs sued defendant for injuries they suffered from burns that covered approximately one-third of Mr. Ferlito’s body. Following a jury verdict entered for plaintiffs, defendant JJP filed a timely motion for judgment (not withstanding) the verdict.

Issue: Should defendant JJP’s motion for j.n.o.v. be granted?

Decision: The trial court granted JJP’s motion for j.n.o.v., vacating the verdict in favor of the Ferlitos.

Reason: The evidence in this case clearly demonstrated that neither the use to which plaintiffs put JJP’s product nor the injuries arising from that use were foreseeable. Susan Ferlito testified that the idea for the costume was hers alone. As described on the product’s package, its intended uses are for cleansing, applying medications, and infant care. Plaintiffs’ showing that the product may be used on occasion in classrooms for decorative purposes failed to demonstrate the foreseeability of an adult male encapsulating himself from head to toe in cotton batting and then lighting up a cigarette.

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Case 4.2: Circuit City Store, Inc. v. Adams Facts: Adams, a sales consultant for Circuit City, signed an employment contract with an arbitration clause agreeing to binding arbitration. Adams filed a discrimination lawsuit in the court. The District Court upheld arbitration via the employment contract but the Circuit Court said that employment contracts are not subject to arbitration. Adams appealed.

Issue: Are employment contracts subject to arbitration?

Decision: Yes. The decision was reversed.

Reason: There was a valid arbitration agreement in effect. The Federal Arbitration Act allows for enforcement.

III. Answers to Legal Environment Cases Long-Arm Statute 4.1. Yes, the Oklahoma state court can use the state’s long-arm statute to gain jurisdiction over Magna Verde. A long-arm statute gives a court the ability to gain jurisdiction over an out-of-state business if that business has minimum contacts with the state and the maintenance of the suit does not offend traditional notions of fair play and substantial justice.

The exercise of long-arm jurisdiction is generally permitted over nonresidents who have a contract that affects the state, or who transact other business in the state. Oklahoma’s longarm statute gave the Oklahoma court jurisdiction over Magna Verde for several reasons.

Magna Verde had entered into a contract that would affect Oklahoma, a contract to stage a fight in that state. Magna Verde had also transacted business in Oklahoma, promoting the O’Grady prizefight. Because of these contacts with the state, the Oklahoma court gained jurisdiction over Magna Verde through Oklahoma’s long-arm statute. Brooks v. Magna Verde Corp., 619 P.2d 1271, 1980 Okla.Cir. App. Lexis 118 (Okla.App.).

Physical Examination 4.2. The court will only order Schlagenhauf to be examined by an ophthalmologist. A court has the power to order the physical and mental examination of a party to a case. However, this power is limited to situations where the physical or mental condition that is the subject of the examination is at issue in the case. The court in this case stated the rule as requiring that parties making a request for examination must make an affirmative showing that the other party’s “mental or physical condition was in controversy and that there was good cause for the examinations requested.” In this case the only issue was Schlagnehauf’s eyesight.

Therefore, the court concluded that: Nothing in the pleadings would affect a basis for a belief that Schlagenhauf was suffering from a mental or neurological illness warranting wide-ranging psychiatric or neurological examinations. Nor is there anything stated justifying the broad internal medicine examination.

Therefore, the only examination that the court ordered Schlagenhauf to undergo was one conducted by an ophthalmologist. Schlagenhauf v. Holder, 379 U.S. 104, 85 S.Ct. 234, 1964 U.S. Lexis 152 (U.S. Sup.Ct.).

Interrogatories 4.3. Yes, Cine is required to answer the questions submitted by Allied Artists’ attorneys. These written questions are known as interrogatories. Interrogatories are an important part of the legal process known as discovery. The purpose of interrogatories, like other forms of discovery, is to obtain facts about the case from the other parties and witnesses before the trial begins. Interrogatories are usually directed at parties, not witnesses. A party is required by the court to answer the interrogatories in writing within a specified time period. Because the person answering the interrogatories must sign them under oath, that person must be careful to answer them truthfully. The interrogatories that were served upon Cine sought to discover information about its theater’s box office receipts. This information was crucial in 31 ..

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determining potential damages in the suit. Because interrogatories are an important part of the discovery process, Cine was required to answer them in a timely and truthful manner.

Cine Forty-Second Street Theatre Corp. v. Allied Artists Pictures Corp., 602 F.2d 1062, 1979 U.S.App. Lexis 13586 (2d Cir.).

Judgment N.O.V. 4.4. A judgment N.O.V. is a motion that asserts that considering the evidence in a light most favorable to the plaintiff, the plaintiff has failed to introduce evidence sufficient for a reasonable jury to have held for the plaintiff. In other words, the judge is being asked to enter a judgment opposite of what the jury has decided because no reasonable jury could have reached the verdict that this jury has entered. The standard used by the court in this case in deciding whether to start a Judgment N.O.V. is “whether the evidence is such that there can be but one conclusion as to the verdict that reasonable men could have reached.” In this case, all of the testimony of the witnesses directly contradicted the statements of Simblest. Where Simblest claimed to have had a green light in his favor, all of the other witnesses stated that the traffic light was not operating. Four witnesses also testified that they had observed the lights and sirens of the fire engine working, in direct contradiction with Simblest’s testimony.

Because all of the evidence in this case favored the defendant, the judge granted the defendant’s motion for a Judgment N.O.V. Simblest v. Maynard, 427 F.2d 1, 1970 U.S. App. Lexis 9265 (2d Cir.).

V. Answers to Business Ethics Cases 4.5. Yes, the service of process served on Mr. Burnham is good. A court must have personal jurisdiction over the defendant in a lawsuit. One method of obtaining personal jurisdiction over a defendant is to serve personal service on the defendant when he is within the territorial boundaries of the state. In this case, Mrs. Burnham filed a divorce action in California after she and her husband separated and she moved to California from New Jersey. She then filed a divorce action in California Superior Court, naming her husband, who lived in New Jersey, as the defendant. When Mr. Burnham was in California on business, he decided to visit his children who were living with Mrs. Burnham. When he was there, he was served the summons and complaint of Mrs. Burnham’s divorce action. In this case, the U.S. Supreme Court held that jurisdiction might be obtained over a nonresident by personal service in the forum state. The Supreme Court reasoned that the fact that American courts have announced the rule since the latter part of the 19th century provides a defendant voluntarily in a particular state today with clear notice that he is subject to suit in that forum. The Court held that service of process was good in this case. Therefore, Mr. Burnham must answer and defend himself in the California divorce action filed by his wife. Burnham v. Superior Court of California, 110 S.Ct. 2105, 109 L.Ed.2d 631, 1990 U.S.Lexis 2700 (U.S.Sup.Ct.).

4.6. Yes, the arbitration agreement between AMF and Brunswick is valid under Federal law. To promote the arbitration of disputes, Congress has enacted the Federal Arbitration Act (FAA).

The act provides that arbitration agreements involving “commerce” are valid, irrevocable, and enforceable as long as the agreement is not illegal. The arbitration agreement between Brunswick and AMF was clearly involved commerce. Because of this fact, the court held that the agreement was covered by the FAA. The court gave the following reasons for enforcing the agreement, citing the language of the legislation that enacted the FAA: Arbitration agreements are purely matters of contract and the effect of the bill is simply to make the contracting party live up to his agreement. He can no longer refuse to perform his contract when it becomes disadvantageous to him.

Because AMF and Brunswick had signed an arbitration agreement involving commerce, the court held that their dispute had to be submitted for arbitration. AMF Incorporated v.

Brunswick Corp., 621 F.Supp. 456, 1985 U.S.Dist. Lexis 14205 (E.D.N.Y.).

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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 conduct in the U.S. This aspect of the chapter will introduce students to key terms which they will be using throughout the rest of the course such as substantive and procedural due process and the like. 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. Topical Outlines 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 2. It protects individual rights by limiting the government’s ability to restrict those rights

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Federalism and Delegated Powers ❖ Federalism is the U.S. form of government ❖ The federal government and the 50 state governments share powers ❖ Enumerated powers – certain powers delegated to the federal government by the states

Federalism (continued) Any powers that are not specifically Any powers that are not specifically delegated to the federal government delegated to the federal government by the Constitution are reserved to by the Constitution are reserved to the states

The Doctrine of Separation of Powers (1 of 3) ❖ Article I of the Constitution establishes the legislative branch of government ❖ The part of the government that consists of Congress: ❖ the Senate ❖ the House of Representatives

The Doctrine of Separation of Powers (2 of 3) ❖ Article II of the Constitution establishes the executive branch of government ❖ The part of the government that consists of: ❖ the President ❖ the Vice President ❖ The president is selected by the electoral college, not elected by popular vote

The Doctrine of Separation of Powers (3 of 3) ❖ Article III of the Constitution establishes the judicial branch of the government ❖ The part of the government that consists of: ❖ the Supreme Court ❖ other federal courts that may be created by the Congress

Checks and Balances Checks and Balances: Certain checks and balances checks and balances are built into the constitution to ensure built into the constitution to ensure that no one branch of the federal that no one branch of the federal government becomes too powerful.

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The Supremacy Clause ❖ Supremacy Clause – 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

The 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.” ❖ Because this clause authorizes the federal government to regulate commerce, it has a greater impact on business than any other provision in the Constitution - in the stream of commerce - substantially affects commerce (Wickard v. Filburn)

Federal Regulation of Interstate Commerce ❖ The Commerce Clause also gives the federal government the authority to regulate interstate commerce ❖ The federal government may regulate: ❖ Interstate commerce that crosses state borders ❖ Intrastate commerce that affects interstate commerce

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State and Local Government Regulation of Business (1 of 2) ❖ Police Power – the power of the states to regulate private and business activity within their borders ❖ States may enact laws that protect or promote the public health, safety, morals, and general welfare as long as the law does not unduly burden interstate commerce ❖ No discrimination no limit on length of passenger trains ❖ No undue burden no anti-federal ban on truck length permissible local road weight controls

State and Local Government Regulation of Business (2 of 2) ❖ State and local governments may regulate: ❖ Interstate commerce ❖ Intrastate commerce not exclusively regulated by the federal government ❖ Zoning ordinances, state environmental laws, corporation and partnership laws, and property laws are enacted under this power

The Bill of Rights and Business ❖ The Bill of Rights provides certain freedoms and protections to individuals and business: ❖ Freedom of speech ❖ Freedom of religion

COURT TESTS

1) Compelling Interest Test (Strict Scrutiny) ❖ Government action sustained only if: 1) Overriding or compelling government interest involved & 2) Government is using narrowest possible means 2) Reasonable Basis Test ❖ Government action constitutional if: 1) Government is pursuing legitimate government purposes & 2) Some reasonable basis for the action INTERMEDIATE TEST Government action sustained if: (1) Pursuit of important government objectives & (2) Significantly related to the attachment of these objectives Fair and substantial relation to important government objectives USE TEST (1) for fundamental rights & suspect classifications. USE TEST (2) For all others except for classes based on sex or sometimes age – then USE TEST (3)

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EXAMPLES Fundamental Rights ❖ Religion ❖ Speech ❖ Association ❖ Privacy ❖ Marry ❖ Vote Non-Fundamental Rights ❖ Housing ❖ Welfare ❖ Education Suspect Clauses ❖ Race ❖ Religion ❖ (Possibly National Origin) Non – Suspect Clauses ❖ Poverty

Freedom of Speech ❖ The right to engage in oral, written, and symbolic speech protected by the First Amendment ❖ The U.S. Supreme Court places speech into three categories: 1. Fully protected 2. Limited protected 3. Unprotected -Commercial speck – time, place & manner restrictions -Symbolic speech – protected -State can define obscenity Freedom of Religion ❖ The U.S. Constitution requires federal, state, and local governments to be neutral toward religion ❖ The Establishment Clause – prohibits the government from either establishing a state religion or promoting one religion over another ❖ The Free Exercise Clause – prohibits the government from interfering with the free exercise of religion in the United States

The Equal Protection Clause ❖ The Supreme Court has adopted three different standards for reviewing equal protection cases: ❖ Strict Scrutiny Test – applied to classifications based on race ❖ Intermediate Scrutiny Test – applied to classifications based on protected classes other than race (e.g., sex or age) ❖ Rational Basis Test – applied to classifications not involving a suspect or protected class - State cannot deny equal protection of the laws to any person within jurisdiction 37 ..

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Due Process Clause ❖ The Fifth and Fourteenth Amendments 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 - Need good reason The Privileges and Immunities Clause ❖ Article IV of the Constitution and the Fourteenth Amendment contain a Privileges and Immunities Clause ❖ This clause prohibits states from enacting laws that unduly discriminate in favor of their residents ❖ This clause applies only to citizens ❖ Corporations are not protected - No discrimination with respect to essential activities without a substantial reason

III. Text Materials Ethics Spotlight: Native Americans and the Federal Government Issue dealing with Native Americans are discussed.

Internet Law & Online Commerce: E-Commerce Protected by the Commerce Clause The U.S. Supreme Court saved e-commerce from a discriminatory state law.

Internet Law & Online Commerce: Free Speech in Cyberspace The Computer Decency Act (CDA) is discussed. Certain provisions were declared unconstitutional.

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Contemporary Environment: Affirmative Action and the Equal Protection Clause Affirmative action programs of educational institutions are discussed. The Gratz and Grutter cases are reviewed.

Case 5.1:Rowe, Attorney General of Maine v. New Hampshire Motor Transport Association Facts: Maine adopted a statute to regulate the trucking industry. One provision forbade anyone other than a Maine-licensed tobacco retailer from accepting an order for delivery of tobacco, and other provisions forbade knowing transportation of a tobacco product to a person in Maine unless either the sender or receiver had a Maine driver’s license. This suit was based on a claim that the Federal Motor Carrier Act of 1980 (deregulating the trucking industry) preempted Maine’s statute. The District Court and the U.S. Court of Appeals ruled that it did.

Issue: Does federal law preempt the 2 provisions of the Maine statute in this case?

Decision: Yes. Reason: Congress’ goal was to assure transportation rates, routes and services reflecting maximum reliance on competition. The Maine statute is contrary to this goal.

Case 5.2: Mainstream Marketing services, Inc. v. FTC and FCC Facts: Telemarketers cannot call people who are on the national do-not-call registry on behalf of sellers of goods and services. Charities and fundraisers are exempt. Mainstream and other telemarketers claim their free speech rights are violated. The FTC and FCC argue that these calls are commercial speech that can be regulated.

Issue: Do unsolicited telemarketing calls constitute commercial speech that can be regulated by the donot-call registry restrictions?

Decision: Yes. They do not violate the free speech rights of telemarketers.

Reason: The lists only restrict commercial speech. They target only calls that invade the privacy of a home. The registry is an opt-in program. The registry helps prevent abuse to telemarketing (a government interest).

Law Case with Answer: Reno, Attorney General of the United States v. Condon Facts: Many state motor vehicle departments register automobiles and issue drivers licenses. Many states also sold personal information such as names, addresses telephone numbers, and social security numbers.

After receiving thousands of complaints from individuals whose personal information had been sold, Congress enacted the Driver’s Privacy Protection Act of 1994. This statute prohibits a state from selling the personal information of a person unless the person gives affirmative consent. South Carolina sued the United States, alleging that the federal government exceeded its authority under the Commerce Clause by adopting the DPPA. Issue: Was the Driver’s Privacy Protection Act properly enacted pursuant to the interstate commerce clause power granted to the federal government by the U.S. Constitution?

Decision: Yes. Reason: The U.S. Supreme Court held that Congress had the authority under the Commerce Clause to enact the federal Driver’s Protection Act.

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IV. Answers to Legal Environment Separation of Powers 5.1. The U.S. Supreme Court held that the President’s seizure of the steel mills was a violation of separation of powers and unconstitutional. The court held that the seizure order could not stand.

Youngstown Company v. Sawyer, Secretary of Commerce, 343 U.S. 579, 72 S.Ct. 863, 1952 U.S. Lexis 2625 (U.S. Sup. Ct.).

Commerce and Supremacy Clauses 5.2. ARCO wins. The U.S. Supreme Court held that the Washington state statute directly conflicted with a valid federal law and was therefore unconstitutional under the Supremacy Clause of the U.S. Constitution. When Congress enacted the Ports and Waterways Safety Act and set the design and length standards for oil tankers, it considered the safety of the vessels and the environment. The federal rules were set so that these standards would be uniform across the country and would also comply with international standards.

The U.S. Supreme Court held that the Washington State statute—which mandated different boat designs and smaller lengths of vessels—directly conflicted with the federal law. Under the Supremacy Clause of the U.S. Constitution that states that federal law is the supreme law of the land, any state law which directly conflicts with valid federal law fails. The Supreme Court held that the state statute directly conflicted with the federal statute and violated the Supremacy Clause. Ray, Governor of Washington v. Atlantic Richfield Company, 435 U.S. 151, 98 S.Ct. 988, 1978 U.S. Lexis 18 (U.S. Sup. Ct.).

Undue Burden on Interstate Commerce 5.3. No, the Iowa statute that limits the length of vehicles to 55 feet is unconstitutional. The United States Supreme Court held that the Iowa statute created an undue burden on interstate commerce.

The U.S. Constitution reserves the right to enact laws and regulations to protect the safety, health, and welfare of its citizens. However, these laws cannot directly conflict with valid federal laws or unduly burden interstate commerce. Since the federal government had not chosen to regulate the size of vehicles that use the highways (a “naked” Commerce Clause), the Iowa statute must be examined to see if it creates an undue burden on interstate commerce.

Iowa argued that it had a right to limit the size of vehicles on highways crossing the state in order to protect the safety of its residents. The Supreme Court rejected this argument, finding that traffic accidents are based on the number of miles driven, rather than size of vehicle. Therefore two smaller trucks crossing Iowa would cause more accidents than one larger truck. Also, the court held that if trucks were diverted around Iowa, Iowa was “exporting” accidents to other states. The Supreme Court held that because of these reasons, and that all other states permitted the larger 65-foot double trailers, Iowa’s statute limiting vehicles to 55 feet unduly burdened interstate commerce in violation of the Commerce Clause and was therefore unconstitutional. Kassel v. Consolidated Freightways Corporation, 450 U.S. 662, 101 S.Ct. 1309, 1981 U.S. Lexis 17 (U.S. Sup. Ct.).

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Privileges and Immunities Clause 5.4. No, the Alaska Hire statute is not constitutional. The Privileges and Immunities Clause of the U.S. Constitution provides that “the citizens of each state shall be entitled to all privileges and immunities of citizens in the several states.” With few exceptions, this clause prohibits a state from favoring its residents over residents of other states in granting privileges or rights. The U.S. Supreme Court held that the Alaska Hire statute that required that employers give preference to hiring Alaska residents over residents of other states violated the Privileges and Immunities Clause. In so holding the court stated that the Constitution “was framed upon the theory that peoples of the several states must sink or swim together, and that in the long run prosperity and salvation are in union and not division.” The Supreme Court held that the Alaska Hire statute cannot withstand constitutional scrutiny. Hicklin v.

Orbeck, Commissioner of the Department of Labor of Alaska, 437 U.S. 518, 98 S.Ct. 2482, 1978 U.S. Lexis 26 (U.S. Sup. Ct.).

Commercial Speech 5.5. Yes, the City of San Diego’s zoning ordinance which prohibits commercial billboards within the city is lawful. What is involved in this case is commercial speech. The U.S. Supreme Court held that although commercial speech such as advertising is protected by the Freedom of Speech Clause of the First Amendment to the U.S. Constitution, it is accorded a lesser protection than other constitutionally guaranteed expressions. The Supreme Court held that commercial speech is subject to proper time, place, and manner restrictions.

In this case, the Supreme Court held that the twin goals of the zoning ordinance—traffic safety and aesthetic values—advanced the city’s interests and justified the prohibition on commercial billboards within the city. The court reasoned that advertisers had other forms of speech to reach consumers, such as print media, handbills, television, and radio commercials. The Supreme Court held that the San Diego zoning ordinance was a proper time, place and manner restriction on commercial speech and did not violate the First Amendment. Metromedia, Inc. v. City of San Diego, 453 U.S. 490, 101 S.Ct. 2882, 1981 U.S. Lexis 50 (U.S. Sup. Ct.).

Substantive Due Process 5.6. The Village of Hoffman Estates wins. The U.S. Supreme Court held that the village’s ordinance that required stores that sold drug paraphernalia to be licensed by the village did not violate substantive due process. Under substantive due process, a law is required to be clear enough on its face so that a normal citizen could read and understand it. If a statute is overly vague, it is unconstitutional as a violation of due process. The process requires that laws give a person of ordinary intelligence a reasonable opportunity to know what is prohibited so that he may act accordingly. Vague laws may trap the innocent by not providing fair warning of what is expected.

The Supreme Court held that the village’s ordinance was facially clear. The court held that the ordinance clearly identified the controlled drugs and that persons of ordinary intelligence could identify drug paraphernalia included in the ordinance. The Supreme Court held that the village’s licensing ordinance was clear on its face and complied with substantive due process. Village of Hoffman Estates v. Flipside, Hoffman Estates, Inc., 455 U.S. 489, 102 S.Ct. 1186, 1982 U.S. Lexis 78 (U.S. Sup. Ct.).

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Equal Protection Clause 5.7. Metropolitan Life Insurance Company (Metropolitan) wins. The Supreme Court held that the Alabama statute that taxed foreign out-of-state insurance companies at a higher rate than domestic insurance companies violated the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution. The Supreme Court found that Alabama’s aim was purely and completely discriminatory, designed only to favor domestic industry within the state, no matter what the cost to foreign corporations also seeking to do business in the state. The court stated that “the Alabama domestic preference tax gives the 'home team' an advantage by burdening all foreign corporations seeking to do business within the state.” The court held that under the circumstances, promotion of domestic business by discrimination against nonresident competitors is not a legitimate state purpose.

The court found no rational basis for the discriminatory tax, and held it to be an unconstitutional violation of the Equal Protection Clause of the Fourteenth Amendment to the U.S. Constitution.

Metropolitan Life Insurance Company v. Ward, Commissioner of Insurance of Alabama, 470 U.S. 869, 105 S.Ct. 1676, 1985 U.S. Lexis 80 (U.S. Sup. Ct.).

V. Answers to Business Ethics Cases 5.8. The exercise of eminent domain powers by the city would unduly burden interstate commerce and would subordinate the interest of the NFL in a substantial way. By preventing the relocation of the franchise, the city would affect gate receipts that provide revenue for all the clubs that play with the Raiders. The income derived from TV and radio contracts would also be impaired. The cost of stadium leases would be affected by the shift in bargaining power to the cities, some of which own these stadiums. So the threat of eminent domain proceedings in other cities throughout the nation would affect national commerce in this industry, which is the very kind of parochial meddling that the Commerce Clause was designed to prohibit. City of Oakland, California v. Oakland Raiders, 174 C. A. 3d 414, 220 Cal. Rptr. 153, 1985 Cal. App. Lexis 2751 (Cal. App.).

5.9 Symbolic speech refers to expressive conduct and it can be protected under the first amendment. The Court said that punishing the acts noted would dilute the very freedom that makes the flag important.

It is, however, destruction of government property. The Court struck down the law against flag burning. U.S. v. Eichman, 496 U.S. 310.

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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. Also introduce 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 decide for him or herself how they feel about the issues. The possibilities for debate and open-ended discussion on these matters are endless. Products liability remains one of the great socioeconomic and legal dilemmas of our day.

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II. Text Materials Introduction ❖ Tort is the French word for a “wrong” ❖ Under tort law, an injured party can bring a civil lawsuit 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 Against Persons (1 of 6) ❖ 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 Intentional Torts Against Persons (2 of 6) → Note: Doctrine of Transferred Intent → victims can sue Assault ❖ The threat of immediate harm or offensive contact; or ❖ Any action that arouses reasonable apprehension of imminent harm ❖ Actual physical contact is unnecessary

Battery ❖ Unauthorized and harmful or offensive physical contact with another person ❖ Actual physical contact is unnecessary

Intentional Torts Against Persons (3 of 6) False Imprisonment ❖ The intentional confinement or restraint of another person without authority or justification and without that person’s consent ❖ Merchant Protection Statutes Misappropriation of the Misappropriation of the Right to Publicity 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

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Torts and Strict Liability

Intentional Torts Against Persons (4 of 6) 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 Intentional Infliction of Emotional Distress 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 Intentional Misrepresentation (Fraud) 1) false representation of material fact 2) intent to deceive 3) justifiable reliance by innocent party 4) injury

Intentional Torts Against Persons (5 of 6) Defamation of Character ❖ False statement(s) made by one person about another. The plaintiff must prove that: ❖ The defendant made an untrue statement of fact about the plaintiff; and ❖ The statement was intentionally or accidentally published to a third party Slander– oral defamation of character Libel – a false statement that appears in a letter, newspaper, magazine, book, photo, video, etc.

- Truth is an absolute defense - Watch for reckless disregard of the truth

Intentional Torts Against Persons (6 of 6) Malicious Prosecution Malicious Prosecution ❖ A successful defendant in a prior lawsuit can sue the plaintiff if the first lawsuit was frivolous ❖ Certain elements must be proven to win a lawsuit for malicious prosecution ❖ The courts do not look favorably on malicious prosecution lawsuits

Intentional Torts Against Property (1 of 3) There are two general categories of property: ❖ Real Property Real Property – consists of land and anything permanently attached to that land ❖ Personal Property Personal Property – consist of things that are movable ❖ Automobiles ❖ Books ❖ Clothes ❖ Pets

Intentional Torts Against Property (2 of 3) Trespass to Land ❖ A tort that interferes with an owner’s right to exclusive possession of land

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Trespass to Personal Trespass to Personal Property ❖ A tort that occurs whenever one person injures another person’s personal property; or ❖ Interferes with that person’s enjoyment of his or her personal property

Intentional Torts Against Property (3 of 3) Conversion of Personal Property Conversion of Personal Property A tort that deprives a true owner of the use and enjoyment of his or her personal property by: ❖ Taking over such property; and ❖ Exercising ownership rights over it

Unintentional Torts (Negligence) (1 of 7) Unintentional Tort Unintentional Tort ❖ A doctrine that says a person is liable for harm that is the foreseeable consequence of his or her actions ❖ Negligence ❖ The omission to do something which a reasonable person would do; or ❖ Doing something which a prudent and reasonable man would not do

Unintentional Torts (Negligence) (2 of 7) 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 caused the plaintiff’s injury

Unintentional Torts (Negligence) (3 of 7) ❖ Duty of Care Duty of Care – the obligation we all each other not to cause any unreasonable harm or risk of harm ❖ The courts apply a reasonable person reasonable person standard ❖ Defendants with a particular expertise or competence are measured against a reasonable professional standard

Unintentional Torts (Negligence) (4 of 7) ❖ Breach of Duty – a failure to exercise care or to act as a reasonable person would act ❖ 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. ❖ Effect on the plaintiff’s life or profession

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Unintentional Torts (Negligence) (5 of 7) ❖ Causation – a person who commits a negligent act is not liable unless his or her act was the cause of the plaintiff’s injuries ❖ Causation in Fact (actual cause) ❖ Proximate Cause (legal cause) ❖ Causation in Fact Causation in Fact (actual cause) ❖ The actual cause of negligence ❖ A person who commits a negligent act is not liable unless causation in fact can be proven

Unintentional Torts (Negligence) (6 of 7) ❖ Proximate Cause Proximate Cause (legal 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

Unintentional Torts (Negligence) (7 of 7) ❖ The doctrine of proximate cause was established in the Palsgraf v. The Long Island Railroad Company case ❖ Professional Malpractice - The liability of a professional who breaches his or her duty of ordinary care Special Negligence Doctrines ❖ Negligent Infliction of Emotional Distress ❖ Negligence Per Se ❖ Res Ipsa Loquitur ❖ Good Samaritan Laws ❖ Dram Shop Acts ❖ Guest Statutes ❖ Fireman’s Rule ❖ Negligence ❖ “Danger Invites ❖ Rescue” Doctrine ❖ Social Host Liability ❖ Liability of Landowners ❖ Liability of Common Carriers and Innkeepers

Special Notes Per Se → violation of statute Res Ipsa Loquitor → exclusive control Danger Invites…→ can sue the person Landowners → Invitees and licenses → duty of ordinary care Trespassers → duty to not willfully or wantonly injurer

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Defenses Against Negligence ❖ Superseding or intervening event ❖ Assumption of the risk ❖ Contributory negligence ❖ Comparative negligence

Special Business Torts (1 of 3) ❖ Entering certain businesses and professions without a license ❖ Unfair competition ❖ Predatory practices ❖ Palming off ❖ Disparagement ❖ False advertising ❖ Intentional misrepresentation (fraud)

Special Business Torts (2 of 3) The elements required to find fraud are: 1. The wrongdoer made a false representation of material fact 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 4. The innocent party was injured

Special Business Torts (3 of 3) ❖ Intentional interference with contractual relations ❖ Breach of the implied covenant of good faith and fair dealing

Special Business Torts: Tort Damages: Actual Damages ❖ Include compensation for personal injury, pain and suffering, emotional distress, and other injuries caused by the defendant’s tortious conduct

Punitive Damages ❖ Are not recoverable for breach of contract ❖ Recoverable for certain tortious conduct ❖ Fraud ❖ Intentional conduct ❖ Other egregious conduct

Strict Liability (1 of 2) ❖ Strict liability is liability without fault liability without fault ❖ A participant in a covered activity will be held liable for any injuries caused by the activity even if he or she was not negligent

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Strict Liability (2 of 2) This doctrine holds that: 1. There are certain activities that can place the public at risk of injury even if reasonable care is taken; and 2. The public should have some means of compensation if such injury occurs Product Liability Based on Fault: Misrepresentation ❖ A buyer or lessee who is injured because a seller or lessor fraudulently misrepresented the quality of a product can sue the seller under the tort of intentional misrepresentation ❖ Seller or lessor either: ❖ Affirmatively misrepresents the quality of a product; or ❖ Conceals a defect in it ❖ Recovery is limited to persons who were injured because they relied on the misrepresentation Product Liability Based on Fault: Negligence ❖ Negligence – a tort related to defective products where the defendant has breached a duty of care and caused harm to the plaintiff ❖ Failure to exercise due care includes: ❖ Failing to assemble the product carefully ❖ Negligent product design ❖ Negligent inspection or testing of the product ❖ Negligent packaging Failure to warn of the negligent propensities of the product Strict Liability ❖ In Greenmun v. Yuba Power Products, Inc., the California Supreme Court adopted the doctrine of strict liability in tort doctrine of strict liability in tort as a basis for product liability actions ❖ Most states have adopted this doctrine as the basis for product liability actions ❖ Removes many of the difficulties for the plaintiff associated with other theories of product liability The Concept of Defect ❖ To recover for strict liability, the injured party must first show that the product that caused the injury was somehow defective ❖ Plaintiffs can allege multiple product defects in one lawsuit Common Types of Defects 1. Defects in Manufacture 2. Defects in Design 3. Defects in Packaging 4. Failure to Warn

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Crashworthiness Doctrine ❖ The courts have held that automobile manufacturers are under a duty to design automobiles so they take into account the possibility of harm from a person’s body striking something inside the automobile in the case of a car accident.

Other Product Defects ❖ Failure to provide adequate instructions ❖ Inadequate testing of products ❖ Inadequate selection of component parts or materials ❖ Improper certification of the safety of a product

Defenses to Product Liability 1. Supervening Event 2. Generally Known Dangers 3. Assumption of the Risk 4. Government Contractor Defense 5. Misuse of the Product 6. Statute of Limitations 7. Contributory and Comparative Negligence

III. Text Materials *The key objectives of this chapter are to itemize the classifications of tort law as used in our system and to help students become familiar with the building block process used to construct each case.

Case 6.1: Wal-Mart Stores, Inc. v. Cockrell Facts: Cockrell was strip-searched in the manager’s office at Wal-Mart even being required to partially remove a bandage covering a wound from a liver transplant. The search was done by Navarro, a security officer. Nothing was found. Cockrell sued for false imprisonment after being released. Cockrell had been “pretty well shook up” and stayed upset for a “long time” according to the mom. Wal-Mart claimed the shopkeeper’s privilege. From a decision in favor of Cockrell, Wal-Mart appealed.

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

Decision: No. 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 o theft had occurred. Here also the manner of detainment was unreasonable.

Contemporary Environment: Ouch! The Coffee’s Too Hot This box discusses the famous case of a woman who sued McDonald’s when she suffered burns from their hot coffee.

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Case 6.2: James v. Meow Media, Inc. The Facts: After watching various videos dealing with high school students dreaming of shooting teacher and classmates, and after playing regularly, certain violent interactive video and computer games, Carneal, a 14 year-old brought a pistol and five shotguns to school, where he shot and killed three students and wounded many others. The parents sued the producers and distributors of the games and movies for wrongful death. The judgment was for the defendants.

Issue: Did the defendant video and movie producers and distributors owe a duty of care to the plaintiffs by selling and licensing violent video games and movies to Carneal, who killed three children?

Decision/Remedy: No. Reason: Duty of care depends on a “foreseeability” test. Individuals can assume that third parties will not commit intentional criminal acts. Applying a policy analysis, the court said there was no foreseeability even though Carneal was not normal. The reactions here were not predictable.

Movies are basically too far removed from the classroom.

Landmark Law: Palsgrapf v. The Long Island Railroad Company Before negligence can be predicated of a given act, back of the act must be sought and found a duty to the individual complaining, the observance of which would have averted or avoided the injury. If a harm is not willful it must be shown that the act had possibilities of danger so many and apparent to entitle protection against the doing of it though the harm was unintended.”

Case 6.3. Lilya v. The Greater Gulf State Fair, Inc. Facts: Lilya paid fee to ride a mechanical bull after watching a mechanical bull of defendant throw a rider. Her had signed a release assuming all risks and acknowledging their existence.

After boarding the bull for a second time, he was thrown, suffering a fractured neck. He sued.

Court said he had assumed the risk.

Issue: Was riding a mechanical bull an open and obvious danger that Lilya had voluntarily assumed the risk of when he rode the mechanical bull?

Decision/Remedy: Yes. The summary judgment was affirmed.

Reason: The duty of reasonable care to invitee does not include the duty to warn of open and obvious dangers. Lilya had watched and been thrown before he was injured.

Case 6.4. Bunch v. Hoffinger Industries, Inc. Facts: The Franks received a gift of a used swimming pool frame and then purchases a liner from McMasker (a supplier). The manufacturer was Hoffinger. The pool was placed in the Frank’s yard where they also built a decl and a wooden fence. Hoffinger did not put warning labels about diving on the liners but supplied labels and showed how to apply them. The labels were applied. Leesa Bunch (11) dove and became a quadriplegic. Mrs. Frank had told her not to dive. Leesa sues McMasker and Hoffinger for strict liability for inadequate warning. It should be noted that 47 other incidents of the same result had taken place over 17 years with Hoffinger pools. McMasker settled. Hoffinger appealed from a decision against them.

Issue: Did Hoffinger adequately warn Leesa?

Decision: no.

Reason: The danger is not obvious and open to an 11 year-old. The design of the warning was a substantial factor in causing the harm. There was a lack of sufficient warning. It did not command attention, galvanize memory, evoke emotion, contain an explicit instruction and show a consequence. These were necessary according to Dr. Buck, a professor of communication sciences and psychology. The risks were also not readily apparent to an 11 year-old. “The evidence presented at trial revealed that the lack of a persuasive label outlining the consequences of diving into the pool was a substantial factor in causing the injury.”

See Law case with Answer in the text.

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IV. Answers to Legal Environment Intentional Tort 6.1. Yes, Ross Grimsley and the Baltimore Baseball Club, Inc. are liable for the injuries suffered

by David Manning when a ball thrown by Grimsley struck him. The Court held that the defendants were liable for the intentional tort of battery under the transferred intent doctrine.

Under this doctrine, the law transfers the perpetrator’s intent from the target person to the actual victim of the act.

In this case, the Court found that Grimsley was an expert pitcher, that on several occasions immediately following the heckling he looked directly at the hecklers, not just into the stands, and that the ball traveled at a right angle to the direction in which he had been pitching and in the direction of the hecklers. The jury could reasonably have inferred that Grimsley intended to throw the ball in the direction of the hecklers, to cause them imminent apprehension of being hit, to respond to conduct presently affecting his ability to warm up and, if the opportunity came, to play in the game itself. Thus, even though Grimsley aimed the ball at a heckler but hit Manning, the Court held Grimsley liable for an intentional tort to Manning under the transferred intent doctrine. The Baltimore Baseball Club, Inc., is liable because Grimsley was an agent of the Club at the time of the incident. Manning v. Grimsley, 643 F.2d 20, 1981 U.S. App. Lexis 19782 (1st Cir.).

Merchant Protection Statute 6.2.

No, K-Mart Enterprises, Inc. (K-Mart) is not liable to Deborah Johnson for false imprisonment. The Court held that K-Mart was protected from liability because it complied with the Wisconsin merchant protection statute. This statutory “shopkeeper’s privilege” permits 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) the suspect is only detained for a reasonable time, and (3) the investigation is conducted in a reasonable manner. In this case, the Court held that K-Mart had reasonable grounds to suspect Johnson of shoplifting because the price tag remained on the child’s seat and Johnson was hurrying to leave the store. Second, Johnson was detained for a reasonable time, i.e., for not more than 20 minutes. And third, the investigation was conducted in a reasonable manner. The security guard requested Johnson to return to the store, she was questioned in a reasonable manner, and was released as soon as the evidence indicated that she had not shoplifted the child’s seat. The Court held that K-Mart was protected from liability for false imprisonment by the statute. Johnson v. K-Mart Enterprises, Inc., 297 N.W.2d 74, 1980 Wisc. App. Lexis 3197 (WS. App.).

Negligence 6.3. The Automobile Club of Southern California (Auto Club) wins. The Court held that the Auto Club was not negligent to Yanase. The law provides that in order for a defendant to be held liable for negligence, he must owe the plaintiff a duty of care and must breach this duty.

In this case, the complaint failed to state sufficient facts to support an action for negligence against the Auto Club. This was because the Court found that the Auto Club did not owe or breach a duty to Yanase regarding the safety of the Royal Lodge. The Auto Club’s Tourbook never made a claim that the listing and rating service included a finding that the neighborhood surrounding the motel was safe or that its security measures were adequate.

The Tourbook only addressed the motel’s accommodations as to the quality of its lodging, food, and services. The scope of any duty of care owed by Auto Club to its members did not 52 ..

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extend to neighborhood safety and security measures. The Court granted Auto Club’s motion on the pleadings. Yanase v. Automobile Club of Southern California, 212 Cal.App.3d 468, 260 Cal.Rptr. 513, 1989 Cal.App. Lexis 746 (Cal.App.).

Causation 6.4. Yes, there was causation in fact and proximate cause linking the defendants’ negligence to the fatal accident in which Mr. Davis was killed. A person who commits a negligent act is not liable unless this act was the actual cause and proximate cause of the plaintiff’s injuries.

Actual cause is measured by the “but for” test, which may be stated as follows: the defendant’s conduct is not a cause of the event if the event would have occurred without it.

In this case, the Court held that if General Motors had not negligently manufactured the alternator, the truck would not have stalled, and there would not have been a stationary vehicle on the freeway for the decedent to hit. Therefore, causation in fact existed.

The law establishes a point along the damage chain after which a negligent party is no longer responsible for the consequences of his negligent act. This limitation on liability is referred to as proximate cause or cause in foreseeability. The Court in this case held that General Motors’ negligence was the proximate cause of the decedent’s death. A jury could reasonably find that the malfunction of a piece of automotive equipment would place any person using the highway in danger of bodily injury. The Court held that the defendant’s negligence was the actual and proximate cause of Mr. Davis’ death. General Motors Corporation v. Davis, 233 S.E.2d 825, 1977 Ga. App. Lexis, 1961 (Ga.App.).

Negligence Per Se 6.5. Julius Ebanks wins. The Court held that he could recover damages from the New York City Transit Authority for the injuries suffered when his foot became caught in the escalator under the doctrine of negligence per se. In a negligence per se action, the plaintiff must prove (1) that a statute existed, (2) the statute was enacted to prevent the type of injury suffered, and (3) the plaintiff was within the class of persons to be protected by the statute. Under the negligence per se doctrine, the injured party does not have to prove the plaintiff breached his duty because the statute establishes that.

The Court in this case held that the building code established the requirement that a “gap” between an escalator step and escalator wall not exceed 3/8-inch. Evidence showed that the gap in this case in which Ebanks’ foot became caught was 2 inches, therefore violating the building code. The Court held that the building code was adopted by the city to prevent the type of injury suffered by Ebanks and that he was within the class of persons to be protected by the building code. The Court held that the elements for negligence per se had been established. Ebanks v. New York City Transit Authority, 70 N.Y.2d 621, 518 N.Y.S.2d 776, 1987 N.Y. Lexis 17294 (N.Y. App.).

Emotional Distress 6.6. Gregory James wins. The Court held that he may recover for emotional distress he suffered when he saw his sister get killed under the doctrine of negligent infliction of emotional distress. The Nebraska Supreme Court adopted the “foreseeability” test in applying this doctrine. To be successful in a lawsuit for negligent infliction of emotional distress, the plaintiff must prove that (1) a relative was killed or injured by the defendant, (2) the plaintiff suffered severe emotional distress, and (3) the plaintiff’s mental distress resulted from a sensory and contemporaneous observance of the accident. Nebraska does not require that the plaintiff’s mental distress be manifested by some physical injury. In this case, the Court held 53 ..

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that all of these elements applied when John Lieb, a driver for Watts trucking service, backed a truck over Demetria James, killing her as her brother Gregory watched. The Court remanded the case for proceedings consistent with its opinion. James v. Watts Trucking Service, Inc., 375 N.W.2d 109, 1985 Neb. Lexis 1209 (Neb.).

Failure to Warn 6.8. Yes, Emerson Electric Co. is strictly liable to Pearce. Under Oklahoma strict liability law, a plaintiff must prove three elements to recover on a theory of the manufacturer’s product liability: (1) the product was the cause of the injury, (2) a causally related defect existed in the product at the time it left the manufacturer’s possession and control, and (3) the defect made the product unreasonably dangerous to the plaintiff or his property. A product is unreasonably dangerous if it is dangerous to an extent beyond that which would be contemplated by the ordinary consumer who purchases it, with the ordinary knowledge common to the community as to its characteristics. Punitive damages may be assessed against a manufacturer whose conduct reflects reckless disregard for the public safety.

Since there was sufficient evidence to support plaintiff’s version of the accident, the court was easily persuaded that the device itself, at an uncontrolled 180 degrees, poses a danger to bystanders like Pearce that exceeds the expectations of the ordinary consumer. The court held that bystanders like Pearce were protected by the doctrine of strict liability. The court awarded Pearce $1 million in compensatory damages and $1 million in punitive damages against Emerson Electric Co. Karns v. Emerson Electric Co., 817 F.2d 1452, 1987 U.S. App. Lexis 5608 (10th Cir.).

Defense 6.7. The defendants win. The Court held that the City of New York, who owned Shea Stadium, the Metropolitan Baseball Club, Inc., who leased the stadium, and the other defendants were not liable to Elliot Maddox for the injuries suffered when he slipped and fell in the outfield of Shea Stadium when trying to catch a baseball during a professional baseball game. The defendants alleged that Maddox had assumed the risk of playing on the wet field. The Court agreed, finding that the defendants had proved the two key elements of the defense of assumption of risk: (1) that Maddox had knowledge of the dangerous conditions (wet field) as demonstrated by his comments to the club manager and (2) that Maddox had voluntarily continued to play centerfield without being ordered to do so by any superior even after being fully aware of the danger. The Court granted the defendant’s motion for summary judgment.

Maddox v. City of New York, 496 N.Y.S.2d 726, 1985 N.Y. Lexis 17254 (N.Y. App.).

Failure to Warn 6.8. Yes, Emerson Electric Co. is strictly liable to Pearce. Under Oklahoma strict liability law, a plaintiff must prove three elements to recover on a theory of the manufacturer’s product liability: (1) the product was the cause of the injury, (2) a causally related defect existed in the product at the time it left the manufacturer’s possession and control, and (3) the defect made the product unreasonably dangerous to the plaintiff or his property. A product is unreasonably dangerous if it is dangerous to an extent beyond that which would be contemplated by the ordinary consumer who purchases it, with the ordinary knowledge common to the community as to its characteristics. Punitive damages may be assessed against a manufacturer whose conduct reflects reckless disregard for the public safety.

Since there was sufficient evidence to support plaintiff’s version of the accident, the court was easily persuaded that the device itself, at an uncontrolled 180 degrees, poses a danger to 54 ..

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bystanders like Pearce that exceeds the expectations of the ordinary consumer. The court held that bystanders like Pearce were protected by the doctrine of strict liability. The court awarded Pearce $1 million in compensatory damages and $1 million in punitive damages against Emerson Electric Co. Karns v. Emerson Electric Co., 817 F.2d 1452, 1987 U.S. App. Lexis 5608 (10th Cir.).

Design Defect 6.9. Yes, the Chevrolet station wagon was a defective product. A defect in the design of a product will support an action for strict liability. The court held that there was a defect in the design of the Chevrolet station wagon in which Christine was seated. The defect in design consisted of placing the fuel tank in a vulnerable location in the back of the station wagon and outside of the crossbars of the frame of the vehicle. This location left the fuel tank exposed to the dangers of a collision from another vehicle. In evaluating the adequacy of a product’s design, the courts consider the gravity of the danger posed by the design, the likelihood that injury will occur, the availability and cost of producing a safer alternative design, and social utility of the product. In this case, the court held that General Motors could have produced a safer alternative design merely by placing the fuel tank underneath the station wagon between the crossbars of the frame.

General Motors contended that defective design was not properly at issue in the case because a design is defective only if it results in a product that is unsafe for its intended use. Here, General Motors asserts, no evidence was produced to show the station wagon was unsafe for its intended use—operation on the highway. The court rejected this assertion, stating that this theory had been repudiated in Cronin v. J. B. E. Olson Corp., 8 C. 3d 121, 104 Cal. Rptr. 433 (Cal. 1972), where the Court stated: The argument that the van was built only for “normal” driving is unavailing. We agree that strict liability should not be imposed upon a manufacturer when injury results from a use of its product that is not reasonably foreseeable. Although a condition may not be the “normal” or intended use of a motor vehicle, vehicle manufacturers must take accidents into consideration as reasonably foreseeable occurrences involving their products. The design and manufacture of products should not be carried out in an industrial vacuum but with recognition of the realities of their everyday use.

The court held that a motor vehicle manufacturer is required to foresee that, as an incident of normal operation in the environment in which his product will be used, accidents will occur, including high-speed collisions between vehicles. Because of this possibility, the manufacturer is required to design its vehicle to minimize unreasonable risks of injury and death. From this duty it follows that a motor vehicle manufacturer must take into account the possibility of a high-speed collision when it selects a location for the fuel tank in the vehicle.

The manufacturer must evaluate the crashworthiness of its product and take such steps as may be reasonable and practicable to forestall particular crash injuries and mitigate the seriousness of other problems. The court ordered a new trial in this case. Smith v. General Motors Corporation, 42 C.A.3d 1, 116 Cal.Rptr. 575, 1974 Cal. App. Lexis 1199 (Cal. App.)

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V. Answers to Business Ethics Cases 6.10. RKO is liable. The determination of what duty of care is owed is governed by the principle that all persons are to use ordinary care to prevent others from being harmed by their conduct.

Foreseeability is of primary importance in determining one’s duty. Given the nature of the contest and the use of a car that would be moving from one location to another, it was foreseeable that the station’s listeners would attempt to follow the car without regard for highway safety in order to claim prizes. Even though third parties inflicted the harm, the negligent act of RKO instigated the actions of the third parties. Thus, RKO acts were a factor in the incident that resulted in the death of Weirum. Weirum v. RKO General, Inc. 15 Cal. 3d 40, 123 Cal. Rptr. 468, 175 Cal. Lexis 220 (Cal.).

6.11. Portee has a right to sue for negligent infliction of mental distress. This tort requires death or serious physical injury of a person because of the negligence of another, observation by a closely related third party of the deadly or injurious event, and mental distress suffered by the third party. If Portee can prove negligence on the part of the Jaffees, she can recover damages because the other elements are present. Portee v. Jaffee, 417 A.2d 521, 1980 N.J. Lexis 1387 (N.J. 1980).

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Chapter 7 Criminal Law and Cyber Crimes

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 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 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, albeit 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. Topic Outline Crime ❖ Any act done by an individual in violation of those duties that he or she owes to society and for the breach of which the law provides that the wrongdoer shall make amends to the public. ❖ Accused must be found guilty beyond a reasonable doubt.

Penal Codes and Regulatory Statutes ❖ Statutes are the source of criminal law ❖ Federal and state statutes define activities that are considered to be crimes within their jurisdictions ❖ Many regulatory statutes provide for criminal violations and penalties

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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 ❖ Violations - usually a fine

Essential Elements of a Crime – same act may be basis for criminal and civil lawsuits 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 Strict or absolute liability Strict or absolute liability – standard for imposing criminal liability without a finding of intent Pretrial Criminal Procedure Pretrial criminal procedure consists of several distinct stages including: ❖ Arrest ❖ Indictment or Information ❖ Arraignment ❖ Plea Bargaining -→ a) Arrests usually need warrants based on probably cause b) Felony → grand jury → indictment c) Misdemeanor → magistrate → information d) Pleas: guilty, not guilty, nolo contendere

The Criminal Trial ❖ All jurors must unanimously agree before the accused is found guilty of the crime charged ❖ If one juror has reasonable doubt reasonable doubt about the guilt of the accused, the accused is 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 -→ a) Defendant may appeal b) Government cannot appeal c) Government may retry after hung jury

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Crimes Affecting Business ❖ Robbery – taking of personal property from another ❖ Burglary – taking of personal property from a home, etc. ❖ Larceny – other taking of personal property ❖ Theft ❖ Receiving stolen property ❖ Arson – burning ❖ Murder – unlawful killing ❖ Extortion White-Collar Crimes – corporations may be criminally liable for actions of officers, employees or agents. ❖ Crimes that are prone to be committed by businesspersons that usually involve cunning and deceit rather than physical force ❖ Forgery – fraudulent document alteration or creation ❖ Embezzlement – conversion of property ❖ Bribery – payoff or kickback ❖ Extortion - blackmail ❖ Criminal Fraud - deceit ❖ Mail Fraud ❖ Wire Fraud ❖ Internet Fraud ❖ Money Laundering – “washing” the money ❖ Identity Fraud The Foreign Corrupt Practices Act ❖ Makes it illegal for American companies, or their officers, directors, agents, or employees, to bribe a foreign official, a foreign political party official, or a candidate for foreign political office ❖ Requires firms to keep accurate books and records of all foreign transactions

Racketeer Influenced and Corrupt Organizations Act (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”

The Information Infrastructure Protection (IIP) Act (1996) ❖ Federal law that addresses computer related crimes as distinct offenses ❖ The Act provides protection for any computer attached to the Internet ❖ The Act makes it a federal crime for anyone to intentionally access and obtain information from a protected computer without authorization

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Identity Theft and Assumption Deterrence Act (1998) ❖ Federal law that criminalizes identity fraud ❖ The Act makes it a federal felony punishable with prison sentences ranging from 3 to 25 years ❖ The Act appoints the Federal Trade Commission (FTC) to help victims restore their credit and erase the impact of the imposter

Constitutional Safeguards ❖ Fourth Amendment Protection Against Unreasonable Searches and Seizures ❖ Fifth Amendment Privilege Against Self-Incrimination ❖ Fifth Amendment Protection Against Double Jeopardy ❖ Sixth Amendment Right to a Public Jury Trial ❖ Eighth Amendment Protection Against Cruel and Unusual Punishment Special Questions for Constitutional Safeguards: 1. Warrantless searches are permitted incident to arrest, evidence in “plain view” or possibility of evidence destruction.

2. Evidence form unreasonable search is usually prohibited under the “exclusionary rule”. Rule usually applies to businesses.

3. Right against self-incrimination applies only to natural persons accused of a crime. Thus, business records of corporations and partnerships are generally not protected.

4. Double jeopardy does not usually apply across jurisdictions.

5. Capital punishment is not usually considered “cruel and unusual”.

6. The attorney-client, psychiatrist-patient, priest-penitent, spouse-spouse and parent child privileges are usually recognized under the Fifth Amendment.

III. Text Materials The chapter moves from criminal procedure and general classification of crimes to the impact of criminal law on corporate behavior. The chapter then wraps up with an overview of how both individuals and business entities are protected from overzealous governmental intrusions into our lives by way of key safeguards detailed in the U.S. Constitution. It is important to note to students that these protections do not always necessarily apply equally to people vis-à-vis business entities.

Case 7.1: State of Ohio v. Wilson Facts: Wilson poured beer on Spear and ignited it. Spear died after at least nine months of treatment. Wilson was convicted and appealed.

Issue: Is there sufficient causation to warrant a conviction for murder.

Decision: Yes. Conviction was affirmed.

Reason: A causal connection between the criminal action and the cause of death must be proven.

Time doesn’t necessarily change this. Here evidence exists of direct and probable causation.

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Case 7.7: U.S.A. v. Deppe Facts: Deppe sold watches over the Internet for wired funds (27 transactions for $115,000).

Deppe did not, however, send a single watch but sent crumpled newspaper. He also (with another) sold nonexistent Super Bowl tickets over the Internet. Deppe pled guilty to wire fraud and mail fraud regarding the watches but went to trial as to the tickets. He was convicted and sentenced to 78 months in jail and fine $520,375. He appealed his sentence expecting a reduced sentence because he accepted responsibility for his crimes.

Issue: Did the District Court err in not reducing Deppe’s jail sentence?

Decision: No. Reason: “..The sentencing court provided logical explanation…- given the … crimes committed and the characteristics of the criminal.” The sentence was sensible.

Internet Law & Online Commerce: IIP Act The Information Infrastructure Protection Act provides protection for any computer attached to the Internet. It is a federal crime for anyone to intentionally access and obtain information from a protected computer without authorization.

International Law: The Foreign Corrupt Practices Act This statute attempts to balance two legitimate concerns. One is to avoid the scandals mentioned in the text where American companies engaged in business practices overseas that were clearly in violation of U.S. law. To recognize these payments as legitimate would, in turn, allow them to be expense deductions and the like. On the other side of the coin, the act is designed to allow U.S. based companies to remain competitive in foreign markets where such payments are legal. More and more countries are adopting the U.S. position in holding such payments illegal within their own jurisdictions.

Landmark Law: RICO This act was intended to apply only to organized crime but is now used in many other situations.

Internet Law & Online Commerce: Identity Theft and Cyber Fraud The Identity Theft and Assumption Deterrence Act of 1998 criminalizes identity fraud.

Internet Law & Online Commerce: CFAA Establishes crimes for knowingly obtaining government reports, records of financial institutions, and consumer reports.

Case 7.3: Kyllo v. United States Facts: In 1992, government agents suspected that marijuana was being grown in the home of Danny Kyllo. Usually, growing marijuana requires high-intensity lamps. To determine whether an amount of heat emanating from Kyllo’s home was consistent with the use of such lamps, federal agents used a thermal imager used in the street in front of his house. The agents concluded that Kyllo was growing marijuana and found over 100 such plants. Kyllo was indicted for manufacturing marijuana, a violation of federal criminal law. Kyllo argued that this was an unreasonable search in violation of the Fourth Amendment. Kyllo lost at the trial and appeals court levels.

Issue: Is the use of a thermal-imaging device aimed at a private home from a public street to deter relative amounts of heat within the home a “search” within the meaning of the Fourth Amendment?

Decision: Yes. Reason: The Supreme Court reversed and remanded the case for further proceedings.

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Law Case with Answer: City of Indianapolis v. Edmond Facts: In August 1998, police of the city of Indianapolis, Indiana began to operate vehicle roadblock checkpoints on Indianapolis roads in an effort to interdict unlawful drugs. James Edmond and Joes Palmer, attorneys who had been stopped at one of the checkpoints, filed a lawsuit on behalf of themselves and the class of all motorists who had been stopped or were subject to being stopped claiming that the roadblocks violated the Fourth Amendment. The district court found for Indianapolis; the court of appeals reversed.

Issue: Does the Indianapolis highway checkpoint programs whereby police, without individualized suspicion, stop vehicles for the primary purpose of discovering and interdicting illegal narcotics, violate the Fourth Amendment?

Decision: Yes. Reason: 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.

IV. Answers to Legal Environment Criminal Liability of Corporations 7.1. Yes, a corporation can be held criminally liable for the acts of its representatives. Moreover, because they cannot be put in prison, they are usually sanctioned with fines and/or loss of a license or franchise. Traditionally, under the common law, it was held that corporations lacked the criminal mind to be held criminally liable. However, modern courts have held that a corporation can be criminally liable for the acts of its managers, agents, and employees. In this case, the court held that the identification of the particular agents responsible for the antitrust law violations is especially difficult, and their conviction and punishment would be particularly ineffective as a deterrent. On the other hand, the court held that the conviction and punishment of the business entity or corporation is likely to be both appropriate and effective. Accordingly, Hilton Hotels was held criminally liable for its antitrust violations.

United States v. Hilton Hotels Corp., 467 F.2d 1000, 1972 U.S.App. Lexis 7414 (9th Cir.).

Forgery 7.2. The crime of forgery has been committed. A person is guilty of forgery when, with intent to defraud, he knowingly makes, alters, or possesses any writing in a fictitious name or in such manner that the writing as made or altered purports to have been made by another person, at another time, with different provisions, or by authority of one who did not give such authority. Knowledge and intent can be inferred from the circumstances of the case, and one can be guilty as one who aided and abetted another, or as one who advised, encouraged, hired, counseled, or procured another to commit the crime. In this case the court held that the circumstances were such that a rational trier of fact could have determined beyond a reasonable doubt that Foster had committed forgery with the necessary elements of intent to defraud and knowledge. Accordingly, his conviction was affirmed. Foster v. State of Georgia, 387 S.E.2d 637, 1989 Ga.App. Lexis 1456 (Ga.App.).

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Extortion 7.3. The crime of extortion would have been committed. Extortion occurs when a person threatens to expose something about another person unless that other person gives money or property. The truth or falsity of the information is immaterial. In this case, the lower court convicted the defendant of extortion and the appellate court affirmed the conviction based on the facts presented. State of Connecticut v. Erhardt, 553 A.2d 188, 1989 Conn.App. Lexis 21 (Conn.App.).

Criminal Fraud 7.4. Walton is guilty of criminal fraud, otherwise known as theft by deception. In order to prove that a defendant committed theft by deception, the state must prove beyond a reasonable doubt that the defendant obtained or exercised control over property of another by deception and with the purpose of depriving that person of the property. Deception occurs when a person intentionally promises performance that is likely to affect the judgment of another in the transaction, which performance the actor does not intend to perform or knows will not be performed. On the other hand, theft by deception does not occur when there is only falsity as to matters having no pecuniary significance, or “puffing” by statements unlikely to deceive ordinary persons. In this case, the court held that Walton’s representations that he would invest Marlowe’s money in gold affected her judgment concerning her investment, and that such evidence was sufficient to convict the defendant of theft by deception. State of Utah v.

Roberts, 711 P.2d 235, 1985 Utah Lexis 872 (Utah).

Bribery 7.5. They have committed the crime of bribery by a public official. The crime of bribery is defined as the giving or receiving of anything of value in corrupt payment for an “official act” by a public official. In this case, the defendants argued that they were executives of a private nonprofit corporation unaffiliated with the federal government, and as such that they were not “public officials.” The court held, however, that the defendants were acting “for or on behalf of the United States in an official function” under the authority of HUD. Accordingly, the defendant’s lower court convictions for bribery were affirmed. Dixon and Hinton v. United States, 465 U.S. 482, 104 S.Ct. 1172, 1984 U.S. Lexis 35 (U.S.Sup.Ct.).

Administrative Search Search Warrant 7.6. No, the search warrant is not valid. Generally, only a warrant particularly describing the place to be searched, and the persons or things to be seized, is valid. The specificity requirement varies depending on the circumstances of the case and the type of items involved. A court will consider such factors as (1) whether probable cause exists to seize all items of a particular type, (2) whether the warrant sets out objective standards by which executing officers can differentiate items subject to seizure from those which are not, and (3) whether the government was able to describe the items more particularly in light of the information available at the time the warrant was issued. In this case, the court concluded that the warrants were overbroad and constitutionally inadequate in that they provided for the almost unrestricted seizure of items that are “evidence of violations of federal criminal law” without describing the specific crimes suspected.

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Moreover, to invoke the good faith exception to the exclusionary rule, the government must prove that its agent’s reliance upon the warrant was objectively reasonable. However, the good faith exception is inapplicable when the warrant is so facially overbroad as to preclude reasonable reliance by executing officers. In this case, the court held that the warrants were so overbroad as to be facially invalid. Center Art Galleries-Hawaii, Inc. v. United States, 875 F.2d 747, 1989 U.S. App.Lexis 6983 (9th Cir.).

Privilege Against Self-Incrimination 7.7. No, the records do not have to be disclosed. The Fifth Amendment provides that no person shall be compelled in any criminal case to be a witness against himself. This applies to compelled oral testimony. In this case, the court held that the subpoena does not force John Doe to restate, repeat, or affirm the truth of the contents of the records. Thus, the court held that the records are not privileged under the Fifth Amendment. The court went on to hold, however, that the act of requiring production of the documents might not be privileged. A subpoena compels the holder of the documents to perform an act that may have testimonial aspects and an incriminating effect. Moreover, the court found that in this case the act of producing the documents would involve testimonial self-incrimination. Accordingly, the court held that the act of producing the records is protected by the Fifth Amendment’s privilege against self-incrimination. United States v. John Doe, 465 U.S. 605, 104 S.Ct. 1237, 1984 Lexis 169 (U.S. Sup.Ct.).

V. Answers to Business Ethics Cases 7.8. A key element of embezzlement is the exempting of property to an embezzler who fraudulently converts it. Shaw did not act ethically in that he abused his power and engaged in a clear conflict of interests. Shaw should be guilty of embezzlement. Intent to repay is generally no defense if not done before defendant is charged.

7.9. Cloud realized that the sale would not go through without lying so he lied. By doing so he hurt the insurance company and its policyholders. He did not consider the effects of his actions on these stakeholders and thus acted unethically. Aiding and abetting involves helping to bring the crime about. Cloud was found guilty of aiding and abetting a bank fraud.

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Chapter 8 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 all of us as teachers identify the basic infrastructure of international law for further elaboration in later chapters.

You can start off this chapter with an opening discussion of 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. Topic Outline International Law (1 of 2) ❖ Law that governs affairs between nations ❖ Law that regulates transactions between individuals and businesses of different countries ❖ No single legislative source of international law ❖ All countries of the world (and numerous international organizations) are responsible or enacting international laws

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International Law (2 of 2) ❖ No single world court responsible for interpreting international law ❖ Several courts or tribunals hear and decide international legal disputes of parties that agree to appear before them ❖ No world executive branch that can enforce international laws ❖ Nations do not have to obey international law enacted by other countries or international organizations

The United States and Foreign Affairs (2 of 3) ❖ Any state or local law that unduly burdens foreign commerce is unconstitutional under the Foreign Commerce Clause Foreign Commerce Clause ❖ The president is the agent of the United States in dealing with foreign countries

The United States and Foreign Affairs (3 of 3) ❖ Under the Treaty Clause Treaty Clause, only the federal government may enter into treaties with foreign nations ❖ Under the Supremacy Clause Supremacy Clause of the Constitution: ❖ Treaties become part of the “law of the land” ❖ Conflicting state or local law is void

Sources of International Law ❖ Sources of international law – those things that international tribunals rely on in deciding international disputes ❖ Article 38(1) of the Statute of the International Court of Justice lists four sources of international law: ❖ Treaties and conventions ❖ Custom ❖ General principles of law ❖ Judicial decisions and teachings

The United Nations (UN) ❖ International organization created by multinational treaty in 1945 ❖ Goals of the United Nations (U.N.): ❖ Maintain peace and security in the world ❖ Promote economic and social cooperation ❖ Protect human rights (UNESCO, UNICEF, IMF, IFAD, World Bank) ❖ Governance of the U.N.: General Assembly, Security Council, Secretariat

Regional International Organizations (1 of 6) The European Union (EU) The European Union (EU) ❖ Comprises many countries of Western and Eastern Europe ❖ Created to promote ❖ Peace and security ❖ Economic, social and cultural development

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Regional International Organizations (2 of 6) The European Union (EU) The European Union (EU) (continued) ❖ The EU treaty creates open borders for trade between members ❖ The EURO is the single monetary unit ❖ European Court of Justice – the judicial branch of the EU ❖ European Court of First Instance (CFI) Regional International Organizations (3 of 6) The North American Free Trade The North American Free Trade Agreement (NAFTA) Agreement (NAFTA) ❖ An international treaty that creates a regional free-trade zone consisting of the United States, Canada, and Mexico ❖ Eliminates or reduces most of the duties, tariffs, quotas, and other trade barriers between the members Regional International Organizations (4 of 6) ❖ Countries of Latin America and the Caribbean Regional International Organizations (5 of 6) ❖ African Economic Communities African Economic Communities ❖ Asian Economic Communities ❖ Middle Eastern Economic Communities World Trade Organization (WTO) ❖ International organization of more than 130 member nations ❖ Created to promote and enforce trade agreements among member nations ❖ WTO members have entered into many trade agreements among themselves ❖ By enforcing trade agreements among its members, the WTO has become the world’s most important trade organization A primary function of the WTO is dispute resolution with its judicial model ❖ WTO Panel ❖ WTO dispute settlement body ❖ WTO appellate body The International Criminal Court (ICC) ❖ Created by the Rome Treaty Rome Treaty of 1998 ❖ The ICC has the authority to prosecute individuals accused of genocide, war crimes, and crimes against humanity ❖ The ICC may prosecute nationals located in the over 100 countries that have ratified the treaty ❖ The ICC has complementary jurisdiction with the national courts of a country - ICJ is the judicial branch of the UN (World Court)

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National Courts Decide International Disputes (1 of 3) ❖ The majority of cases involving international law are heard by national courts national courts of individual nations Judicial Procedure Judicial Procedure ❖ Choice of forum clause Choice of forum clause – designates the judicial or arbitral forum that hear and decide the case ❖ Choice of law clause Choice of law clause – designates the law to be applied by the court or arbitrator in deciding the case National Courts Decide International Disputes (2 of 3) Act of State Doctrine Act of State Doctrine ❖ Judges of 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 territory National Courts Decide International Disputes (3 of 3) The Doctrine of Sovereign Immunity ❖ A doctrine that states that countries are granted immunity from suits in courts of other countries ❖ Foreign Sovereign Immunities Act Foreign Sovereign Immunities Act – exclusively governs suits against foreign nations that are brought in federal or state courts in the United States ❖ There is a commercial activity exception International Arbitration (1 of 2) Arbitration (UN convention on recognition and enforcement of Foreign Arbitral Awards) ❖ A non-judicial method of dispute resolution ❖ A neutral third party decides the case ❖ The parties agree to be bound by the arbitrator’s decision ❖ Faster, less expensive, less formal, and more private than litigation International Arbitration (2 of 2) Arbitration Clause Arbitration Clause ❖ A clause contained in many international contracts ❖ Stipulates that any dispute between the parties concerning the performance of the contract will be submitted to an arbitrator or arbitration panel for resolution

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III. Text Materials Case 8.1: Crosby v. National Foreign Trade Council Facts: The country of Burma (renamed Myanmar in 1989) has been accused of major civil rights violations. Massachusetts enacted a statute banning that state’s government from purchasing goods and services from any company that did business with Burma. In the meantime, Congress enacted its own federal statute that delegated power to the President to regulate the United State’s dealings with Burma. The National Foreign Trade Council filed a lawsuit against Massachusetts to have the state law declared unconstitutional.

Issue: Does the Massachusetts’ “anti-Burma” state statute violate the Supremacy Clause of the U.S. Constitution?

Decision: Yes. Reason: Massachusetts’ anti-Burma law conflicted with and was therefore preempted by the Supremacy Clause of the Constitution.

Case 8.2: Glen v. Club Mediterranee, S.A. Facts: Sisters, Cuban residents, owned property in Cuba which was expropriated by the Cuban government around 1/1/1959. The sisters fled Cuba in 1959. One died and left her interest to her nephew. They sued Club Med who entered a joint venture with the Cuban government in 1997 to develop the property. They wanted profit from alleged wrongful occupation and use of the property.

Issue: Does the act of state doctrine bar recovery?

Decision: Yes. The District Court’s decision against the plaintiffs was affirmed.

Reason: Since the act of state doctrine requires the courts to uphold the Cuban government’s expropriation, the plaintiffs cannot maintain a claim against Club Med. International Law: International Monetary Fund (IMF) The primary function of the IMF is to promote sound monetary, fiscal, and macroeconomic policies worldwide by providing assistance to needy countries.

International Law: World Bank The World Bank provides money to developing countries to fund projects for humanitarian purposes and to relieve poverty.

International Law: Dominican Republic-Central America Free Trade Agreement (DR-CAFTA) Lowers tariffs and reduces trade restrictions with members (U.S. and several Central American countries).

International Law: Jewish Law and the Torah Jews, no matter where they live, abide by the principles of the Torah in many legal matters such as marriage, divorce, inheritance, and other family matters.

International Law: Islamic Law and the Koran Today, Islamic law is primarily used in the areas of marriage, divorce, and inheritance and used to a limited degree criminal law.

International Law: Hindu Law--Dharmasastra Over 20 percent of the world’s population is Hindu. Most live in India, where they make up 80 percent of the population.

See Legal Case with answer in the text.

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IV. Answers to Legal Environment Cases Act of State Doctrine 8.1. 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, 54 S.Ct. 758, 1937 U.S. Lexis 293 (U.S. Sup. Ct.).

Act of State Doctrine 8.2. 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 (S.D.N.Y.).

Forum-Selection Clause 8.3. 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 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.

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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 (U.S. Sup. Ct.).

V. Answers to Business Ethics Cases 8.4. The doctrine of sovereign immunity grants countries immunity from suits in courts of other countries. Plaintiffs win under the commercial activity exception. Bank of Jamaica did not act ethically since they were deceiving Chisholm and probably were never going to uphold the contracts.

8.5. 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 Untied 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 (2nd Cir.).

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Chapter 9 Formation of Traditional and E- Contracts

When do we have a contract?

I. Teacher to Teacher Dialogue A good way to open the overview of contracts 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 end, 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 endeavor, a contract 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, 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 contract are met?

Once the parties have formed an agreement, are the performance obligations already fully met (executed), or are there still remaining performance obligations on the part of one or more of the parties (executory)? In addition, you may have to examine issues of enforceability. If all the elements are in place, the agreement is now considered a valid contract. If one or more of the essential elements is missing, the agreement is not raised to the status of contract and may be legally void. There are also certain situations where a contract is created, but it will not be enforced. If a legal defense is found to be in place, such as a writing requirement, the contract may be an unenforceable contract. Sometimes, certain persons are given a legally recognized power to avoid a contract after it has been entered into. These contracts are voidable, and examples of this sort of situation can be found in cases involving young people with limited mental capacity.

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II. Topic Outline A contract is an agreement that is enforceable by a court of law or equity.

Introduction (1 of 2) ❖ 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 ❖ Without enforceable contracts, commerce would collapse

Introduction (2 of 2) ❖ Contracts are voluntarily entered into by parties ❖ The terms of the contract become private law between the parties

Legally Enforceable Contract ❖ If one party fails to perform as promised, the other party can use the court system to enforce the contract and recover damages or other property. ❖ If done over the Internet, we refer to this as E-Commerce.

Parties to a Contract (1 of 2) 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

Parties to a Contract (2 of 2)

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Elements of a Contract (1 of 2) ❖ Agreement There must be 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 There must ❖ 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

Elements of a Contract (2 of 2) 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 Lawful Object ❖ The object of the contract must be lawful ❖ Contracts to accomplish illegal objects or contracts that are against public policy are void

Defenses to the Enforcement of a Contract (1 of 2) Genuineness of Assent Genuineness of Assent The consent of the parties to create a contract must be genuine There is no real consent if the consent is obtained by: ❖ Duress ❖ Undue influence ❖ Fraud

Defenses to the Enforcement of a Contract (2 of 2) Writing and Form Writing and Form ❖ The law requires that certain contracts be in writing or in a certain form ❖ Failure of these contracts to be in writing or be in proper form may be raised against the enforcement of the contract

Classifications of Contracts: Formation(1 of 4) Bilateral Contract ❖ A contract entered into by way of exchange of promises of the parties “A promise for a promise

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”

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Classifications of Contracts: Formation(2 of 4) Express Contract ❖ An agreement that is expressed in written or oral words Implied-in-fact Contract ❖ A contract where agreement between parties has been inferred from their conduct

Classifications of Contracts: Formation(3 of 4) Quasi-Contracts (Implied-in-Law Contracts) ❖ 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

Classifications of Contracts: Formation(4 of 4) Formal Contracts ❖ Contracts that require a special form or method of creation ❖ Contracts Under Seal ❖ Recognizances ❖ Negotiable Instruments ❖ Letters of Credit Informal Contracts ❖ No special form or method is required for their creation ❖ Fully enforceable and may be sued upon if breached, e.g.: ❖ Leases ❖ Sales Contracts ❖ Service Contracts

Classifications of Contracts: Enforceability(1 of 2) 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 ❖ Neither party can enforce the contract

Classifications of Contracts: Enforceability(2 of 2) Voidable Contract ❖ Contract where one or both parties have the option to avoid their contractual obligations ❖ If a contract is avoided, 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

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Classifications of Contracts: Performance Executed Contract ❖ A contract that has been fully performed on both sides ❖ A completed contract Executory Contract ❖ A contract that has not been fully performed by one or both parties

Equity ❖ A doctrine that permits judges to make decisions based on fairness, equality, moral rights, and natural law Agreement – Offer and Acceptance The manifestation by two or more persons of the substance of a contract Parties Involved Offeror ❖ Person who makes an offer Offeree ❖ Person to whom an offer has been made

Offer ❖ “The 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.” ❖ [Section 24 of the Restatement (Second) of Contracts]

Requirements of an Offer For an offer to be effective: 1. The offeror must objectively intend objectively intend to be bound by the offer 2. The terms of the offer must be definite or reasonably certain 3. The offer must be communicated to the offeree - Effective when received

Objective Intent The intent to enter into a contract is determined using the objective theory of objective theory of contracts ❖ i.e., 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

Definiteness of Terms (1 of 3) ❖ The terms of an offer must be clear enough to the offeree to be able to decide whether to accept or reject the terms of the offer ❖ If the terms are indefinite, the courts cannot enforce the contract or determine an appropriate remedy for its breach

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Definiteness of Terms (2 of 3) An offer (and contract) must contain the following terms: ❖ Identification of the parties ❖ Identification of the subject matter and quantity ❖ Consideration to be paid ❖ Time of performance

Definiteness of Terms(3 of 3) Implied Terms Implied Terms ❖ The court can supply a missing term if a reasonable term can be implied ❖ Terms that are supplied in this way are called implied terms

Communication ❖ An offer cannot be accepted if it is not communicated to the offeree by the offeror or a representative or agent of the offeror.

Special Offer Situations: Advertisements ❖ A general advertisement is an invitation to make an offer ❖ A specific advertisement is an offer

Special Offer Situations: Rewards An offer to pay a reward is an offer to form a unilateral contract To collect a reward, the offeree must: 1. Have knowledge of the reward offer prior to completing the requested act 2. Perform the requested act

Special Offer Situations: Auctions 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 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

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Termination of an Offer (1 of 3) 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 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

Termination of an Offer (2 of 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 Destruction of the Subject Matter ❖ The offer terminates if the subject matter of the offer is destroyed through no fault of either party prior to its acceptance

Termination of an Offer (3 of 3) Death or Incompetency of the Offeror or Offeree ❖ The death or incompetency of either party terminates the offer Supervening Illegality ❖ The enactment of a statute, regulation, or court decision that makes the object of an offer illegal ❖ This action terminates the offer Lapse of Time ❖ An offer terminates when a stated time period expires

Option Contracts ❖ An option contract option contract is created if an offeree pays the offeror compensation to keep an offer open for an agreed upon period of time ❖ The offeror cannot sell the property to anyone else during the option period

Acceptance (1 of 2) Acceptance ❖ A 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.

Acceptance (2 of 2) ❖ Only the offeree can legally accept an offer and create a contract ❖ The offeree’s acceptance must be unequivocal ❖ Mirror image rule Mirror image rule requires the offeree to accept the offeror’s terms ❖ Silence is not considered acceptance even if the offeror states that it is (exception for agreement or prior dealings)

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Time of Acceptance (1 of 2) Mailbox Rule ❖ A rule that states that an acceptance is effective when it is dispatched, even if it is lost in transmission ❖ Also called the acceptance-upon dispatch rule ❖ If an offeree first dispatches a rejection and then sends an acceptance, the mailbox rule does not apply to the acceptance

Time of Acceptance (2 of 2) Proper Dispatch Rule ❖ The acceptance must be properly dispatched ❖ The acceptance must be properly addressed, packaged, and posted to fall within the mailbox rule ❖ Under common law, if an acceptance is not properly dispatched, it is not effective until it is actually received by the offeror

TIME LINE Offer

Effective upon receipt

Acceptance

Effective upon receipt except when mailbox rule is appropriate

Revocation

Effective upon receipt if before acceptance unless option says no revocation

Rejection

Effective upon receipt

Example

(Mailbox rule in effect)

Offer sent on 1/1:

Received on 1/5

Acceptance sent on 1/8

Received on 1/12

Revocation sent on 1/6

Received on 1/10

Contract is valid on 1/8

Consideration Consideration– something of legal value given in exchange for a promise (bargained-for) Consideration is a necessary element for the existence of a contract Common types of consideration are: ❖ A tangible payment (money or property); or ❖ Performance of an act (e.g., providing legal services)

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Requirements of Consideration Legal Value 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 Bargained-For Exchange ❖ Exchange that parties engage in that leads to an enforceable contract ❖ Gift or gratuitous promise is an unenforceable promise because it lacks consideration

Types of Equitable Remedies Types of Consideration Illegal consideration Illusory promise

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 made out of sense of moral obligation or honor or love or affection. Some states enforce these types of contracts.

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.

Moral obligation

Preexisting duty

Past consideration

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Promissory Estoppel (1 of 3) ❖ A doctrine that prevents the withdrawal of a promise by a promisor if it will adversely affect a promise who has adjusted his or her position in justifiable reliance on the promise

Promissory Estoppel (2 of 3) For the doctrine of promissory estoppel to be applied, the following elements must be shown: 1. The promisor made a promise 2. The promisor should have reasonably expected to induce the promisee to rely on the promise

Promissory Estoppel (3 of 3) 3. The promisee actually relied on the promise and engaged in an action or forbearance of a right of a definite and substantial nature 4. Injustice would be caused if the promise were not enforced

Capacity (1 of 2) The law presumes that the parties to a contract have the requisite contractual capacity to enter into the contract Certain persons do not have this capacity: ❖ Minors ❖ Insane persons ❖ Intoxicated persons

Capacity (2 of 2) ❖ 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 ❖ An essential element for the formation of a contract is the object of the contract be lawful

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Minors (1 of 2) ❖ Minors do not always have the maturity, experience, or sophistication needed to enter into contracts with adults ❖ Common law defines minors as: ❖ Females under the age of 18; and ❖ Males under the age of 21 ❖ Many states have enacted statutes that specify the age of majority age of majority ❖ The most prevalent age of majority is 18 years of age for both males and females

Minors (2 of 2) ❖ Any age below the statutory age of majority is called the period of minority period of minority Thus, a minor is: ❖ A person who has not reached the age of majority

The Infancy Doctrine (1 of 4) ❖ A doctrine that allows minors to disaffirm (or cancel) most contracts they have entered into with adults ❖ Doctrine based on public policy that reasons that minors should be protected from unscrupulous behavior of adults

The Infancy Doctrine (2 of 4) ❖ Disaffirmance– 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 ❖ Competent Party’s Duty of Restitution – if the minor has transferred consideration to the competent party before disaffirming the contract, that party must place the minor in status quo

The Infancy Doctrine (3 of 4) ❖ Minor’s Duty of Restoration – 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 ❖ Minor’s Duty of Restitution – 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

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The Infancy Doctrine (4 of 4) Misrepresentation of Age ❖ 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 Ratification ❖ If a minor does not disaffirm a contract either during the period of minority or within a reasonable time after reaching the age of majority: ❖ The contract is considered ratified (accepted) ❖ The minor (now an adult) is bound by the contract ❖ The right to disaffirm the contract has been lost

Necessaries of Life Minors are obligated to pay for the necessaries of life necessaries of life that they contract for: ❖ Food, Shelter, Clothing, Medical Services ❖ The seller’s recovery is based on the equitable doctrine of quasi quasi-contract contract rather than on the contract itself ❖ The minor is obligated only to pay the reasonable value of the goods or services

Mentally Incompetent Persons (1 of 4) ❖ 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 legally insane at the time of entering into the contract

Mentally Incompetent Persons (2 of 4) Legal Insanity – a state of contractual incapacity as determined by law The law has developed two standards concerning contracts of mentally incompetent persons: 1. Adjudged Insane 2. Insane, But Not Adjudged Insane

Mentally Incompetent Persons (3 of 4) 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

Mentally Incompetent Persons (4 of 4) 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

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Intoxicated Person ❖ A person who is under contractual incapacity because of 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

Illegality One requirement to have an enforceable contract is that the object of the contract must be lawful Contracts with an illegal object are void and therefore unenforceable There are two key categories of illegality: ❖ Contracts contrary to statutes Contracts contrary to statutes ❖ Contracts contrary to public policy

Contracts Contrary to Statutes 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 ❖ Usury Laws ❖ Gambling Statutes ❖ Sabbath Laws ❖ Contracts to Commit a Crime ❖ Licensing Statutes ❖ Regulatory Statute ❖ Revenue-Raising Statute

Contracts Contrary to Public Policy ❖ Contracts that have a negative impact on society or that interfere with the public’s safety and welfare ❖ Such contracts are void ❖ Immoral Contracts ❖ Contracts in Restraint of Trade ❖ Exculpatory Clauses Effect of Illegality ❖ Since illegal contracts are void, the parties cannot sue for nonperformance ❖ The court will generally refuse to enforce or rescind an illegal contract ❖ The court will generally leave the parties where it finds them

Doctrine of Unconscionability (1 of 2) ❖ 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, or a contract of contract of adhesion

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Doctrine of Unconscionability (2 of 2) Elements that must be shown to prove that a contract or clause is unconscionable: ❖ The parties possessed severely unequal bargaining power ❖ The dominant party unreasonably used its unequal bargaining power ❖ The adhering party had no reasonable alternative

Remedies for Unconscionability Where a contract or contract clause is found to be unconscionable, the court may do one of the following: ❖ Refuse to enforce the contract ❖ Refuse to enforce the unconscionable clause but enforce the remainder of the contract ❖ Limit the applicability of any unconscionable clause so as to avoid any unconscionable result

III. Text Materials *The first point of coverage should be involved with the notion of who the parties to the contract are. You can stress the notion that being a party is essential to having one’s rights, duties, and obligations ascertained. Nonparties may have an interest in the outcome but no recognized standing unless they qualify as intended third parties.

Case 9.1: Wrench v. Taco Bell The Facts: Rinks and Shields, through their company Wrench, created an advertising campaign for Taco bell at their request using their cartoon character “Psycho Chihuahua”. Wrench suggested that they use a real male dog passing by a female dog to get to Taco Bell. No express contract was entered. Instead, Taco Bell gave Wrench’s material to Chiat/Day who made the same proposal which they say they came up with on their own. Taco Bell aired its commercials as suggested by Chiat/Day without paying anything to Wrench who sued for breach of an impliedin-fact contract. The district court granted summary judgment in favor of Taco Bell.

Issue: Do the plaintiffs Wrench, LLC, Rinks, and Shields state a cause of action for the breach of an implied-in-fact contract?

Decision/Remedy: Yes. The judgment was reversed and the case remanded for trial.

Reason: Taco Bell understood if it used the Psycho Chihuahua concept, it would have to pay plaintiffs.

Case 9.2: Lim v. The .TV Corporation International Facts: dotTV posted the name for Golf.TV for sale on its website. The high bid by Lim was in response to this announcement. This was continued by dotTV via email. Subsequently dotTV sends another email releasing the defendant “from the bid.” They then offered the name with a much higher beginning bid. Lim claims breach of contract. dot.TV says Lim purchased “—golf” not “golf.”

Issue: Did Lim properly state a cause of action for breach of contract against dot TV? Decision/Remedy: Yes. Claim was reinstated.

Reason: The announcement of the auction was an invitation to make an offer. The bid was the offer that was accepted by defendant’s confirmation. The confusion was not justified.

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Contemporary Environment: Option Contracts 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.

Ethics Spotlight: A “Coin Toss” Bet A situation with a coin flip is discussed. Illegal gambling contracts are discussed.

See Legal Case with Answer in the text.

IV. Answers to Legal Environment Cases Objective Theory 9.1. Yes, Zehmer’s statement forms the basis for an enforceable contract. If a reasonable person believes an offer was being made, the speaker risks formation of a contract even if made in jest. It is the objective manifestation that is important. Secret, unexpressed intentions are irrelevant. Accordingly, such statements, conduct, and circumstances could show intent to lead any person to believe the statements were serious. The court rule that Zehmer was not too intoxicated to know what he was doing. Lucy v. Zehmer, 196 Va.. 493.

Terms of a Contract 9.2. No, there was not an oral contract for long-term financing. In order to make a contract, there must be a meeting of the minds as to all terms. A court cannot make a contract for the parties. The court found that the total amount of loan proceeds was never decided and that no interest rate or repayment terms were ever agreed upon. There was apparently some discussion as to long-term financing, however, the parties never agreed on any essential terms. Such terms were left to future determination.

In addition, the court stated that there was no way that it could take the general terms discussed between Hunt and the bank and be asked to enforce the contract without supplying the necessary terms essential to the formation of the contract. Accordingly, the trial court’s judgment in favor of the Bank was affirmed. Hunt v. McIlroy Bank and Trust, 616 S.W.2d 759, 1981 Ark.App. Lexis 716 (Ark.App.).

Counteroffer 9.3. No, there has not been a settlement of the lawsuit. A valid acceptance of an offer must be absolute and unqualified. A qualified acceptance that contains terms or conditions materially different from those in the original offer constitutes a counteroffer that terminates the power of the original offeree to accept the offer.

In the instant case, the court held that the process of settlement is best served by allowing the law of contracts to control. Thus, the court held that the tenant’s qualified acceptance of the settlement offer, conditioned upon the execution of a new lease, constituted a counteroffer that terminated its ability to accept the settlement offer. The trial court’s denial of the tenant’s motion to compel entry of judgment due to the existence of the settlement was therefore affirmed. Glende Motor Company v. Superior Court, 159 Cal.App.3d 389, 205 Cal.Rptr. 682 Cal.App. Lexis 2435 (Cal.App.)

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The Mailbox Rule 9.4. Yes, the notice exercising the option to renew the lease was effective, thereby extending the lease for the next five years. Acceptance of a bilateral contract occurs at the time the offeree dispatches the acceptance by an authorized means of communication. Under this rule, the acceptance is effective when it is dispatched, even if it is lost in transmission. The court found that the lease notice provision required notice to be sent by “registered or certified United States mail.” The court went on to state that the risk of loss of the notice of extension had transferred to the addressee once the notice reached the custody of the U.S. Postal Service, notwithstanding that the notice was not deposited in an officially designated receptacle.

In addition, the court held that the tenant’s habit and custom regarding mailing practices was sufficient to affirm the trial court’s holding that the tenant’s renewal notice had been properly mailed under the terms of the lease. Accordingly, in the landlord’s unlawful detainer action, the trial court correctly rendered judgment in favor of the tenant, thereby extending the lease for the next five years. Jenkins v. Tuneup Masters, 190 Cal.App.3d 1, 235 Cal.Rptr. 214, 1987 Cal.App. Lexis 1475 (Cal.App.).

Consideration 9.5. Lena wins because the contract was supported by valid consideration. Waiver of, or forbearance to exercise, a right that is not utterly groundless is sufficient consideration to support a contract made in reliance thereon. In this case, the court found that Carter’s promise to pay was supported by Lena’s forbearance from prosecuting an action against him for his interest in her husband’s estate. The Idaho Supreme Court affirmed the District Court’s judgment awarding Lena $19,358.62 plus interest at a rate of 6 percent. Frasier v.

Carter, 437 P.2d 32, 1968 Ida. Lexis 249 (Idaho).

Consideration 9.6. No, Gough cannot recover the cost to re-erect the thirty-two fallen trusses. An agreement on the part of one to do what he is already legally bound to do is not sufficient consideration for the promise of another. In this case, Gough assumed no obligation or duty that he was not bound to perform under the terms of the original contract. Under both agreements Gough agreed to erect and properly place the same number of trusses. Accordingly, Gough is not entitled to any sum not contemplated by the original contract. Robert Chuckrow Construction Company v. Gough, 159 S.E.2d 469, 1968 Ga. App. Lexis 1007 (Ga.App.).

Infancy Doctrine 9.7. Toyota wins and may enforce the security agreement. It is well settled that the conventional contract of a minor, except those for necessities, are voidable at the election of the minor during minority or within a “reasonable time” after reaching majority. What constitutes a “reasonable time” will be determined on a case-by-case basis. In making this determination, a court will consider affirmative actions as well as silent acquiescence.

In the instant case, Smith continued to make monthly payments as required by the note for ten months. The court held that Smith’s extended acceptance of the benefits and continuance of payments under the contract after he reached the age of majority constituted a ratification of the contract, thereby precluding any subsequent disaffirmance. Bobby Floars Toyota, Inc. v.

Smith, 269 S.E. 320, 1980 N.C. App. Lexis 3263 (N.C.App.).

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Adjudicated Insane 9.8. Yes, Miss Johnson is allowed to void the contract to sell her real estate to Obbie Neal. The law provides that once a person is adjudged insane, any contracts entered into by that person are void. Here, Miss Johnson had been adjudged insane prior to her entering into the contract to sell her real estate to Obbie Neal. Therefore, the court held that the sale contract is void, and Miss Johnson may retain her real property. Beavers v. Weatherby, 299 So.E.2d 730 (Ga. 1983).

Intoxication 9.9. Betty wins and may void the settlement contract. A contract of a person of unsound mind, but not entirely without understanding, made before her incapacity has been determined judicially upon application for the appointment of a guardian, is subject to rescission.

Furthermore, where the competency of one of the partners to marriage is a significant element in a suit for divorce, subsequent settlement agreement should be thoroughly scrutinized before the court accepts it. In this case, the record raises many doubts as to Betty’s capacity to contract for an extended period of time prior to and after the settlement agreement. Thus, the court held that Betty may avoid the contract at issue. Galloway v. Galloway, 281 N.W.2d 804 (N.D. 1979).

Exculpatory Clause 9.10. No, the exculpatory clause in this case is not valid against Alston. Although parties have a right to contract against liability, a party cannot protect himself by contracting against liability for negligence where a public duty is owed or a public interest is involved. The practice of cosmetology and instruction involves the use of hazardous chemicals that may affect the health of the general public. Accordingly, the court held that the Institute and its employees may not contract with their customers in a manner that would absolve themselves from their duty to use reasonable care. Alston v. Monk, 373 S.E.2d 463, 1988 N.C.App. Lexis 987 (n.C. App.).

V. Answers to Business Ethics Cases 9.11. The contract is a unilateral contract. A unilateral contract is one in which the offer can only be accepted by the performance of an act by the offeree. Here, there is no contract until the offeree performs the requested act. The offer cannot be accepted by Chenard promising to get a hole-in-one. This would constitute a bilateral agreement. The court held that where Chenard, the offeree, shot a hole-in-one, he had accepted the offeror’s offer of a unilateral contract thereby obligating performance of the promise. Accordingly, the Appellate Court upheld the Superior Court’s ruling that Chenard is entitled to the car. Chenard v. Marcel Motors, 387 A.2d 596, 1978 Me. Lexis 911 (Maine).

9.12. The trial court upheld in favor of Zientara. Although lotteries were illegal in Indiana, they were legal in Illinois. The contract called for the purchase of a lottery ticket in Illinois. Such an act is not illegal under Indiana law or against public policy. To not support the contract would allow one who converted the property of another to be rewarded. Therefore, the contract is not illegal, and should be enforced. Kaszuba v. Zientara, 506 N.E. 2d 1 (Ind. 1987).

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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 how 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; yet 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 on end of the spectrum is an innocent mistake that can be either unilateral or bilateral.

In 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 (unilateral) of the parties is mistaken, 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. Where the mistake is mutual (bilateral), 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 grounds for recission are 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 recission 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 law 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.

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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 interest 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 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 90 ..

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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 first 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 possibly 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 to 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 91 ..

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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 already was 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 their reciprocal obligations under that 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 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 time-line 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 formulate 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 result in the eyes of the law.

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 contact 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 had 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 that 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 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

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been related to a bad faith tort within the contract setting, the court might also grant punitive damages.

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 damage measure possibility 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., 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 contact 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 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. Topic Outline Introduction 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 ❖ i.e., genuiness of assent ❖ i.e., the contract did not meet the requirements of the Statute of Frauds

Mistakes – look to what non-mistaken thought ❖ A mistake occurs where one or both of the parties has an erroneous belief about the subject matter, value, or some other aspect of the contract ❖ Mistakes may be either unilateral or mutual ❖ The law permits recission of some contracts made in mistake

Unilateral Mistakes ❖ Occur 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

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Mutual Mistakes ❖ Mutual Mistake of Fact A mistake made by both parties concerning a material fact that is important to the subject matter of the contract In Raffles v. Wichelhaus, the court held that a mutual mistake of fact excused performance of the 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 The contract remains enforceable by either party because the identity of the subject matter of the contract is not at issue

Fraudulent Misrepresentation When a person intentionally makes an assertion that is not in accord with the facts.

Also called fraud.

Elements of Fraud 1. The wrongdoer made a false representation of material fact 2. The wrongdoer intended to deceive the innocent party 3. The innocent party justifiably relied on the misrepresentation 4. The innocent party was injured

Legal Consequence if Fraudulent Misrepresentation is Found The innocent party may: 1. Rescind the contract and obtain restitution, or 2. Enforce the contract and sue for damages

Common Types of Fraud (1 of 2) Fraud in the inception ❖ An innocent person is deceived as to the nature of his or her act Fraud in the inducement ❖ The wrongdoer fraudulently induces another party to enter into a contract Fraud by concealment ❖ The wrongdoer takes specific action to conceal a material fact from the other party

Common Types of Fraud (2 of 2) Silence as misrepresentation ❖ The wrongdoer remains silent when he or she is under a legal obligation to disclose a material fact Misrepresentation of law ❖ A professional who should know what the law is intentionally misrepresents the law to a less sophisticated party

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Innocent Misrepresentation ❖ Occurs when a person unintentionally makes an assertion that is not in accord with the facts ❖ The innocent party may rescind the contract but cannot recover damages ❖ Innocent misrepresentation is not fraud

Undue Influence (1 of 2) ❖ Occurs when one person takes advantage of another person’s mental, emotional, or physical weakness and unduly persuades that person to enter into a contract ❖ The persuasion by the wrongdoer must overcome the free will of the innocent party

Undue Influence (2 of 2) The following elements must be shown to prove undue influence: 1. A fiduciary or confidential relationship must have existed between the parties 2. The dominant party must have unduly used his or her influence to persuade the servient party to enter into a contract

Duress Types of duress: ❖ Physical duress Physical duress ❖ Extortion Occurs when one party threatens to do some wrongful act unless the other party enters into a contract A contract entered into under duress cannot be enforced

Statute of Frauds (1 of 3) State statute that requires the following types of contracts to be in writing: 1. Contracts involving the transfer of interests in land 2. Contracts that by their own terms cannot possibly be performed within one year 3. Collateral contracts in which a person promises to answer for the debt or duty of another

Statute of Frauds (2 of 3) 4. Promises made in consideration of marriage 5. Contracts for the sale of goods for $500 or more and leases of $1,000 or more 6. Real estate agents’ contracts 7. Agents’ contracts where the underlying contract must be in writing 8. Promises to write a will

Statute of Frauds (3 of 3) 9. Contracts to pay debts barred by the statute of limitations or discharged in bankruptcy 10. Contracts to pay compensation for services rendered in negotiating the purchase of a business 11. Finder’s fee contracts

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Contracts Involving Interests in Land ❖ Under the Statutes of Fraud, any contract that transfers an ownership in real property must be in writing to be enforceable Part Performance Exception: ❖ A doctrine that allows the court to order an oral contract for the sale of land or transfer of another interest in real estate to be specifically performed if it has been partially performed and performance is necessary to avoid injustice Transfer of Other Interests in Real Property That Must Be in Writing ❖ Mortgages ❖ Leases ❖ Life Estates ❖ Easements

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

Promissory Estoppel ❖ Equitable doctrine that prevents the application of the Statute of Frauds Statute of Frauds ❖ It permits the enforcement of oral contracts that should otherwise be in writing under the Statute of Frauds Statute of Frauds to prevent injustice or unjust treatment

Sufficiency of the Writing (1 of 2) Formality of the writing Formality of the writing ❖ A written contract does not have to be formal or drafted by a lawyer to be enforceable ❖ Informal contracts are enforceable contracts Required signature Required signature ❖ The party against whom enforcement of the contract is sought must have signed the contract

Sufficiency of the Writing (2 of 2) Integration of several writings Several writings may be integrated to form a contract ❖ Express reference Express reference – one document incorporates another document ❖ Implied reference Implied reference – documents are physically attached by staple or by paper clip or are placed in the same envelope

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The Parol Evidence Rule ❖ Parol evidence – any oral or written words that are outside of the four concerns 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 Exceptions to the Parol Evidence Rule– look for integration clause Parol evidence may be admitted in court to: ❖ Prove mistake, fraud, misrepresentation, undue influence, or duress ❖ Explain ambiguous language ❖ Explain a prior course of dealing or course of performance between the parties or a usage of trade ❖ Fill in the gaps of a contract ❖ Correct obvious clerical or typographical errors Privity of Contract ❖ The state of two specified parties being in a contract ❖ Contracting parties have a legal obligation to perform the duties specified in their contract ❖ If one party fails to perform as promised, the other party may enforce the contract and sue for breach Third Party Rights Third parties generally do not acquire any rights under other people’s contracts Two exceptions are: 1. Assignees to whom rights subsequently are transferred, and 2. Intended third Intended third-party beneficiaries party beneficiaries to whom the contracting parties intended to give rights under the contract at the time of contracting Assignment of Rights ❖ Assignment– The transfer of contractual rights by the obligee to another party ❖ Assignor– The obligee who transfers the right ❖ Assignee– The party to whom the right has been transferred Rights That Can and Cannot Be Assigned (1 of 2) ❖ Personal Service Contracts. Contracts for the provision of personal services are generally not assignable ❖ Assignment of Future Rights. Usually, a person cannot assign a currently nonexistent right that he or she expects to have in the future Rights That Can and Cannot Be Assigned (2 of 2) ❖ Contracts Where Assignment Would Materially Alter the Risk. A contract cannot be assigned if the assignment would materially alter the risk or duties of the obligor ❖ Assignment of Legal Actions. Legal actions involving personal rights cannot be assigned

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Successive Assignments If the obligee makes successive assignments of the same right, one of the following rules applies: ❖ American Rule (or New York Rule) ❖ English Rule ❖ Possession of Tangible Token Rule - Remember notice requirements

Delegation of Duties ❖ Delegation – A transfer of contractual duties by the obligor to another party for performance ❖ Delegator – The obligor who transferred his or her duty – remains liable ❖ Delegatee – The party to whom the duty has been transferred

Duties that Can and Cannot Be Delegated If the obligee has a substantial interest in having the obligor perform the acts required by the contract, duties may not be transferred ❖ e.g., Personal service contracts calling for the exercise of personal skills, discretion, or expertise ❖ e.g., Contracts whose performance would materially vary if the obligor’s duties were delegated

Third-Party Beneficiaries Third parties sometimes claim rights under others’ contracts Such third parties are either: ❖ Intended Beneficiaries Intended Beneficiaries, or ❖ Incidental Beneficiaries

Covenant Covenants and Conditions ❖ An unconditional promise to perform ❖ Nonperformance of a covenant is a breach of contract that gives the other party the right to sue Conditions of Performance ❖ A qualified or conditional promise that becomes a covenant is met

Types of Conditions: Precedent: event must occur or not occur before an obligation exists Subsequent: event or non-event excuses duty to perform Concurrent: parties are obligated to perform simultaneously

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Performance and Breach ❖ If a contractual duty has not been discharged or excused, the contracting party owes an absolute duty (covenant) to perform the duty Breach of contract – If a contracting party fails to perform an absolute duty owed under a contract

Summary: Types of Performance Type 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

Anticipatory Breach ❖ A breach that occurs when one contracting party informs the other that he or she will not perform his or her contractual duties when due ❖ This gives an immediate cause of action to the non-breaching party to sue for breach of contract ❖ This is also called anticipatory repudiation

Monetary Damages A non-breaching party may recover monetary damages monetary damages from a breaching party Monetary damages are available whether the breach was minor or material: ❖ Compensatory damages – if no breach ❖ Consequential damages - foreseeable ❖ Liquidated damages – agreed in advance ❖ Nominal damages

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 contract involved

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Examples Compensatory ❖ Sale of goods: market price minus contract price at time of delivery ❖ Construction: can include lost profits ❖ Employment: costs to hire new employee plus increase in salary Consequential ❖ Needs knowledge Liquidated ❖ Cannot be a penalyt Rescission and Restitution Rescission An action to undo the contract Available if there has been: ❖ A material breach of contract ❖ Fraud ❖ Undue influence ❖ Mistake Restitution ❖ Returning of goods or property received from the other party to rescind a contract ❖ If the actual goods or property is not available, a cash equivalent must be made Types of Equitable Remedies Type 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.

Torts Associated With Contracts ❖ The recovery for breach of contract usually is limited to contract damages ❖ The major torts associated with contracts are: ❖ Intentional Interference with Contractual Relations ❖ Breach of the Implied Covenant of Good Faith and Fair Dealing Tort Damages: Compensatory Damages ❖ These include compensation for personal injury, pain and suffering, emotional distress, and other injuries caused by the defendant’s tortious conduct

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Tort Damages: Punitive Damages Damages that are awarded to: ❖ Punish the defendant ❖ Deter the defendant from similar conduct in the future ❖ Set an example for others ❖ These are recoverable against a defendant for intentional or egregious conduct - Usually not for breach of contract but sometimes for tortious non-performance.

III. Text Materials Ethics Spotlight: Fraudulent Misrepresentation (Fraud) The elements of fraud are discussed in this box. They include material false representation, intent to deceive, justifiable reliance and injury.

Ethics Spotlight: Liquidated Damages: Trump World Tower This box deals with a 25% downpayment which was treated as liquidated damages.

See Case with Answer in Text. l contract on the terms found by the court and reliance by the Suttons upon that contract warranting specific performance relief.

International Law: Chinese Chops and Japanese Hankos as Signatures Some countries, such as Japan and China, use a stamp as their signature. It is much more difficult to prove forgery, since anyone with another’s hanko or chop can apply it.

Case 10.1: Sawyer v. Mills Facts: Mills orally agreed to pay a bonus to Sawyer to be paid in monthly installments over 167 months. There was a secret tape. Mills would not sign a written contract. When Mills stopped paying, Sawyer sued for breach. Mills claimed the deal was for over a year and defended with no writing.

Issue: Does the Statute of Frauds require the agreement to be in writing to be enforceable?

Decision: Yes. Reason: There is no writing. The tape is not a writing and, although ethically the agreement should be upheld, this is not the law.

Case 10.2: Krysa v. Payne Facts: Payne told Krysa that a particular truck on his lot would tow his trailer. After a test drive, they bought the truck. Many things went wrong with the truck including a problem with towing the trailer. Evidence showed that the truck was 2 halves of different trucks. An expert declared it was okay. Krysa sued and won.

Issue: Was this fraudulent nondisclosure, fraudulent misrepresentation and reckless disregard for safety enough for $500,00 in punitive damages?

Decision: Yes. Reason: Payne acted either indifferently or with reckless disregard for safety. Punitive damages are intended to inflict punishment and act as a deterrent. The harm was the result of intentional malice, trickery, or deceit, and was not just an accident.

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IV. Answers to Legal Environment Mutual Mistake 10.1. Yes, Beachcomber can rescind the contract. A mutual mistake occurs where both parties to a contract are mistaken as to a fact assumed by them as the basis upon which they agreed.

Generally in such cases, the contract is voidable by either party if enforcement would be materially more onerous to that party than it would have been had the facts been as the parties believed them to be. Moreover, negligent failure of a party to know or to discover the facts to which both parties are mistaken does not preclude rescission.

Here, it is undisputed that both parties believed that the coin was genuine. Both parties were laboring under the same misapprehension as to this particular essential fact. The price asked and paid was based directly on that assumption. There was no assumption of the risk that the coin might not be genuine. Accordingly, the lower court holding was reversed, and Beachcomber was entitled to rescission of the contract. Beachcomber Coins, Inc. v. Boskett, 400 A.2d 78, 1979 N.J.Super. Lexis 659 (N.J.).

Fraud 10.2. Campbell wins and may recover damages from McClure for fraud. The essential elements of fraud are (1) a false statement, (2) knowledge that the statement was false, (3) intent that the statement induced another to act in reliance thereon, and (4) actual reliance resulting in damage. In this case, the court found ample evidence to support a finding of intentional fraud and justifiable reliance. McClure signed the escrow instructions which guaranteed the accuracy of his sales brochure while also admitting on the stand that he knew the business did not make as much money as he represented. Moreover, expert testimony established that the business records were misleading.

Knowing the problematic nature of the business records, Campbell would not have bought the business unless he was assured that the business generated at least $150,000 in net income. McClure allowed Campbell to believe such representation, with no reasonable basis to conclude it was true. Accordingly, the court held McClure made the warranty to induce Campbell to buy the business by deceiving him as to the size of the profits, that when he made the warranty McClure knew it was false and had no reasonable grounds to conclude it was true, and that Campbell relied upon the warranty in purchasing the business. The court awarded compensatory and punitive damages for fraud in the inducement, and also granted rescission of the contract. Campbell v. McClure, 182 Cal.App.3d 806, 227 Cal.Rptr. 450, 1986 Cal.App. Lexis 1751 (Cal.App.).

Undue Influence 10.3. Yes, the conservator of the estate can cancel the deed transferring the farm to Lawrence.

The court found that Conrad was subject to the influence of Lawrence, who was acting in a confidential relationship, that the opportunity to exercise undue influence existed, that there was a disposition on the part of Lawrence to exercise such undue influence, and that the conveyance appeared to be the effect of such influence. The court held this was sufficient to establish a prima facie case of undue influence and that Lawrence had the burden of going forward with the evidence. Moreover, the court stated that one of the most important elements in determining whether this presumption can be rebutted is whether the grantor received independent counsel. In affirming the lower court’s judgment in favor of the conservator, the court found that it was apparent that Conrad was not afforded the opportunity

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to seek independent advice from any source other than Lawrence. Schaneman v. Schaneman, 291 N.W.2d 412, 1980 Neb. Lexis 823 (Neb.).

Statute of Frauds 10.4. The Sacketts win. The Statute of Frauds provides that oral contracts for the sale of land are invalid unless in writing. Where, however, the party seeking to enforce the conveyance has partially performed the contract, so as to render recession inequitable and unjust, the contract may be outside of the statute. Thus, where it appears that a vendee has taken continuous and exclusive possession under the contract and has made improvements, or where other equitable considerations are present, specific performance will be granted.

Among the relevant equitable considerations that may justify specific performance, a court will consider the amount of time that has passed before the vendee’s possession was challenged. This factor is considered because it would be inequitable to aid one who induced another’s detrimental reliance by his failure to promptly pursue his rights.

In this case, during the 14 years the Sacketts inhabited the home on Orchard Drive, Robert Briggs never visited, sought rent, checked on the condition of the home, or otherwise asserted any interest in the property. Under these circumstances, the court agreed with the lower court that there was sufficient evidence of part performance of the oral contract to render it specifically enforceable. Thus, the judgment in favor of the Sacketts was affirmed. Briggs v.

Sackett, 418 A.2d 586, 1980 Pa.Super. Lexis 2034 (Pa.App.) Guaranty Contract 10.5. No, the Wests are not liable on the guaranty contract. It is well settled that an agreement to guarantee the debt of another must be in writing. In this case, the lower court found that the bank reasonably relied on Mr. West’s statements and applied the doctrine of equitable estoppel to find that the Wests were liable under the guarantee. The Supreme Court of Idaho, however, held that the bank could not have relied on the oral statements made by Mr. West because the bank was in the business of making loans to its customers on a regular basis and knew, or should have known, that a guarantee for the debt of another had to be in writing.

Moreover, the court held that there was no meeting of the minds between the Wests and the bank, and without such a meeting of the minds, there is no enforceable contract.

Accordingly, the court held that the bank simply jumped the gun in giving Brown the loan and that the Wests were not liable as guarantors on the loan. First Interstate Bank of Idaho, N.A. v. West, 693 P.2d 1053, 1984 Ida. Lexis 600 (Idaho).

Condition 10.6. Pace wins the lawsuit and does not have to pay OBS. Until a condition precedent is satisfied, the other terms of the contract are not enforceable. In most subcontract agreements, payment by the owner to the contractor is not intended to be a condition precedent to the contractor’s duty to pay the subcontractor. In order to properly shift the risk to the subcontractor, the subcontract must unambiguously express such an intention. In this case, the subcontract clearly states that payment from the owner shall be a condition precedent to the contractor’s obligation to make final payment to the subcontractor. Accordingly, the court held that OBS must bear the risk of nonpayment by the owner. Pace Construction Corporation v. OBS Company, Inc., 531 So.2d 737, 1988 Fla.App. Lexis 4020 (Fla.App.).

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Damages 10.7. Welch wins and may recover damages for breach of contract. Generally, the purpose of the contract damages is to give the aggrieved party the benefit of her bargain, i.e., to put the aggrieved party where she would have been monetarily had the promise been performed. In this case, the court awarded $1 million for the loss of professional income. The court held that such damages were supported by the evidence concerning money which Welch had made from previous film work, absence of film offers subsequent to termination of the instant contract, expert testimony that Welch would have obtained additional film roles but for the termination of the instant contract, and the amount of money which film stars were making at the time of the trial. Moreover, the court awarded $750,000 for loss of reputation based on evidence of the difference between Welch’s premovie reputation as a somewhat difficult but professional actress and her postmovie reputation as a contract breaker who had been fired for cause. Welch v. Metro-Goldwyn-Mayer Film Co., 207 Cal.App.3d 164, 254 Cal.Rptr.

645, 1988 Cal.App. Lexis, 1202 (Cal.App.).

Damages 10.8. Yes, Gundersons can recover the lost profits on the remaining two-thirds of the contract to build the golf course. A contractor is entitled to recover, from a breaching defendant, damages sufficient to place it in the position in which it would have been had the breach not occurred, including any incidental or consequential damages caused by the breach.

Moreover, lost profits may be awarded if they are shown with reasonable certainty and are not speculative, remote, or imaginary. In this case, the court concluded that the lost profit damages were shown with reasonable certainty where the president broke down the project into various components and testified as to separate costs to complete each part.

The court also held that where the non-breaching party maintained a long-term lease for equipment used on the project and such equipment was left idle due to the breach, consequential damages were appropriate. Moreover, because a non-breaching party is under a duty to use reasonable means to avoid loss and damage, consequential damages were awarded for costs incurred in attempting to mitigate damages by seeking substitute golf course construction contracts. Accordingly, Gundersons may collect for both lost profits and consequential damages. Gundersons, Inc. v. Ptarmigan Investment Company, 678 P.2d 1061,1983 Colo.App.Lexis 1133 (Colo.App.).

Specific Performance 10.9. Yes, an order of specific performance is an appropriate remedy in this case. Specific performance may be decreed where the goods are unique or in other circumstances where money damages do not adequately compensate the plaintiff. In this case, the court found that the uniqueness of Claiborne’s cosmetics line, including its distinctive package, is obvious.

Moreover, the court found that money damages would not adequately compensate Claiborne for such intangibles as how the destruction of the Claiborne cosmetic line will affect the other business carried on under the Claiborne name. The closing of a much-publicized venture and its failure to supply stores would do nothing to enhance its reputation with suppliers, distributors, retailers, and customers. Therefore, the court held that money damages would be inadequate to compensate Claiborne for damages to its reputation and ordered Avon to fill and deliver in a timely and diligent fashion, all purchase orders placed by Claiborne in accordance with the contract. Liz Claiborne, Inc. v. Avon Products, Inc., 530 N.Y.S.2d 425, 141 A.D.2d 329,1988 N.Y. App.Div Lexis 6423 (N.Y.Sup.App.).

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Injunction 10.10. No, an injunction is not an appropriate remedy in this case. Generally, a contract to render personal services cannot be specifically enforced. An unwilling employee cannot be compelled to continue to provide services to his employer by ordering specific performance.

To hold otherwise would be a violation of the constitutional right against involuntary servitude. Accordingly, Beverly Glen is prohibited from enjoining Baker from performing the contract with Warner. In this case, however, Beverly Glen is also seeking to enjoin Warner from employing Baker. The court held that to do so would have the same effect and intent as enjoining Baker herself; she would be deprived of her livelihood and pressured to return to Beverly Glen. Moreover, Beverly Glen has an adequate remedy by way of damages; an injunction adds nothing to Beverly Glen’s recovery other than to coerce Baker to honor her contract. Accordingly, the court affirmed the order of the trial court denying injunctive relief.

Beverly Glen Music, Inc. v. Warner Communications, Inc., 178 Cal.App.3d 1142, 224 Cal.Rptr. 260, 1986 Cal.App. Lexis 2729 (Cal.App.).

V. Answers to Business Ethics Cases 10.11. Barber wins. As a general rule, one cannot rescind based on a unilateral mistake, but if the mistake was innocent and rescission would have no adverse effect on the mistaken party, then rescission can occur. Barber notified the church immediately upon discovering the error.

The church had not yet acted upon the bids. Therefore, there was no harm to the church; it only lost what it attempted to gain by taking advantage of another’s mistake. It would be inequitable to allow it to do so. First Baptist Church of Moultrie v. Barber Contracting Co., 377 S.E. 2d 717, 1989 Ga.App. Lexis 25 (Ga. App.).

10.12 The facts of this case warranted the equitable remedy of an injunction to protect Walgreen’s interests. Injunctions to enforce exclusivity clauses are quite likely to be justifiable by just the considerations present here ---damages are difficult to estimate with any accuracy and the injunction is a one-shot remedy requiring no continual judicial involvement.

Walgreen Co. v. Sara Creek Property Co., 966 F.2d 273 (7th Cir. 1992).

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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 land-marked 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 never imagined before. 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 ethical sensitivity to see that not only good can come from the information age; but so too, can there be great harm.

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 concerns and intellectual property rights. The Internet is impacting governmental regulation, employment law, consumer protection, business formation, and agency laws today. 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 everyday 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 107 ..

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Uniform Computer Information Transactions Act (UCITA). The UCC has long provided us with a tool by which 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 economic well being 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 bounded by all the rules of good conscience first evolved in the common law and transferred to the UCC. For example, on the privacy front, we may be looking at unprecedented accumulations of personal information though 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 the 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 land safely.

II. Topic Outline The Internet and World Wide Web ❖ E-Commerce - The sale of goods and services by computer over the Internet ❖ Internet – A collection of millions of computers that provide a network of electronic connections between computers ❖ World Wide Web – An electronic connection of computers that support a standard set of rules for the exchange of information

Selected Definitions: Website - composed of web pages Web pages – stored on servers and operated by ISPs ISPs – provide access to Internet with many services – not liable for content transmitted over their networks by e-mail and websites

Contemporary environment: Uniform Computer Information Transactions Act (UCITA) A model act that provides uniform and comprehensive rules for contracts involving: ❖ computer information transactions ❖ software licenses ❖ information licenses

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Cyber Law and E-Commerce Electronic Mail (E-Mail ❖ Electronic written communication between individuals using computers connected to the Internet ❖ Controlling the Assault of Non-Solicited Pornography and Marketing Act ❖ Called the CAN-SPAM Act ❖ Prohibits spammers from using falsified headers in e-mail messages ❖ Requires scammers who send sexually oriented e-mail to properly label it as such

E-Mail and Web Contracts ❖ E-mail is sometimes the method used to negotiate and agree on contract terms and to send and agree to the final contract ❖ Assuming that all of the elements to establish a contract are present, an e-mail contract is valid and enforceable ❖ Electronic contracts meet the writing requirements of the Statute of Frauds for most contracts

Electronic Signatures ❖ Electronic Signature in Global and National Commerce Act (E National Commerce Act (E-Sign Act) Sign Act) ❖ Recognizes and gives electronic signatures the same force and effect as a pen-inscribed signature on paper ❖ The act is technology neutral ❖ i.e., the law does not define or decide which technologies should be used to create a legally binding signature in cyberspace ❖ The act specifies ways to verify electronic signatures

Internet Domain Names ❖ Domain name – a unique name that identifies an individual’s or company’s Web site ❖ Internet Corporation for Assigned Names and Numbers and Numbers (ICANN) ❖ Approves registrars of domain names ❖ Domain names may be registered by filing the appropriate form with the domain name registration service and paying the appropriate fee

Anticybersquatting Consumer Protection Act of 1999 ❖ 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 name must be famous ❖ The domain name was registered in bad faith

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Licensing ❖ Intellectual property and information rights are valuable assets of individuals and businesses ❖ License – a contract that transfers limited rights in intellectual property and informational rights ❖ Licensor – the owner of intellectual property or informational rights who transfers rights in the property or information to the licensee ❖ Licensee – the party who is granted limited rights in or access to intellectual property or informational rights owned by the licensor ❖ Exclusive License – a license that grants the license exclusive rights to use informational rights for a specified duration ❖ Exclusive license grants the licensee exclusive rights to use informational rights for a specified duration ❖ Licensing agreement sets forth the express terms of the agreement between the licensor and licensee

Electronic Errors (1 of 2) The Uniform Computer Information Transactions Act (UCITA) provides that consumers are not bound by their unilateral electronic errors if the consumer: 1. Promptly upon learning of the error notifies the licensor of the error 2. Does not use or receive any benefit from the information, or make the information or benefit available to a third party UCITA was drafted to answer problems dealing with licensing ↓ Forming contracts over the Internet Enforcing e-commerce contracts Providing consumer protection

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Electronic Errors (2 of 2) 3. Delivers all copies of the information to the licensor or destroys all copies of the information, pursuant to reasonable instructions from the licensor 4. Pays all shipping, reshipping, and processing costs of the licensor [UCITA § 217] ❖ Section 217 of the UCITA only applies to consumers who make electronic errors in contracting

Express Warranty ❖ Any affirmation of fact of promise by the licensor about the quality of its software or information ❖ The UCITA does not require a licensor to make an express warranty about the quality of its software or information [UCITA § 402] ❖ The UCITA permits a licensor to disclaim all implied warranties [UCITA § 406(c)]

Breach of License Agreements (1 of 2) ❖ The parties to a contract for the licensing of information owe a duty to perform the obligations stated in the contract ❖ If a party fails to perform as required, there is a breach of the contract ❖ Breach of contract by one party to a licensing agreement gives the non-breaching party certain rights, including recovering damages or other remedies [UCITA § 701]

Breach of License Agreements (2 of 2) ❖ Licensee’s refusal of defective tender ❖ Licensee’s revocation of acceptance ❖ Adequate assurance of performance

Remedies ❖ The UCITA provides various remedies that injured parties can obtain against breaching parties: ❖ Cancellation ❖ Licensor’s damages ❖ Licensor’s right to cure ❖ Licensee’s damages ❖ Specific performance ❖ Liquidation of damages

Limitations of Remedies ❖ The UCITA provides that the parties to an agreement may limit the remedies available for breach of the contract ❖ Limitation of remedies in licenses subject to the UCITA are enforceable unless they are unconscionable [UCITA § 803]

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III. Text Materials Internet Law & Online Commerce: The Federal CAN-SPAM ACT The Act prohibits falsified headers and deceptive subject lines and requires an opt-out philosophy along with proper labeling of sexually oriented e-mail.

Internet Law & Online Commerce: ECPA It is a crime to intercept electronic communication.

Internet Law & Online Commerce: Domain Name Anticybersqatting Act Congress passed the Anticybersquatting Act that prohibits bad faith registration or use of an Internet domain name that infringes upon a company’s trademark or an individual’s famous name.

Case 11.1: E & J Gallo Winery v. Spider Web Ltd. Facts: Ernest and Julio Gallo Winery (Gallo) is a famous maker of wines that is located in California. The company registered the trademark “Ernest & Julio Gallo” in 1964 with the United States Patent and Trademark Office. The company has spent over $500 million promoting its brand name and has sold over four billion bottles of wine. Its name has taken on a secondary meaning as a famous trademark name. In 1999, Steve, Pierce, and Fred Thumann created Spider Web Ltd., a limited partnership, to register Internet domain names. Spider Web registered more than 2,000 Internet domain names, including “ernestandjuliogallo.com.” Spider Web is in the business of selling some of its domain names. Gallo filed suit against Spider Web Ltd. and the Thumanns, alleging violation of the federal Anticybersquatting Consumer Protection Act (ACPA). The district court held in favor of Gallo and ordered Spider to transfer the domain name “ernestandjuliogallo.com” to Gallo. Spider Web Ltd. appealed.

Issue: Did Spider Web Ltd. and the Thumanns act in bad faith in registering the Internet domain name “ernestandjuliogallo.com”?

Decision: The court of appeals held that the name “Ernest & Julio Gallo” was a famous trademark name and that Spider Web Ltd. and the Thumanns acted in bad faith when they registered the Internet domain name “ernestandjuliogallo.com.” The court of appeals upheld the district court’s decision ordering the defendants to transfer the domain name to plaintiff E. & J. Gallo Winery.

Reason: Spider Web has no intellectual property rights or trademark in the name “ernestandjuliogallo,” aside from its registered domain name. The domain name does not contain the name of Spider Web or any of the other defendants. Spider Web had no “prior use” (or any current use) of the domain name in connection with the bona fide offering of goods or services.

Spider Web’s use is commercial, and there is no indication that it is a fair use. Steve Thumann admitted that the domain name was valuable and that they hope Gallo would contact them so that they could “assist” Gallo in some way. Additionally, there is un-contradicted evidence that Spider Web was engaged in commerce in the selling of domain names and that they hoped to sell this domain name some day. The ACPA was passed to address situations just like this one.

Evidence was presented that Gallo’s mark is distinctive and famous. Gallo registered the mark, which is a family name, thirty-eight years ago, and “Gallo” has clearly become associated with wine in the United States such that its evolution to “secondary meaning” status may not be seriously questioned. The circumstances of this case all indicate that Spider Web knew Gallo had a famous mark in which Gallo had built up goodwill, and that they hoped to profit from this by registering “ernestandjuliogallo.com” and waiting for Gallo to contact them so they could “assist” Gallo.

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Cyber Law and E-Commerce Internet Law & Online Commerce: Domain Names Sold for Millions www.business.com originally sold for $150,000 after being registered for less than $50. It has now been sold for $350 million.

Internet Law & Online Commerce: E-signatures(E-SIGN ACT) Electronic signatures are recognized under E-Sign: The Act, however, is technology neutral.

Internet Law & Online Commerce: Click-Wrap Licenses Software is sold, often over the Internet, but installed later. Clicking on “I agree” is considered consent to enter a contract.

Internet Law & Online Commerce: Counteroffers Ineffectual Against Electronic Agents Counteroffers are not effective against electronic agents. An example is offered.

Case 11.2: M.A. Mortenson Company, Inc. v. Timberline Software Corporation Facts: Timberline Software Corporation produces software programs that are used by contractors to prepare bids to do work on construction projects. Timberline’s software license agreement contained a limitation of remedies clause. Mortenson, a customer of Timberline, claimed that the software did not work correctly and resulted in a bid that was too low. Mortenson sued to recover consequential damages alleging that the software calculated an inaccurate bid. Timberline defended, alleging that the limitation of remedies clause in the software license prevented Mortenson’s lawsuit.

Issue: Was the limitation of remedies clause in the Timberline software contract unconscionable?

Decision: No. Reason: The court of appeals held that the limitation of remedies clause in the software license was conspicuous and not unconscionable. There it prohibited Mortenson’s lawsuit to recover consequential damages from Timberline.

See Law Case with Answer.

IV. Answers to Legal Environment Note on Chapter 14: The scenarios in this chapter are not real cases. They are fictitious cases to be used for class discussion. The law of the Internet is not as fully developed as laws in other areas. Also, please keep in mind that model acts and uniform laws are not statutes, but rather the opinions of different legal experts about how law in a particular area should develop in an ideal world. Some model acts and uniform laws are eventually adopted by states in whole or in part.

The answers below are possible answers to the questions based on the materials in the chapter, but other answers are possible since many of the answers are based on model acts and uniform laws.

Domain Name 11.1. While this is subject to debate, the Anticybersquatting Act has two main tests. The first is whether the name is famous, and the second is whether the domain name was registered in bad faith. Obviously, Classic Coke is a famous name, and Francis Net’s objective was to make a fortune selling domain names, pretty obviously a bad faith gesture.

Therefore, Francis Net loses in this scenario.

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E-Mail Contract 11.2. Under the Uniform Electronic Transactions Act, an electronic record satisfies the requirement for writing where the contract is required to be in writing by the Statute of Frauds. Since the electronic e-mails establishing the contract between Litle Steel and West Coast Steel were signed electronically, West Coast Steel wins under this scenario.

E-Contract 11.3. Einstein Financial Analysis entered into an exclusive license with William Buffet. This means that for the specified duration of the license, the licensor will not grant any other person rights in the same information. Under this scenario, Buffet wins.

E-License 11.4. The Uniform Computer Information Transactions Act recognizes that electronic agents do not have the ability to evaluate and accept counteroffers or to make counteroffers. Each new counteroffer, such as the one Mildred Hayward made, extinguishes the previous offer and becomes a new viable offer. Because Info.com, Inc. did not accept the counteroffer, it can recover the license payments for three years under its contract in this scenario.

E- Signature 11.5. The Federal Electronic Signature Act recognizes an electronic signature or e-signature.

The act gives the e-signature the same force and effect as a pen-inscribed signature on paper.

Therefore, in this scenario, Inet can recover the license fee against David Abacus.

E-License 11.6. Under the Uniform Computer Information Transactions Act, if one of the parties is not a merchant, varying the terms of an offer by the offeree is a rejection of the offer and constitutes a counteroffer. This rejects the offer, and no contract is formed. Therefore, no contract was formed by Tiffany and iSoftware.

E-License 11.7. Under the Uniform Computer Information Transactions Act, if a licensor tenders a copy that is a material breach of the contract, i.e., it is defective; the nonbreaching party may refuse the tender. Therefore, under this scenario, Silvia wins.

E-License 11.8. Under the Uniform Computer Information Transactions Act, when a licensee breaches a contract, the licensor may sue and recover monetary damages from the licensee depending on the facts of the situation. Therefore, under this scenario, Metatag wins.

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Cyber Law and E-Commerce V. Answers to Business Ethics Cases 11.9. Under the Anitcybersquatting Consumer Protection Act, the test of violation of the law is bad faith. WhileBluePeace.org may have had the best of intentions, unless it could prove that General Motors, Macy’s, and Exxon Oil were guilty of the crimes depicted on their website, it was acting in bad faith, and General Motors, Macy’s, and Exxon Oil win.

11.10. Bates did not pay for service provided. This is obviously not ethical. Bates is probably trying to determine if the service works. Unless included in the agreement, it seems that Apricot was within its rights. Apricot probably should have demanded payment first.

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Chapter 12 Sales, Leases Contracts, 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 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 U.C.C 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 contract 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 evolve 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 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 116 ..

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they fail to anticipate the issue in the initial contract. The same holds true in the law of wills. If the 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 pace 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 may 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.

Because 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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The section of this chapter on warranties gives us a timely opportunity to remind students of the multifaceted aspects of the issues covered in this chapter. Warranty issues invariably raise the 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. Topic Outline Overview of the Uniform Commercial Code (UCC) Article 1 Article 2 (revised) Article 2A Article 3 Article 4 Article 4A Article 5 Article 6 Article 7 Article 8 Article 9 (revised)

General provisions Sales Leases Negotiable instruments Bank deposits & collections Wire Transfers Letter of Credit Bulk transfers Documents of title Investment securities Secured transactions

Scope of Articles 2 (Sales ❖ All states except Louisiana have adopted some version of Article 2 (Sales) of the UCC ❖ Article 2 is also applied by federal courts to sales contracts governed by federal law ❖ Article 2 establishes rules that govern the sale of goods ❖ Article 2 has recently been revised

-

Has been adopted by some states

Goods are tangible things moveable at the time of identification to a contract.

Note: Look for dominant feature on a mixed sale

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Scope of Articles 2A (Leases) ❖ Article 2A applies only to leases involving goods ❖ Article 2A does not apply to real estate or other leases ❖ Many states have adopted Article 2A Leases involve transfers of rights to possession and use of the goods.

Formation of Sales and Lease Contracts ❖ Any rules established by Articles 2 and 2A take precedence over the common law of contracts ❖ Offer ❖ A contract for the sale or lease of goods may be made in any manner sufficient to show agreement ❖ This includes conduct by both parties that recognizes the existence of a contract [UCC 2-204(1), 2A-204(1)] Formation of Sales and Lease Contracts (continued) ❖ Open Terms – Sometimes the parties to a sales or lease contract leave open a major term in the contract ❖ Open Price Term ❖ Open Payment Term ❖ Open Delivery Term ❖ Open Time Term ❖ Open Assortment Term ❖ These open terms are permitted to be read into a sales or lease contract ❖ This rule is commonly referred to as the gap-filling rule [UCC 2-204(3), 2A-204(3)] ❖ Open Explanation: Price→reasonable (market) Payment → at delivery Delivery →seller’s place Time →reasonable Assortment →buyer chooses Formation of Sales and Lease Contracts (continued) ❖ Firm Offer Rule [UCC 2-205, 2A-205] ❖ A merchant who (1) offers to buy, sell, or lease goods, and (2) gives a written and signed assurance on a separate form 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 ❖ Three months is the maximum amount of time permitted under this rule ❖ Acceptance ❖ The UCC provides that a contract is created when the offeree (i.e., the buyer or lessee) sends an acceptance to the offeror, not when the offeror receives the acceptance ❖ The UCC permits acceptance by any reasonable manner or method of communication [UCC 2-206(1)(a), 2A-206(1)]

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Formation of Sales and Lease Contracts (continued) ❖ Accommodation Shipment ❖ A shipment that is offered to the buyer as a replacement for the original shipment when the original shipment cannot be filled ❖ The accommodation is a counteroffer from the seller to the buyer ❖ The buyer is free either to accept or to reject the counteroffer [UCC 2-206(1)(b)] ❖ Consideration ❖ The formation of sales and lease contracts requires consideration ❖ Under the UCC, an agreement modifying a sales or lease contract needs no consideration to be binding [UCC 2-209(1), 2A-208(1)] ❖ Modification of a sales or lease contract must be made in good faith [UCC 1-203] UCC Statute of Frauds ❖ A rule that requires all contracts for the sale of goods costing $500 or more, and lease contracts involving payments of $1,000 or more be in writing [UCC 2-201(1), 2A201(1)] ❖ The writing must be sufficient to indicate that a contract has been made between the parties Statute of Frauds and The U.C.C ❖ $500 ❖ Exceptions for written confirmations between merchants ❖ Exception for specially manufactured goods ❖ Exception for part performance Parole Evidence Rule and The U.C.C ❖ Course of performance exemption ❖ Course of dealing exception ❖ Usage of trade exception Identification of Goods ❖ Distinguishing the goods named in the contract from the seller’s or lessor’s other goods ❖ Identification of goods can be made at any time and in any manner explicitly agreed to by the parties to the contract ❖ In the absence of such an agreement, the UCC mandates when identification occurs [UCC 2-501(1), 2A-217] Passage of Title (1 of 2) ❖ Once the goods exist and have been identified, title to the goods may be transferred from the seller to the buyer ❖ Article 2 of the UCC establishes precise rules for determining the passage of title in sales contracts ❖ Lessees do not acquire title to the goods they lease

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Passage of Title (2 of 2) ❖ Under UCC 2-401(1), title to goods passes from seller to the buyer in any manner and on any conditions explicitly agreed upon by the parties: ❖ Shipment contracts [UCC 2-401(2)(a)] ❖ Destination contracts [UCC 2-401(2)(b)] ❖ Document of title [UCC 2-401(3)(a)] E-Sales and Lease Contracts ❖ Electronic means technology with electronic, digital, magnetic, wireless, optical, electromagnetic or similar capabilities ❖ A record or signature may not be denied legal effect or enforcement solely because of electronic form ❖ A contract may not be denied legal effect or enforceability solely because an electronic record was used in its formation Bulk Sales Law(2 of 2) ❖ For a bulk transfer of assets, Article 6 requires that: 1. The seller furnish the buyer with a list of all of the creditors of the business, and 2. The buyer notify all of the listed creditors at least 10 days before taking possession of or paying for the goods, whichever occurs first ❖ The buyer is not responsible for or liable to unlisted creditors [UCC 6-105] Risk of Loss: Carrier Cases: Movement of Goods ❖ Generally, goods shipped via carrier are considered to be sent pursuant to a shipment contract or a destination contract ❖ Shipment contract – the buyers bears the risk of loss during transportation [UCC 2509(1)(a)] ❖ Destination contract – requires the seller to deliver conforming goods to a specific destination [UCC 2-509(1)(b)]

o The seller bears the risk of loss during transportation Shipping Terms ❖ Sales contracts often contain the following terms:

o o o o o o

F.O.B. (free on board) point of shipment F.A.S. (free alongside) or F.A.S. (vessel) port of shipment C.I.F. (cost, insurance, and freight) and C. & F. (cost and freight) F.O.B. place of destination Ex-ship (from the carrying vessel) No arrival, no sale contract

Noncarrier Cases: No Movement of Goods (1 of 3) ❖ A sales contract may stipulate that the buyer is to pick up the goods, either at the seller’s place of business or another specified location ❖ Who bears the risk of loss if the goods are destroyed or stolen after the contract date and before the buyer picks the goods up from the seller?

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Noncarrier Cases: No Movement of Goods (2 of 3) ❖ Merchant-Seller Rule: If the seller is a merchant, the risk of loss does not pass to the buyer until the goods are received ❖ Nonmerchant-Seller Rule: Nonmerchant-sellers pass the risk of loss to the buyer upon “Tender of delivery” of the goods [UCC 2-509(3)]

Noncarrier Cases: No Movement of Goods (3 of 3) ❖ Goods in the Possession of a Bailee (e.g., a warehouse) – goods sold by a seller to a buyer are sometimes in the possession of a bailee o If such goods are delivered to the buyer without moving them, the risk of loss passes to the buyer [UCC 2-509(2)]

Risk of Loss: Conditional Sales (1 of 3) Sale on Approval Sale on Approval ❖ There is no actual sale unless and until the buyer accepts the goods ❖ In a sale on approval the risk of loss and title remain with the seller ❖ They do not pass to the buyer until acceptance [UCC 2-327(1)]

Risk of Loss: Conditional Sales (2 of 3) ❖ Sales or Return Contract o The seller delivers goods to a buyer with the understanding that the buyer may return them if they are not used or resold within a stated or reasonable period of time o The risk of loss and title transfer to the buyer when he or she takes possession of the goods [UCC 2-237(2)]

Risk of Loss: Conditional Sales (3 of 3) ❖ Consignment o A seller (the consignor) delivers goods to a buyer (the consignee) for sale o The consignee is paid of fee if he or she sells the goods on behalf of the consignor o A consignment is treated as a sale or return under the UCC [UCC 2-326(3)]

Risk of Loss: Breach of Sales Contract ❖ Seller in Breach o A seller breaches a sales contract if he or she tenders or delivers nonconforming goods to the buyer [UCC 2-510] ❖ Buyer in Breach o Buyers breach a sales contract if they: o Refuse to take delivery of conforming goods o Repudiate the contract, or o Otherwise breach the contract [UCC 2-510]

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Risk of Loss: Lease Contracts If the parties to a lease contract do not agree as to who will bear the risk of loss of the goods if they are lost or destroyed, the UCC supplies risk of loss rules: ❖ Ordinary Lease Ordinary Lease – risk of loss is retained by the lessor ❖ Finance Lease Finance Lease – risk of loss passes to the lessee ❖ Tender of delivery of goods fails to conform to the lease Tender of delivery of goods fails to conform to the lease contract – the risk of loss remains with the lessor or supplier until cure or acceptance [UCC 2A-219, 2A-220(1)(a)]

Insuring Goods Against Loss or Damage ❖ Determine the value of goods subject to the sales or lease contract ❖ Purchase insurance from a reputable insurance company covering the goods subject to the contract ❖ Maintain the insurance by paying the premiums when they are due ❖ Immediately file the proper claim and supporting documentation with an insurance company if the goods are damaged, destroyed, lost, or stolen

Sales by Nonowners (1 of 2) ❖ Void Title and Lease: Stolen Goods o A thief acquires no title to the goods he or she steals [UCC 2-403(1)] ❖ Voidable Title o Title that a purchase has if the goods were obtained by: o Fraud o A check that is later dishonored o Impersonating another person o [UCC 2-201(1), 1-201(44)(d), UCC 2-403(1)]

Sales by Nonowners (2 of 2) ❖ Good Faith Purchaser for Value o A person to whom good title can be transferred from a person with voidable title o The real owner cannot reclaim goods from a good faith purchaser for value ❖ Good Faith Subsequent Lessess o A person to whom a lease interest can be transferred from a person with voidable title o The real owner cannot reclaim the goods from the subsequent lessee until the lease expires

Entrustment Rule: 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 [UCC 2-403(2)]

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Entrustment Rule (continued) ❖ The entrustment rule also applies to leases ❖ If a lessor entrusts the possession of his or her goods to a lessee who is a merchant who deals in goods of that kind, the merchant-lessee has the power to transfer all the lessor’s and lessee’s rights in the goods to a buyer or sublessee in the ordinary course of business [UCC 2A-305(2)]

Summary: Passage of Title in Sales by Nonowner Third Parties and Sales of Goods Subject to Security Agreements Type of Transaction

Title Possessed by Innocent Purchaser Seller Goods acquired by Void title Good faith purchaser theft are resold for value Goods acquired by Voidable title fraud or dishonored check are resold Goods entrusted by No title owner to merchant who deals in that type of good are resold Creditor possesses Good title security interest in goods that are sold

Purchaser Acquires Title to Goods No. Original owner may not reclaim the goods Good faith purchaser Yes. Purchaser takes for value free claim of original owner Buyer in ordinary Yes. Purchaser takes course of business free claim of original owner Buyer in ordinary Yes. Purchaser takes course of business free of creditor’s security interest

Seller’s and Lessor’s Performance: Tender of Delivery Tender of Delivery The obligation of the seller to transfer and deliver goods to the buyer or lessee in accordance with the sales or lease contract Requires the seller or lessor to: 1. put and hold conforming goods at the buyer’s or lessee's disposition; and 2. give the buyer or lessee any notification reasonably necessary to enable the buyer or lessee to take delivery of the goods [UCC 2-503(1), 2A-508(1)]

Seller’s and Lessor’s Performance: Place of Delivery ❖ Many sales and lease contracts state where the goods are to be delivered ❖ If the contract does not expressly state where the delivery will take place, the UCC will stipulate place of delivery on the basis of whether a carrier is involved o [UCC 2-504, 2-503] ❖ Bailee – a holder of goods who is not a seller or buyer o e.g., a warehouse ❖ Shipment Contract – a sales contract that requires the seller to send the goods to the buyer, but not a specifically named destination ❖ Destination Contract – a sales contract that requires the seller to deliver the goods to the buyer’s place of business or another specified destination

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Seller’s and Lessor’s Performance: Perfect Tender Rule ❖ The seller or lessor is under a duty to deliver conforming goods ❖ If the goods or tender of delivery fails in any respect to conform to the contract, the buyer or lessee may opt either to: o Reject the whole shipment o Accept the whole shipment; or o Reject part and accept part of the shipment ❖ Cure is the opportunity given by the U.C.C. to fix a nonconforming delivery: 1) Time not expired and 2) Notification

Seller’s and Lessor’s Performance: Perfect Tender Rule (continued) ❖ Exceptions to the perfect tender rule: o Agreement of the parties o Substitution of carriers ❖ Cure ❖ Installment contracts ❖ Destruction of goods

Seller’s and Lessor’s Performance: General Obligations ❖ The UCC has adopted several broad principles that govern the performance of sales and lease contracts: o Good Faith o Reasonableness o Commercial Reasonableness

Seller’s and Lessor’s Performance: Right of Inspection ❖ Unless otherwise agreed, the buyer or lessee has the right to inspect goods that are tendered, delivered, or identified to the sales contract prior to accepting or paying for them [UCC 2-513(1), 2A-515(1)] ❖ If the goods conform to the contract, the buyer pays for the inspection ❖ Buyers who agree to C.O.D. (cash on delivery) deliveries are not entitled to inspect the goods before paying for them [UCC 2-513(3)]

Seller’s and Lessor’s Performance: Payment ❖ Due to Pay – goods that are accepted must be paid for ❖ Unless the parties agree otherwise, payment is due from a buyer when and where the goods are delivered even if the place of delivery is the same as the place of shipment [UCC 2-310, 2A-516(1)]

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Buyer’s and Lessee’s Performance: Acceptance Occurs when the buyer or lessee takes any of the following actions after a reasonable opportunity to inspect the goods [UCC 2-606, 2A-515]: ❖ Signifies to the seller or lessor in words or by conduct that the goods are conforming or that the buyer or lessee will take or retain the goods despite their nonconformity, or ❖ Fails to effectively reject the goods within a reasonable time after their delivery or tender by the seller or lessor

Buyer’s and Lessee’s Performance: Revocation of Acceptance ❖ A buyer or lessee who has accepted goods may subsequently revoke acceptance if: 1. The goods are nonconforming; 2. The nonconformity substantially impairs the value of the goods to the buyer or lessee; and 3. One of the following factors is shown: a) The seller’s or lessor’s promise to seasonably remedy the nonconformity is not met; b) The goods were accepted before the nonconformity was discovered and the nonconformity was difficult to discover; or c) The goods were accepted before the nonconformity was discovered and the seller or lessor assured the buyer or lessee that the goods were conforming

Seller’s and Lessor’s Performance: Right to Withhold Delivery ❖ Delivery of the goods may be withheld if the seller or lessor is in possession of them when the buyer or lessee breaches the contract ❖ The remedy is available if the buyer or lessee: o Wrongfully rejects or revokes acceptance of the goods; o Fails to make payment when due; or o Repudiates the contract

Seller’s and Lessor’s Performance: Right to Stop Delivery of Good in Transit ❖ In Transit – a state in which goods are in the possession of a bailee or carrier and not in the hands of the buyer, seller, lessee, or lessor ❖ A seller or lessor may stop delivery of goods in transit if he or she learns of the buyer’s or lessee’s insolvency ❖ The same remedy is available if the buyer or lessee: o Repudiates the contract o Fails to make payment when due; or o Otherwise gives the seller or lessor some other right to withhold or reclaim the goods

Seller’s and Lessor’s Remedies: Right to Reclaim Goods ❖ The right of a seller or lessor to demand the return of goods from the buyer or lessee under specified situations ❖ To exercise the right of reclamation, the seller or lessor must send the buyer or lessee a written notice demanding return of the goods

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Seller’s and Lessor’s Remedies: Right to Dispose of Goods ❖ If the buyer or lessee breaches or repudiates the seller or lease contract before the seller or lessor has delivered the goods, the seller or lessor may resell or release the goods and recover damages from the buyer or lessee ❖ This right also arises if the seller or lessor has reacquired the goods after stopping them in transit

Seller’s and Lessor’s Performance: Right to Recover the Purchase Price or Rent ❖ A seller or lessor may recover the contracted-for purchase price or rent from the buyer or lessee if: o The buyer or lessee accepts the goods but fails to pay for them when the price or rent is due o The buyer or lessee breaches the contract after the goods have been identified to the contract and the seller or lessor cannot resell or dispose of them o The goods are damaged or lost after the risk of loss passes to the buyer or lessee

Seller’s and Lessor’s Remedies: Recovery of Damages ❖ A seller or lessor may recover damages measured as the difference between the contract price (or rent) and the market price (or rent) at the time and place the goods were to be delivered, plus incidental damages, from a buyer or lessee who repudiates the contract or wrongfully rejects tendered goods

Seller’s and Lessor’s Remedies: Recovery of Loss Profits ❖ The seller or lessor may recover lost profits, plus an allowance of overhead and incidental damages, from the buyer or lessee if the recovery or damages would be inadequate to put the seller or lessor in as good a position as if the contract had been fully performed by the buyer or lessee

Seller’s and Lessor’s Remedies: Right to Cancel the Contract A seller or lessor may cancel a sales or lease contract if the buyer or lessee: ❖ Rejects or revokes acceptance of the goods; ❖ Fails to pay for the goods; or ❖ Repudiates the contract in part or in whole

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Summary: Seller’s and Lessor’s Remedies Possession of Goods at Time Seller’s or Lessor’s Remedies of Buyer’s Breach Goods in the possession of - Withhold delivery of the goods the seller - 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 damages - Cancel the contract Good in the possession of a - Stop goods in transit: carrier or bailee - Carload, truckload, planeload, or larger shipment if the buyer is solvent - Any size shipment if the buyer is insolvent Goods in the possession of - Sue to recover the purchase price or rent the buyer - Reclaim the goods

Buyer’s and Lessee’s Remedies (1 of 2) ❖ Right to reject nonconforming goods or improperly tendered goods ❖ Right to recover goods from an insolvent seller or lessor ❖ Right to obtain specific performance ❖ Right to cover ❖ Right to replevy goods Cover involves substituted goods ↓ Damages now = cost of cover – contract price Replevy involves recovering scarce goods

Buyer’s and Lessee’s Remedies (2 of 2) ❖ Right to cancel the contract ❖ Right to recover damages for non-delivery or repudiation ❖ Right to recover damages for accepted nonconforming goods

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Summary: Buyer’s and Lessee’s Remedies Situation Buyer’s or Lessee’s Remedy Seller or lessor refuses to - Reject nonconforming goods deliver the goods or delivers - Revoke acceptance of nonconforming goods the nonconforming goods that - Cover the buyer or lessee does not - Sue for breach of contract and recover damages want - Cancel the contract Seller or lessor tenders - Sue for ordinary damages nonconforming goods and the - Deduct damages from the unpaid purchase price buer or lessee accepts them.

Sellor or lessor refuses to - Sue for specific performance deliver the goods and the - Replevy the goods buyer or lessee wants them - Recover the goods from an insolvent seller or lessor

Additional Issues Affecting Performance and Breach 1) Assurance of Performance 2) Anticipatory Repudiation 3) Statute of Limitations 4) Agreements Affecting Remedies

❖ Warranty → buyer or lessee’s assurance that the goods met certain standards

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EXPRESS AN IMPLIED WARRANTIES OF GOODS Type of How Created Description Warranty Express Made by the Affirms that the goods meet certain standards of warranty seller or lessor. quality, description, performance, or condition [UCC 2-313(1), 2A-210(1)].

Implied Implied by law Implies that the goods: warranty of if the seller or 1. Are fit for the ordinary purposes for which they merchantabili lessor is a are used. ty merchant.

2. Are adequately contained, packaged, and labeled.

3. Are of an even kind, quality, and quantity within each unit.

4. Conform to any promise or affirmation of fact made on the container or label.

5. Pass without objection in the trade.

6. Meet a fair, average, or middle range of quality for fungible goods [UCC 2-314(1), 2A-212(1)].

Implied Implied by law. Implies that the goods are fit for the purpose for which warranty of the buyer or lessee acquires the goods if: fitness for a 1. The seller or lessor has reason to know the particular particular purpose for which the goods will be purpose used.

2. The seller or lessor makes a statement that the goods will serve that purpose.

3. The buyer or lessee relies on the statement and buys or leases the goods [UCC 2-315, UCC 2A213].

Unconscionable Contract The UCC Article 2 (Sales) and Article 2A (Leases) have adopted the equity doctrine of unconscionability ❖ To prove unconscionability, there must be proof: ❖ that the parties had substantial unequal bargaining power; ❖ that the dominant party misused its power in contracting; and ❖ that it would be manifestly unfair or oppressive to enforce the contract ❖ This doctrine also applies to Web contracts ❖ The UCC Article 2 (Sales) and Article 2A (Leases) have adopted the equity doctrine of unconscionability

Warranties of Quality ❖ Seller’s or lessor’s assurance to buyer or lessee that the goods meet certain standards of quality ❖ If the goods fail to meet a warranty, the buyer or lessee can sue the seller or lessor for breach of warranty ❖ Warranties may be expressed or implied

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Notes 1) Must be a basis of the bargain 2) Opinion (puffing) are not warranties

Express Warranties ❖ 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 [UCC 2313(1); UCC 2A-210(1)] ❖ It is not necessary to use formal words such as warrant or guarantee to create an express warranty [UCC 2-313(2); UCC 2A-210(2)] ❖ Sellers and lessors are not required to make such warranties ❖ Basis of the Bargain – buyers and lessees can recover for breach of an express warranty if the warranty was a contributing factor (not necessarily the sole factor) that induced the buyer to purchase the product or the lessee to lease the product [UCC 2-313(1); UCC 2A210(1)]

Implied Warranty of Merchantability (1 of 2) ❖ Unless properly disclosed, a warranty is implied when sold or leased goods are fit for the ordinary purpose for which they are sold or leased, and other assurances [UCC 2-314(1); UCC 2A-212(1)] ❖ The implied warranty of merchantability does not apply to sales or leases by nonmerchants or casual sales

Implied Warranty of Merchantability: Standards That Must Be Met ❖ The goods must be fit for the ordinary purposes for which they are used ❖ The goods must be adequately contained, packaged, and labeled ❖ The goods must be of an even kind, quality, and quantity within each unit ❖ The goods must conform to any promise or affirmation of fact made on the container or label ❖ The quality of the goods must pass without objection in the trade ❖ Fungible goods must meet a fair average or middle range of quality

Implied Warranty of Fitness for Human Consumption ❖ A warranty that applies to food or drink consumed on or off the premises of:

o o o o

Restaurants Grocery stores Fast-food outlets Vending machines

→ Must pass the consumer expectation test

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Implied Warranty of Fitness for Human Consumption (continued) ❖ Consumer Expectation Test – a test to determine merchantability based on what the average consumer would expect to find in food products ❖ Foreign Substance Test – A test to determine merchantability based on foreign objects that are found in food

Implied Warranty of Fitness for a Particular Purpose ❖ A warranty that arises where a seller or lessor warrants that the goods will meet the buyer’s or lessee’s expressed needs ❖ The warranty is breached if the goods do not meet the buyer’s or lessee’s expressed needs ❖ The warranty applies to both merchant and nonmerchant sellers and lessor

Warranty Disclaimers ❖ Warranties can be disclaimed or limited ❖ If an express warranty is made, it can only be limited if the disclaimer and the warranty can be reasonably construed with each other ❖ All implied warranties of quality may be disclaimed by expressions like as is, with all faults, or other language that makes it clear to the buyer that there are no implied warranties

Other Warranty Issues ❖ Overlapping and inconsistent warranties ❖ Warranty disclaimers ❖ Conspicuous display of disclaimer ❖ Unconscionable disclaimers ❖ Warranty disclaimers in software licenses ❖ Third-party beneficiaries of warranties ❖ Damages: a) Compensatory = warranted value – actual value (at acceptance) b) Consequential c) Incidental Product Liability Based on Fault: Misrepresentation ❖ A buyer or lessee who is injured because of a seller or lessor fraudulently misrepresented the quality of a product can sue the seller under the tort of intentional misrepresentation ❖ Seller or lessor either:

o Affirmatively misrepresents the quality of a product; or o Conceals a defect in it ❖ Recovery is limited to persons who were injured because they relied on the misrepresentation

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III.

Text Materials

Contemporary Environment: UCC “Firm Offer Rule” The firm offer rule states that a merchant who offers to buy, sell, or lease goods and gives a written and signed assurance on a separate form 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 (up to three months).

Contemporary Environment: UCC Additional Terms Rule This box discusses the mirror image rule and counteroffers.

Contemporary Environment: UCC “The Battle of the Forms” Rule There is a contract based on original terms unless the additional terms so materially alter the terms of the original offer that the parties cannot agree on the contract or limitations are in contract or notification of non-acceptance of modification.

Contemporary Environment: UCC Written Conformation 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. Needs reasonable time and no written objection within 10 days.

Contemporary Environment: Shipping Terms See previous material the commonly used shipping terms.

Case. 12.1. Brandt v. Boston Scientific Corp. and Sarah Bush Lincoln Health Center Facts: Brandt was admitted to the Health Center and had a sling surgically implanted which was recalled by Boston. Brandt suffered serious complications and sued for breach of implied warranty of merchantability. Health Center claimed they were not a seller of goods as covered under Article 2 of the U.C.C. The trial court and appellant court agreed with Health Center. This appeal ensued.

Issue: Was the transaction between Brandt and Health Center predominantly for services or goods?

Decision: Services. There was no U.C.C. Article 2 liability.

Reason: Using the predominant purpose test, the court found that a majority of the changes were for services rather than goods. Services were the primary purpose of the transaction.

Case: 12.2. Denny v. Ford Motor Company Facts: Nancy Denny purchased a Bronco II, a small SUV that was manufactured by Ford Motor Company. When Denny slammed on her brakes on a paved road to avoid hitting a deer, the Bronco II rolled over and Denny was severely injured. She sued to recover damages for breach of the implied warranty of merchantability, claiming that the Bronco II presented a significantly higher risk of rollover accidents than did ordinary passenger vehicles.

Issue: Did Ford Motor Company breach the implied warranty of merchantability?

Decision: Yes. Reason: The vehicle was not safe for the “ordinary purpose” of daily driving for which it was marketed and sold. Therefore, Ford breached the implied warranty of merchantability.

Landmark Law: Magnuson-Moss Warranty Act Protects Consumers The Magnuson Moss Warranty Act covers written warranties relating to consumer products.

Internet Law & Online Commerce: Warranty Disclaimers in Software E-Licenses This box discusses disclaimer of warranty and limitation of liability clauses that are included in a typical software license.

See Law Case with Answer in the text.

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IV. Answers to Legal Environment Cases Disclaimer of Warranty 12.1. No, Ingersoll-Rand is not liable for the breach of implied warranty of merchantability because it properly disclaimed any such warranty. Disclaimers of the merchantability warranty must specifically mention the term “merchantability.” If the disclaimer is in writing, it must be conspicuous. The court held that the UCC applies to contracts for leases, in the same way it applies to contracts for the sale of goods. In the agreement between Ingersoll-Rand and Cole Energy, the disclaimer clearly mentions merchantability. The disclaimer is set out in large type and the section is clearly labeled “Warranties.” This passes the UCC test for conspicuousness. Because Ingersoll-Rand had properly disclaimed the implied warranty of merchantability, Cole Energy was not able to recover. Cole Energy Development Company v. Ingersoll-Rand Company, 678 F.Supp. 208 (C.D.Ill. 1988).

Firm Offer 12.2. 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. M. Gordon Construction Co., 216 A.2d 246, 1966 N.J.Super. Lexis 368 (N.J. Super.).

Battle of the Forms 12.3 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 (D.Del.).

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Open Terms 12.4. Yes, a valid sales contract had been formed. Under the UCC, a contract does not fail for indefiniteness if (1) the parties intended to form a contract, and (2) there is a reasonably certain basis for giving an appropriate remedy. The UCC allows “open terms” to be determined at a later date. One such open term is the price, which may be determined by a market rate. If the market price is not available, the court will imply a reasonable price. The court did not agree with Schmieding’s claim that the contract was void for indefiniteness. The court found that the contract specified the type of potatoes ordered, the quantity in terms of acreage, and the approximate delivery date. Market prices for commodities like potatoes are readily available from government agencies. The court determined that the parties had intended to form a contract, and that it was possible to supply any open terms in that contract.

Although this agreement would have been too indefinite under the common law, the appellate court found it to be a valid contract under the UCC. H.C. Schmieding Produce Co. v. Cagle, 529 So.2d 243, 1988 Ala. Lexis 284 (Ala.) Stolen Goods 12.5. Michaels Jewelers has valid title to the stolen jewelry. It is true that a good faith purchaser for value can obtain valid title to goods from a seller who only has voidable title to them.

However, a good faith purchaser cannot obtain valid title to goods sold by a seller who has void title to them. A thief only has void title to the goods he has stolen. The buyer of a good from a seller who has void title to that good cannot obtain valid title against the original owner. In this case, Torniero had stolen jewelry from Michaels. This meant that Torniero only had void title to the jewels. Even though G & W was a good faith purchaser of the goods, they could not obtain valid title to them. The court held that the original owner of the jewelry, Michaels Jewelers, had title to the goods and returned the jewelry to them. United States v. Michaels Jewelers, Inc., 42 UCC Rep.Serv. 141, 1985 U.S.Dist. Lexis 15142 (D.C. Conn.).

Entrustment Rule 12.6. Ryan has a valid title to the house. The UCC provides that: where an owner entrusts the possession of his or her goods to a merchant who deals in goods of that kind, the merchant has the power to transfer all rights (including title) to the goods to a buyer in the ordinary course of business. The real owner cannot reclaim goods from this buyer. The court in this case found that MMM was a dealer in respect to prefabricated homes. On at least seven occasions MMM had sold Fuqua modular houses to retail customers. Ryan was a buyer in the ordinary course of business because he had no knowledge of the security interest Fuqua held in the house that MMM sold to him. Because MMM was a merchant of prefabricated homes, they were able to transfer title to Ryan as a buyer in the ordinary course of business. Ryan now holds title to the home and Fuqua cannot reclaim it. Fuqua Homes, Inc. v. Evanston Bldg. & Loan Co., 370 N.E.2d 780, 1970 Ohio App. Lexis 6968 (Ohio App.).

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Risk of Loss 12.7 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., 477 N.Y.S.2d 288, 1984 N.Y.Misc. Lexis 3319 (N.Y.CityCir.Ct.).

Implied Warranty of Merchantability 12.8. Maybank wins the lawsuit against S.S. Kresge Col, based upon the breach of an implied warranty of merchantability. Unless excluded or modified, a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to the goods of that kind. To be merchantable, the goods must be fit for the ordinary purposes for which it is used. Maybank purchased the flashcubes from a Kresge store. The court found Kresge to be a merchant with respect to goods of that kind, i.e.…, flashcubes. A flashcube that does not work properly and causes unexpected harm is not fit for the ordinary purpose for which it is used, and is therefore not merchantable. When the flashbulb that Maybank purchased exploded, the implied warranty of merchantability was breached. The appellate court found for Maybank, based upon this breach of the implied warranty of merchantability. Maybank v. S.S. Kresge Company, 266 S.E. 409, 1980 N.C.App. Lexis 2927 (N.C.App.).

V. Answers to Business Ethics Cases 12.9. 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 “suppose” (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 “onesided” such that substantive unfairness results. Although courts are generally not sympathetic to commercial entitie4s, 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 supp9osed to do rises to the level of substantive unconsionability. A. & M. Produce Company v. FMC Corporation, 135 Cal.App.3d 473, 186 Cal.Rptr.114, 1982 Cal.App. Lexis 1922 (Cal.App.).

12.10. Affirmed for the farmers. The UCC provides that if you entrust your goods to a merchant who deals in the goods of the kind you empower that merchant to pass your title to a purchaser in the ordinary course of business. Executive allowed Tri-County to retain possession of the tractors. This constituted an entrusting. Thus, Tri-County was empowered to pass Executive’s title to purchasers in the ordinary course of business. The farmers were such purchasers. Therefore, the farmers received good title. Executive Financial Services, Inc. v. Pagel, 715 P.2d 381 (Kan. 1986).

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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 particular troublesome. First, compared to real estate, personal property is portable. Being more moveable, 137 ..

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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 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 138 ..

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Bankruptcy Amendments and other legislation and subsequent revisions. This legislation sought to pull in the reins on many of these abuses.

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. Topic Outline Introduction ❖ The American economy is a credit economy ❖ Businesses and individuals use credit to purchase many goods and services ❖ Debtor – the borrower in a credit transaction ❖ Creditor – the lender in a credit transaction

*Credit involves risk. Inherent in the nature of our business enterprise system is the principle that risk will be rewarded if well placed and punished if not. The riches of wise credit extension are the stuff of financial and family dynasties. It is no accident that most economic measures of a nation’s growth are tied to the success of its credit-granting financial institutions. Conversely, failure to wisely administer and manage these key elements in our society leads to debacles such as the savings and loan crisis. The law has long reflected this win/lose dichotomy of the credit marketplace. Many of the protections and remedies accorded to creditors have long historical tracings in the common law. In today’s highly codified scheme of things, most of the rights and duties of both debtor and creditor are found in statutes, but the principles harken back to an earlier age of debtor’s prisons and the like. The possibilities for fraud and conspiracy in this area of law have provided both the challenge and the need to seek a balance between the competing rights and duties of creditors. If the law takes an uneven hand to either side, the long-term interests of the entire economic system are badly served.

In an examination of credit relationships, remember that most disputes have more than one level of controversy. On the surface, the most apparent problem revolves around resolution of the differences between the debtor and creditor. A second dispute can often be found in competing creditors fighting over priority rights to the debtor’s property. A proper examination of any credit case answers both aspects. Although there are many sorts of credit relationships, the main focus of this chapter is on Article 9 of the UCC. That chapter covers the sale of personal property coupled with a security interest in the debtor’s property.

Contemporary Environment: Klondike Bar’s Unsecured Claim Melts This box discusses why one would always rather be a secured rather than an unsecured creditor.

Unsecured Credit ❖ Credit that does not require any security (collateral) to protect the payment of the debt ❖ The creditor relies on the debtor’s promise to repay the principal (plus an interest) when it is due ❖ The creditor may bring legal action if the debtor fails to make the payments

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Secured Credit ❖ Credit that requires security (collateral) that secures payment of the loan ❖ Security interests may be taken in real, personal, intangible, and other property ❖ The collateral may be repossessed to recover the outstanding amount if the debtor fails to make payment

Mortgage ❖ A collateral arrangement where a property owner borrows money from a creditor who uses a deed as collateral for repayment of the loan. ❖ Mortgagor – the owner-debtor in a mortgage transaction ❖ Mortgagee – the creditor in a mortgage transaction

Notes and Deeds of Trust ❖ Note - an instrument that evidences the borrower’s debt to the lender ❖ Deed of Trust – An instrument that gives the creditor a security interest in the debtor’s property that is pledged as collateral

Recording Statute ❖ A statute that requires the mortgage or deed of trust to be recorded in the county recorder’s office of the country in which the real property is located ❖ This record gives potential lenders or purchasers of real property the ability to determine whether there are any existing liens (mortgages) on the property

Foreclosure ❖ Legal procedure by which a secured creditor causes the judicial sale of the secured real estate to pay a defaulted loan ❖ All states permit foreclosure sales ❖ Most state permit foreclosure by power of sale

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Deficiency Judgment ❖ Some states permit the mortgagee to bring a separate legal action to recover a deficiency from the mortgagor ❖ If the mortgagee is successful, - The court will award a deficiency judgment - Entitles the mortgagee to recover the amount of the judgment from the mortgagor’s property

Right of Redemption ❖ A right that says the mortgagor has the right to redeem real property after default and before foreclosure ❖ Requires the mortgagor to pay the full amount of the debt incurred by the mortgagee because of the mortgagor’s default

❖ Contemporary Environment: Mechanic’s Lien ❖ Contractors and Laborers that make improvements to property can protect their investments with a mechanic’s lien against the improve real property.

Article 9 of the UCC – Security Interests in Personal Property ❖ An article of the Uniform Commercial Code (UCC) that governs secured transactions in personal property ❖ Article 9 has been adopted by all states except Louisiana ❖ Although there may be some variance among states, most of the basics of Article 9 are the same Attachment → secured part beats debtor; occurs at later of: Value given Rights in collateral Security agreement

Perfection → secured party beats other creditors or people with an interest in collateral; occurs at later of: Attachment Perfecting step Security Agreement → creates security interest Description Promise Rights upon default Debtor’s signature

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Contemporary Environment: Personal Property Subject to a Security Agreement Goods → Consumer goods: personal or household Equipment: business use (or default category) Farm products: farming use Inventory: sell or lease Fixtures: affixed to real estate Instruments→Checks, notes, stocks, bonds, etc.

Chattel Paper: note plus security agreement Documents of title: bills of lading, warehouse receipts, etc.

Accounts: accounts receivable General Intangibles: patents, copyrights, etc.

Perfecting Steps: Collateral/Step Consumer Goods Inventory Farm Products Equipment Instruments Docus. of Title Chattel Paper Accounts Contract Rights General Intang.

Filing A Financing Statement ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Possession ✓ ✓ ✓ ✓ ✓ ✓ ✓

Attachment ✓ (PMSI)

PMSI → Creditor extends credit to buy goods or sells on credit and takes interest in goods.

Floating Lien: lien floats to property not in possession → after acquired property, future advances and sale proceeds.

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Priorities – General Rules 1.

2.

3.

4.

5.

Order of perfection Order of filing if filing is perfecting step Liens over prior unperfected security interest Buyer of goods in ordinary course of business (BGOCB) usually wins Purchasers of collateral a. Beat unperfected if value and no notice – if inventory (BGOCB) win even if knowledge b. Beat perfected if authorized sale or (BGOCB) or buyer of consumer goods for consumer use with value and without notice 6. PMSI’s a. Collateral not inventory wins for 10 days and if filed then wins b. Inventory wins with notice and perfection before possession 7. Order of attachment if no perfection

Default and Remedies: Keep → notice; no written objection; not for 60% paid consumer goods -Take possession or Sell → costs; satisfy debt; second, (etc.) debts; → need notice of reasonable sale - Deficiency is still owed - Can redeem by payment

Contemporary Environment: Revised Article 9 Secured Transactions ❖ The National Conference of Commissioners on Uniform State laws promulgated Revised Article 9 Secured Transactions of the Uniform Commercial Code.

Contemporary Environment: Artisan’s Liens ❖ This box discusses how these types of liens usually prevail over other interests.

E-Secured Transactions: Revised Article 9 Recognizes E-Commerce ❖ Revised Article 9 recognizes many aspects of e-commerce and the digital world.

“Record” means information inscribed on a tangible medium or stored electronically or other retrievably perceivable form. Financing Statements can be an electronic record.

Surety Arrangement ❖ An arrangement where a third party promises to be primarily liable with the borrower for the payment of the borrower’s debt ❖ Surety – the third person who agrees to be liable in a surety arrangement

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Guaranty Arrangement ❖ An arrangement where a third party promises to be secondary liable for the payment of another’s debt ❖ Guarantor – the third person who agrees to be liable in a guarantor arrangement

Summary: Liability of Sureties and Guarantors Compared Type of Arrangement Surety Contract

Party Surety

Guaranty Contract

Guarantor

Liability Primary liable.

The surety is a co-debtor who is liable to pay the debt when it is due.

Secondary liable.

The guarantor is liable to pay the debt if the debtor defaults and does not pay the debt when it is due.

Collection Remedies (1 of 2) ❖ When a debt is past due, the creditor may bring a legal action against the debtor ❖ If the creditor is successful, the court will award a judgment against the debtor ❖ The judgment will state that the debtor owes the creditor a specific sum of money: - Principal and interest past due on the debt, - Other costs resulting from the debtor’s default, and - Court costs

Collection Remedies (2 of 2) ❖ The most common collection remedies are: 1. Attachment 2. Execution 3. Garnishment

Contemporary Environment: Collection Remedies ❖ This box discusses the most common collection remedies including attachment, execution, and garnishment.

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Surety Concurrent liability “If he doesn’t” Same instrument No new consideration No demand from debtor

vs.

Guarantor Non-concurrent liability “If he can’t” Different instrument New consideration Needs demand from debtor

Rights & duties are basically same Defense of Debtor Discharge Minority of debtor Performance Breach Non-personal

Defenses of Surety All non-personal defenses Minority of surety Creditor’s fraud or nondisclosure Modification of debtor’s contract Release of security or debtor

Federal Bankruptcy Code (1 of 2) ❖ Article I, section 8, clause 4 of the U.S. Constitution provides that “The congress shall have the power…to establish…uniform laws on the subject of bankruptcies throughout the United States” ❖ Bankruptcy law is exclusively federal law ❖ There are no state bankruptcy laws

Landmark Law: Federal Bankruptcy Code (2 of 2) ❖ Bankruptcy Reform Act of 1978 ❖ Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

Type of Bankruptcy

Chapter 7 11 12 13

Type Liquidation Reorganization Adjustment of debts of a family farmer or fisherman with regular income Adjustment of debts of an individual with regular income

Fresh Start ❖ The primary purpose of federal bankruptcy law is to discharge the debtor from burdensome debts ❖ The law gives debtors a fresh start by freeing them from legal responsibility for past debts

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Bankruptcy Courts ❖ Bankruptcy Amendments and Federal Judgeship Act (1984) – federal statute that created federal bankruptcy courts ❖ Bankruptcy courts decide core proceedings regarding bankruptcy cases: - e.g., allowing creditor claims - e.g., deciding preferences - e.g., confirming plans of reorganization ❖ Only federal bankruptcy courts can hear core proceedings regarding bankruptcy cases ❖ Noncore proceedings concerning the debtor are resolved in federal or state court: - e.g., decisions on personal injury - e.g., divorce - e.g., other civil proceedings

Bankruptcy Procedure: 1) Prepetition and post petition counseling 2) Filing a petition Voluntary  Chapters 7, 11, 12, 13

3) 4) 5) 6) 7) 8)

Involuntary Chapters 7, 11  Fewer than 12 creditors → 1 creditor  12 or more creditors → 3 creditors  $12,300 unsecured claims

Submit schedules Attorney certification Order of relief First creditors meeting → 10 to 20 days Creditor files proof of claim Trustee is appointed

Mandatory

May be appointed   Chapters 7, 12, 13 Chapter 11 9) Trustee: - Takes possession of property - Investigates - Distributes 10) Automatic stay 11) Discharge

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Exceptions from discharge ❖ Claims for taxes accrued within three years prior to the filing of the petition in bankruptcy ❖ Certain fines and penalties payable to federal, state, and local governmental units ❖ Claims based on the debtor’s liability for causing willful or malicious injury to a person or property ❖ Claims arising from the fraud, larceny, or embezzlement by the debtor while acting in a fiduciary capacity ❖ Alimony, maintenance, and child support ❖ Unscheduled claims ❖ Claims based on the consumer-debtor’s purchase of luxury goods of more than $500 from a single creditor within 90 days of the order for relief ❖ Cash advances in excess of $750 obtained by a consumer-debtor by use of a revolving line of credit or credit cards within 70 days of the order for relief

Bankruptcy Estate 1) Created upon commencement of a bankruptcy case.

2) Includes all debtor’s legal and equitable interests in real, personal, tangible and intangible property unless exempt.

3) For list of exempt property see list on page 238 of text.

Preferential and Fraudulent Transactions 1) Preferential - to or with any party on or within 90 days of filing - to or with any insider between 90 days and one year of filing - for benefit of creditor - antecedent debt - creditor receives more than the Ch. 7 amount - insolvent debtor - exceptions 2) Fraudulent - intent to defraud - debtor receives less than reasonable value - insolvent debtor or can’t pay

Special Applications 1) Chapter 7 - new simple abuse rules and means testing to determine if relief should be granted

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Median Income Test and Means Test - If debtor’s family income (last 6 mos. Income x 12) < state’s median 6 income → no presumption of abuse.

- If debtor’s family income > state’s median income → look to mean’s test.

Debtor’s Monthly Income (DMI) = last 6 mos. Income (certain deductions are available) 6 -

State’s Median Income for 5 years x ( DMI x 60) = Total If total < 6,000 → no presumption of abuse If total between 6,000 and 9,999 Relief granted if total can’t pay 25% of unsecured debt

Deny relief if total can pay 25% of unsecured debt -

If total > 10,000 → abuse is presumed → not eligible for chapter 7 relief.

Statutory Distribution of Property: Chapter 7: Distribution of Property ❖ Nonexempt property of the bankruptcy estate must be distributed to the debtor’s secured and unsecured creditors pursuant to the statutory priority established by the Bankruptcy Code - A secured creditor’s claim to the debtor’s property has priority over the claims of unsecured creditors

Unsecured Creditors Priority: 1) Fees and expenses 2) Gap claims 3) Wages, etc.

4) Employee benefit claims 5) Farmers and fishermen 6) Deposits 7) Taxes 8) Banks 9) Claims due to a alcohol or drugs

Chapter 7: Discharge ❖ The termination of the legal duty of a debtor to pay debts that remain unpaid upon the completion of a bankruptcy proceeding ❖ Only individuals may be granted a discharge - Not all debts are dischargeable in bankruptcy ❖ Discharge is not available to partnerships and corporations

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Chapter 7: Act That Bar Discharge ❖ Certain acts by the debtor may bar discharge: ❖ Making false representations about his or her financial position when he or she obtained an extension of credit ❖ Transferring, concealing, or removing property from the estate with the intent to hinder, delay, or defraud creditors ❖ Falsifying, destroying, or concealing records of his or her financial condition ❖ Failure to account for any assets ❖ Failure to submit to questioning at the meeting of the creditors (unless excused) ❖ Failure to complete mandated personal financial management course

Chapter 13 Consumer Debt Adjustment ❖ A rehabilitation form of bankruptcy that permits the courts to supervise the debtor’s plan for the payment of unpaid debts by installments ❖ Debtor avoids the stigma of Chapter 7 liquidation ❖ Creditors may recover a greater percentage of the debts owed them than they would under a Chapter 7 proceeding

Limitations on filing ❖ Need unsecured debts < $307,675, and secured debts < $922,975 ❖ Trustee is appointed ❖ Plan of payment must be filed no later than 90 days after order of relief. It can be either up to 3 or 5 years.

(DMI x 12) < State’s median income + 525/mo.

(DMI x 12) > State’s median income + 525/mo.

Chapter 13: Confirmation of the Plan ❖ The plan may modify the rights of unsecured creditors and some secured creditors ❖ The plan must: - Be proposed in good faith - Pass the feasibility test - Be in the interests of the creditors

Chapter 13: Discharge ❖ A discharge is granted to a debtor in a Chapter 13 consumer debt adjustment bankruptcy only after all the payments under the plan are completed by the debtor ❖ Even if the debtor does not complete the payments called for in the plan, the court may grant the debtor a hardship discharge

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Chapter 11 Reorganization Bankruptcy ❖ A bankruptcy method that allows reorganization of the debtor’s financial affairs under the supervision of the Bankruptcy Court ❖ Chapter 11 is used primarily by businesses to reorganize their finances under the protection of the Bankruptcy Court ❖ The debtor usually emerges from bankruptcy a “leaner” business, having restructured and discharged some of its debts

Chapter 11: Creditors’ Committee ❖ The creditors holding the seven largest unsecured claims are usually appointed to the creditor’s committee ❖ Representatives of the committee appear at Bankruptcy Court hearings, participate in the negotiation of a plan of reorganization, assert objections to the plan, etc.

Chapter 11: Plan of Reorganization ❖ A plan that sets forth a proposed new capital structure for the debtor to have when it emerges from reorganization bankruptcy ❖ The debtor has the exclusive right to file the first plan of reorganization ❖ Any party of interest may file a plan thereafter

Chapter 11: Confirmation of a Plan of Reorganization ❖ The final step is the confirmation of the plan of reorganization by the court ❖ A plan of reorganization must be confirmed by the court before it becomes effective ❖ Confirmation is either by: - The acceptance method: or - The cram down method

Chapter 11: Discharge ❖ Upon confirmation of a plan of reorganization, the debtor is granted a discharge of all claims not included in the plan ❖ The plan is binding on all parties once it is confirmed

Chapter 12 Family Farmer Bankruptcy ❖ Chapter 12 is a reorganization provision of the Bankruptcy Code ❖ Allows family farmers to reorganize financially under the supervision of the Bankruptcy Court

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III. Text Materials 2005 Act Limits the Homestead Exemption The Bankruptcy code’s federal homestead exemption is $20,200. The 2005 act limits abusive exemptions.

Case 13.1. I n re FV Steel and Wire company Facts: PSC extended credit to Keystone and took back a security interest in personal property.

PSC filed a financing statement listing the trade name and the corporate name.

Issue: Was the financing statement filed in the debtor’s trade name, rather than its corporate name, effective?

Decision: No. PSC became an unsecured creditor.

Reason: The wrong name made it very difficult to find the filing and notice was thus ineffective under Revised Article 9 of the UCC. PSC knew the correct name but ignored it.

Case 13.2. Kawaauhau v. Geiger Facts: Margaret Kawaahau sought treatment from Dr. Geiger for a foot injury. Geiger prescribed an ineffective drug because he wanted to minimize treatment cost. Eventually her condition deteriorated, and she had to have her leg amputated at the knee. Kawaahau and her husband sued Geiger for malpractice. Geiger, who did not have malpractice insurance, filed for bankruptcy. The bankruptcy court denied the discharge; the court of appeals reversed; and the Kawaahau’s appealed to the US Supreme Court.

Issue: Is a debt arising from a medical malpractice judgment that is attributable to negligent or reckless conduct dischargeable in bankruptcy?

Decision: Yes. Reason: A medical malpractice judgment based on negligent or reckless conduct, and not intentional conduct, is discharable in bankruptcy.

Contemporary Environment: Discharge of Student Loans Students can only discharge student loans if non-discharge would cause an undue hardship on the debtor and his or her dependents—a hardship that is strictly construed.

Contemporary Environment: UAL Corporation’s Chapter 11 Bankruptcy This box discusses the Bankruptcy Code as it helps UAL take advantage of Chapter 11.

See Law Case with Anaswer.

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IV. Answers to Legal Environment Mechanic’s Lien 13.1 Ironwood should win. Lantz could have had a mechanic’s lien but Ironwood paid Lantz.

Graco’s claim is against Lantz only Floating Lien 13.2. Columbus Junction State Bank wins the case. The Bank is a secured creditor of Joseph Jones based upon a properly filed security agreement. Once filed, a perfected security interest is valid for five years. The creditor may continue his perfected interest for another five years by filing a continuation statement. A continuation statement may be filed up to six months prior to the expiration of the financing statement’s five-year term. Once filed, they are effective for another five years and may be refilled. Subsequently, when a creditor has obtained a security interest and the debtor goes bankrupt, the secured party’s interest is satisfied out of the specific property given as collateral for the loan. Secured creditors have priority over other creditors. In this case, Columbus Bank was a secured creditor because it had properly purchased a security interest in Jones’ property by filing a financing statement.

The Bank subsequently filed a valid continuation statement six weeks prior to the expiration of the perfected security interest. Thus, Columbus Bank, a secured creditor, had first priority in obtaining the property of the bankrupt Jones. The Court awarded the Bank $10,075 and Jones’ soybeans. In Re Jones, 79 B.R. 839, 1987 Bank v. Lexis 1825(Bk.N.D. Iowa 1987).

Priority of Security Interests 13.3. The security interest of the Nebraska State Bank has priority over the security interest of the McGowens. Although the McGowens security interest arose first in time, the Bank was first to perfect its security interest by filing a financing statement with the appropriate government office. The UCC has established a set of rules to determine which claim will have priority when two or more creditors claim a security interest in the same collateral or property of the debtor. UCC 9-312 (5)(a), adopted by the state of Nebraska, states that if two or more creditors have perfected security interests in the same collateral, the first to have perfected that interest generally has priority. In this case, both creditors had perfected their security interests by filing a financing statement. Nebraska State Bank perfected its security interest by filing a financing statement with the County Clerk of Dakota County, Nebraska, on December 20, 1980. The McGowens filed their financing statement four months later.

Therefore, when High defaulted on his obligations and a controversy arose as to whose claim had priority; the Court awarded the disputed property to the Bank. McGowen v. Nebraska State Bank, 427 N.W.2d 772, 1988 Neb. Lexis 290 (Neb. 1988).

Priority of Security Agreements 13.4. Metropolitan State Bank wins the suit. To be valid, a written security agreement must (1) be signed by the debtor, (2) contain a description of the collateral, and (3) reasonably identify the collateral. A security interest can be created in various types of personal property, including consumer goods, chattel paper, and accounts. The issue in this case was which of the two parties, State Bank or World Wide Tracers, had a valid security agreement and financing statement in regards to Metropolitan Protection’s accounts receivable. In order for a financing statement to be valid, it must identify the collateral. The court ruled in favor of the Bank because their agreement with Metropolitan Protection specifically mentioned the 152 ..

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accounts receivable, while World Wide Tracers agreement was too vague to create a perfected security interest. World Wide Tracers was relying on the language “any property of the debtor obtained after July 15, 1980” to claim an interest in Metropolitan Protection’s accounts receivable. The Court awarded MP’s accounts receivable to the Bank, because Metropolitan State Bank’s Agreement was more specific. World Wide Tracers, Inc. v.

Metropolitan Protection, Inc., 384 N.W.2d 442, 1986 Minn. Lexis 753 (Minn. 1986).

Artisan’s Lien 13.5. Ozark Financial Services wins. The court held that Pete & Sons did not have a common law artisan’s lien on the tractor truck. The common law gives artisans and repair people’s liens on personal property of customers to secure payment for labor or services rendered.

Here, when Pete & Sons performed the repair services for the Turners, a common law lien attached to the truck to secure payment for these services. However, a common law lien is a possessory lien, i.e., the lien only lasts as long as the lien holder has possession of the goods.

The court held that when Pete & Sons released the truck to the Turners, its common law lien terminated. Because there was no common law lien on the truck, Ozark could foreclose on its perfected security interest in the truck.

Note: If not terminated, it would have taken priority over Ozark’s prior perfected security interest. Ozark Financial Services v. Turner, 735 S.W.2d 374, 1987 Mo. App. Lexis 4273 (Mo.App. 1987).

Automatic Stay 13.6. Yes, First Interstate, as the mortgagee, should be granted a release from stay so that it can foreclose on the debtor’s residence. Normally, the filing of a bankruptcy petition stays legal proceedings against the debtor and his property. However, the Bankruptcy Code provides that the court may grant a creditor relief from stay if there is lack of adequate protection of the creditor’s interest in the property or the debtor does not have adequate equity in the property and it is not necessary to an effective reorganization.

In this case, the Bankruptcy Court held that the debtor’s equity cushion of 11.5 percent does not constitute adequate protection of the mortgagee’s interest in the property. Further, other evidence showed that the property was deteriorating and the debtor did not have the financial ability to maintain or insure the property, and that the Greybull/Basin area in which the property was located was suffering tough economic times, and the real estate market was declining. Based upon this evidence, the Bankruptcy Court granted First Interstate’s motion for relief from the stay. First Interstate foreclosed on the property and sold it. In re Kost, 102 B.R. 829, 1989 U.S. Dist. Lexis 8316 (D.Wyo. 1989).

Fraudulent Transfer 13.7. The bankruptcy trustee wins, and the debtors’ transfer of their home 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 it 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. In re Tabala, 11 B.R. 405, 1981 Bankr.Lexis 3663 (Bk.S.D. N.Y.).

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Executory Contract 13.8. 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 (Bk.S.D.Ind.).

Plan of Reorganization 13.9. No, the debtor’s plan of reorganization cannot be confirmed by the Bankruptcy Court.

Under the Bankruptcy Code, a class of creditors is impaired if (1) the plan alters the legal, equitable, and contractual rights of the class of creditor and (2) the class does not vote to accept the plan. In this case, the Bankruptcy Court held that the debtor’s proposed plan of reorganization alters the legal, equitable, and contractual rights of Class 2 because it reduced the class’ claims by 50 percent. Therefore, in order for the plan to be confirmed without use of the cramdown provisions, these creditors must vote for the plan, which they have not.

Since Class 2 is impaired and has not accepted the plan, the requirements for confirmation under Section 1129(a) of the Bankruptcy Code have not been met.

In addition, the plan cannot be confirmed under the “cramdown” provisions of Section 1129(b). In order for the court to confirm a plan under the cramdown provisions, the Bankruptcy Code requires that at least one class of creditors must vote to accept the plan.

Here, the court found that no class of creditors has voted for the plan. Therefore, the court held that the debtor’s proposed plan cannot be crammed down on the impaired Class 2 creditors. The Bankruptcy Court denied confirmation of the debtor’s proposed plan of reorganization. In re Friese, 103 B.R. 90, 1989 Bankr.Lexis 1309 (Bk.S.D.N.Y.).

Guaranty Contract 13.10. Yes. The guaranty is to pay if the debtor doesn’t. They will then take over the place of Murphy Oil in the bankruptcy proceedings.

V. Answers to Business Ethics Cases 13.11. Yes, Mrs. Salem 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. Forsyth County Hospital Authority, Inc. v. Sales, 346 S.E.2d 212, 1986 N.C. App. Lexis 2432 (N.C.App. 1986).

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13.12. No, the debtor’s student loan should not be discharged in bankruptcy. Congress, which was concerned about debtors who incurred student loans and then filed bankruptcy after leaving school, enacted Section 523(a)(8)(B) of the Bankruptcy Code to make it more difficult for student loans to be discharged in bankruptcy. This section provides that during the first five years after a student loan becomes due and payable, it is not dischargeable in bankruptcy unless payment would cause “undue hardship” on the debtor and his dependents.

After this five-year period has run, student loans are dischargeable in the same manner as other loans. Section 523(a)(8)(B) is strictly construed by the courts, and the debtor bears the burden of proof as to undue hardship.

The Bankruptcy Court held that since the debtor’s student loan became due and payable one month before he declared bankruptcy, it falls within the five-year period and is subject to the “undue burden” standard of dischargeability. The court held that the debtor’s two children were reasonably well shielded from the effects of the debtor’s liability for the student loan by virtue of the state court’s order that he pay $300 per month for the support of the children. In addition, the court found that the debtor’s former wife was not dependent on the debtor.

Therefore, the only question was whether the liability for the student loan would impose an undue hardship on the debtor. The court, recognizing that this was a “close case,” held that the monthly payment of $50 per month toward paying off the student loan would not cause an undue burden on the debtor. The court held that the debtor’s liability for the student loan was not dischargeable in bankruptcy.

His attempt to have the loan discharged was an unethical example of cheating. In re Doyle, 106 B.R. 272, 1989 Bankr.Lexis 1772 (Bk.N.D.Ala.).

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Chapter 14 Entrepreneurship and Small Business

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 stands 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 Professor Cheeseman’s 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 Twenty First 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

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of the partnership and yet is also a principal. Agency law dominates as the foundation of partnership law.

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, 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. Where 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. Topic Outline Law for Business Organizations Types of Organization Partnership

Common Law Contract and Agency

Corporation

Contracts and Agency

Statutory Law Uniform Partnership Act (UPA) Model Business Corp. Act (MBCA)

Advantages of a Sole Proprietorship (1 of 2) – owner is the business ❖ The ease and low cost of formation ❖ The owner’s right to make all management decisions concerning the business ❖ Including those involving hiring and firing employees ❖ The sole proprietor owns all of the business and has the right to receive all of the business’s profits

Advantages of a Sole Proprietorship (2 of 2) ❖ A sole proprietorship can be easily transferred or sold if and when the owner desires to do so ❖ No other approval (such as from partners or shareholders) is necessary

Personal Liability of a Sole Proprietor (1 of 2) ❖ The sole proprietor bears the risk of loss of the business ❖ The owner will lose his or her entire capital contribution if the business fails ❖ The sole proprietor has unlimited personal liability

Personal Liability of a Sole Proprietor (2 of 2) ❖ Creditors may recover claims against the business from the sole proprietor’s personal assets ❖ The law holds that a sole proprietorship is not a distinct legal entity – it pays no taxes but earnings are reported as income on the sole proprietor’s personal income tax return ❖ The sole proprietorship and the sole proprietor are one and the same

General Partnership ❖ A voluntary association of two or more persons for carrying on a business as co-owners for profit ❖ Also called a partnership ❖ General partners, or partners are personally liable for the debts and obligations of the partnership

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Contemporary Environment: Uniform Partnership Act (UPA) ❖ Model act that codifies partnership law ❖ Most states have adopted the UPA in whole or part ❖ The UPA covers most problems that arise in the formation, operation, and dissolution of ordinary partnerships

Formation of a General Partnership - voluntary - person can be natural person, partnership, corporation and other association - very little formality - sharing of profits is prima facie evidence unless paid in lieu of certain other items - partnership agreement

Right to Participate in Management ❖ Unless otherwise agreed, each partner: - Has a right to participate in the management of the partnership, and - Has an equal vote on partnership matters ❖ Under the UPA, a simple majority decides most ordinary partnership matters

Right to an Accounting A formal judicial proceeding in which the court is authorized to: ❖ Review the partnership and the partners’ transactions; and ❖ Award each partner his or her share of the partnership assets

Right to Participate in Profits ❖ Profits are shared equally unless agreed to otherwise and losses are shared as profits unless otherwise agreed to. ❖ Voting is also usually equal unless otherwise agreed to.

Tort Liability of Partnerships and Partners ❖ The partnership is liable if the tortious act of a partner or an employee or agent of the partnership is committed while the person is acting within the ordinary course of partnership business or with the authority of his or her co-partners ❖ Usually joint and several liability

Joint and Several Tort Liability ❖ Partners are jointly and severally liable for tort liability of the partnership - i.e., 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

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Summary: Personal Liability of General Partners Issue Type of lawsuit Defendants

Joint Liability Contract action Plaintiff must name all partners as defendants Recovery If successful, the plaintiff can recover the judgment against all or any of the defendants Indemnification Partner who pays judgment can recover contribution from other partners for their share of the judgment

Joint and Several Liability Tort action Plaintiff can sue partners individually If successful, the plaintiff can recover the judgment against all or any of the named defendants Partner who pays judgment can recover contribution from other partners for their share of the judgment

Liability of Incoming Partners ❖ A new partner who is admitted to the partnership is liable for the existing debts and obligations (antecedent debts) of the partnership only to the extent of his or her capital contribution ❖ The new partner is personally liable for debts and obligations incurred by the partnership after becoming a partner

Dissolution of Partnerships (1 of 3) ❖ Partnership for a term ❖ A partnership for a fixed duration Partnership at will l ❖ A partnership with no fixed duration ❖ A partner has the power to withdraw and dissolve the partnership at any time, but he or she may not have the right to do so Dissolution of Partnerships (2 of 3) Wrongful dissolution ❖ When a partner withdraws from a partnership without having the right to do so at that time ❖ The partner is liable for damages caused by the wrongful dissolution of the partnership Notice of dissolution ❖ Notice of dissolution must be given to certain third parties ❖ The degree of notice depends on the relationship of the third person with the partnership

Dissolution of Partnerships (3 of 3) Continuation of a partnership after dissolution ❖ The surviving or remaining partners have the right to continue the partnership after dissolution Liability of outgoing partners ❖ The dissolution of a partnership does not itself discharge the liability of outgoing partners for existing partnership debts and obligations

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Distribution of Assets Upon Dissolution: 1) creditors (not partner-creditors) 2) creditor-partners 3) capital contributions 4) profits

Limited Partnership (Revised Uniform Limited Partnership Act) A type of partnership that has two types of partners: ❖ General Partners General Partners – who invest capital, manage the business, and are personally liable for partnership debts ❖ Limited Partners Limited Partners – who invest capital but do not participate in management and are not personally liable for partnership debts beyond their capital contribution

Summary: Liability of Limited Partners General Rule

Limited partners are not individually liable for the obligations or conduct of the partnership beyond the amount of their capital contribution.

Exceptions to the General Limited partners are individually liable for the debt, Rule obligations, and tortuous acts of the partnership in three situations: 1. Defective Formation 2. Participation in Management 3. Personal Guarantee

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

Distribution of Partnerships (winding up) 1) creditors 2) partners (a) unpaid distributions (b) capital contributions (c) remainder of proceeds

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Limited Liability Partnership (LLP) (1 of 4) ❖ A special form of partnership where all partners are limited partners and there are no general partners ❖ None of the partners is personally liable for the debts and obligations of the partnership beyond his or her capital contribution

Limited Liability Partnership (LLP) (3 of 4) ❖ The LLP is taxed as a partnership ❖ Each partner’s share of the income or loss from the partnership is reported on his or her individual income tax return ❖ The LLP is required to file an informational income tax return with the IRS ❖ LLPs are mainly used by professionals such as accountants and lawyers

Limited Liability Partnership (LLP) (4 of 4) ❖ Many state laws require LLPs to carry a minimum of $1 million of liability insurance that covers negligence, wrongful acts, and misconduct by partners or employees of the LLP ❖ This requirement guarantees that injured third parties will have compensation to recover for their injuries

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III. Text Materials Contemporary Environment: Entrepeneurs: The Founding of Facebook The success of Fcaebook is discussed.

Contemporary Environment: d.b.a.—Doing Business As This box discusses the concept of trade name.

Contemporary Environment: Right of Survivorship Partners own property as co-owners (tenants in partnership). Upon the death of a partner, the deceased partner’s property vests in the remaining partner or partners, not to his or her heirs or next of kin.

Contemporary Environment RULPA This was promulgated in 1976 and amended in 2001.

Contemporary Environment: Limited Liability Partnership (LLLP) General partners are not jointly and severally personally liable. Debts are the responsibility of the partnership.

See Law Case with Answer in Text.

Case 14.1: Vernon v. Schuster The Facts: Vernon hired Diversity to install a new boiler, which was done along with a 10- year warranty. Schuster, a sole proprietor owner of Diversity died within the 10-year warranty period.

Jerry inherited the business and ran it as a sole proprietorship. The boiler broke (without possible repair) within the warranty period. Jerry refused to honor the warranty. Upon suit by Vernon for replacement costs, the trial court dismissed but the appellate court reinstated.

Issue: Is Jerry liable for the warranty made by his father?

Decision/Remedy: No. Supreme Court of Illinois reversed the decision of the appellant court.

Reason: There is generally no continuity of existence because of the death of a sole proprietor.

Additionally, a sole proprietorship has no legal identity separate from the owner even if it is doing business under a fictitious name. Jerry’s business was basically a new sole proprietorship Case 14.2: Zuckerman v. Antenucci The Facts: Pena and Antenucci were doctors and partners in a medical practice who both treated Zuckerman during her pregnancy. Son was born with severe physical problems. In a malpractice suit against both doctors, the jury found only Pena guilty with a $4 million verdict and a corresponding judgment was entered. The plaintiffs filed a post trial motion for judgment against both defendants.

Issue: Is Antenucci jointly and severally liable for the medical malpractice of his partner?

Decision/Remedy: Yes. The Supreme Court reversed the decision of the trial courts and held Antenucci jointly liable.

Reason: When a partner commits a tort, the partnership is liable, and the wrong is imputable to all the partners jointly and severally.

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IV. Answers to Legal Environment Fiduciary Duty 14.1. Yes, the partnership, Husted and Husted, is liable to the estate for the conversion by Edgar Husted of the estate’s funds. Under the Uniform Partnership Act, a partner is jointly and severally liable for the tortious conduct of another partner committed within the ordinary course of partnership business. The court held that Edgar Husted was acting within his apparent authority when he took the estate’s check and misappropriated it. The partnership is liable for this tortious act, as are the partners of the partnership. The court awarded compensatory and punitive damages to the estate. Husted v. McCloud, 436 N.E.2d 341, 1982 Ind.App. Lexis 1244 (Ind.App.).

Tort Liability 14.2. McGrath is liable. 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.

Torbenson, Thatcher, McGrath, Treadwell & Schoonmaker, 749 P.2d 178, 1988 Wash.App. Lexis 27 (Wash.App.).

Liability of General Partners 14.3. The partnership assets are subject to the claims of the unpaid suppliers. Under limited partnership law, a partnership is bound by a general partner’s wrongful acts, and the general partners are jointly and severally liable for everything chargeable to the partnership. The court held that Somers and Robertson had charged McGowan and his company, Advance, with the responsibility of developing Vermont Place, and effectively made McGowan and Advance their agents. The partnership agreement provided that the purpose of the partnership was to acquire real estate and construct duplexes for lease or sale. In furtherance of this purpose, the partners agreed that McGowan and Advance would supervise the construction of the duplexes.

When McGowan acquired labor and materials and then failed to pay for them, he was acting within his authority as a partner and agent of the partnership and thereby bound the other two general partners. McGowan and Advance are liable for their acts. In addition, the court held that Somers and Robertson, as general partners of the limited partnership, were jointly and severally liable for the partnership debts owed to the unpaid suppliers. Because of their limited liability, none of the limited partners are liable for the debts of the partnership.

National Lumber Company v. Advance Development Corporation, 732 S.W.2d 840, 1987 Ark. Lexis 225 (Ark.).

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Liability of Limited Partners 14.4. No, the limited partners of USANL are not individually liable for the alleged breach of contract by the limited partnership. Partnership law stipulates that only general partners are individually liable for the debts of a limited partnership. Limited partners are not individually liable unless they take part in the management of the partnership or personally guarantee the performance of the partnership. The court held that in this case the limited partners did not take part in the management or control of the limited partnership, nor had they personally guaranteed the performance of the lease with the NRPA. Only the limited partnership and its general partners may be held liable to the NRPA. Note, however, that the limited partners may lose their capital contribution that they have made to the limited partnership. National Railroad Passenger Association v. Union Station Associates of New London, 643 F.Supp.

192, 1986 U.S. Dist. Lexis 22190 (D.D.C.).

Liability of Limited Partners 14.5. No, the recently added limited partners are not individually liable for the debts of the limited partnership that were allegedly owed to Sloate and Bear Stearns. Generally, partnership law provides that if there is a substantial defect in the formation of a limited partnership, the partnership is a general partnership and the purported limited partners are individually liable as general partners. However, there is an exception to this rule. This exception provides that if a person who has contributed capital to a business conducted by a partnership erroneously believing that he has become a limited partner in a limited partnership, he is not bound by the obligations of the partnership if, upon ascertaining the mistake, he promptly renounces his interest in the profits of the business.

Although Brookwood was defectively formed as a limited partnership because it had failed to amend its certificate of limited partnership to reflect the addition of the new limited partners, the court held that these partners were not individually liable because (1) they erroneously believed that they were limited partners in a limited partnership and (2) upon receipt of the arbitration notice from Sloate and Bear Stearns they immediately renounced their interest in the profits of the Brookwood. Therefore, the court held that the newly added partners were not individually liable on the debts allegedly owed by Brookwood to Sloate and Bear Sterns.

8 Brookwood Fund v.Bear Stearns & Co., Inc., 539 N.Y.S. 2d 411, 1989 N.Y.App.Dist.

Lexis 4208 (N.Y.A.D.) Liability of Partners 14.6. 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 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 corporate limited partners. However, because all of these entities are corporations, Molander can only recover against the shareholders of these entities. That is, Molander, 165 ..

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cannot recover against Calvin Raugust’s, 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 ignorance as to corporate and partnership liability. Subjective expectations or post disaster 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, eh 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 (Wash.App.).

V. Answers to Business Ethics Cases 14.7 If Peterson was hiding his interests he was not acting ethically. He personally guaranteed payment if Meteor did not pay. Chrysler should probably be able to recover against Peterson’s limited partnership interests.

14.8. 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 apprising itself of he assert4ed 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. Dwinell’s Central Neon v. Cosmopolitan Chinook Hotel, 587 P.2d 191, 1978 Wash.App. Lexis 2735 (Wash.App.).

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Chapter 15 LLCs, LLPs, and Global Forms of Business

What is the Commotion about LLC’s?

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. Topic Outline Limited Liability Company (LLC) (1 of 3) ❖ An incorporated business entity that combines the most favorable attributes of general partnerships, limited partnerships, and corporations ❖ An LLC may elect to be taxed as a partnership ❖ The owners can manage the business ❖ The owners have limited liability

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Limited Liability Company (LLC) (2 of 3) ❖ Limited liability companies are creatures of state law, not federal law ❖ Limited liability companies can only be created pursuant to the laws of the state in which the LLC is being organized ❖ Limited liability company codes regulate the formation, operation, and dissolution of LLCs

Limited Liability Company (LLC) (3 of 3) Legal Entity – An LLC is a separate legal entity (an artificial person) that can: ❖ Own property ❖ Sue and be sued ❖ Enter into and enforce contracts ❖ Be found civilly and criminally liable for violations of law

Contemporary Environment: The Uniform Limited Liability Company Act (ULLCA) ❖ A model act that provides comprehensive and uniform laws for the formation, operation, and dissolution of LLCs ❖ The ULLCA is not law unless a state adopts it as its LLC statute ❖ Many states have adopted all or part of the ULLCA as their limited liability company law ❖ Revised in 2006

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Members’ Limited Liability Member – an owner of an LLC ❖ Members have limited liability ❖ Members are liable for the LLC’s debts, obligations, and liabilities only to the extent of their capital contributions ❖ The debts, obligations, and liabilities of an LLC are solely those of the LLC ❖ A member is personally liable if he or she personally guarantees repayment of the debts of the LLC Liability of Managers Managers of LLCs are not personally liable for the debts, obligations, and liabilities of the LLC they manage [ULLCA § 303(a)]

Liability of an LLC ❖ Loss or injury from an act or omission of (within course of business or with authority of LLC)

o o o o

Member Agent Manager Employee

❖ Managers not personally liable for debts of LLC ❖ Tortfeasors (members and managers included) liable for injuries personally caused

Taxation of LLC ❖ Taxed as a partnership unless it elects to be taxed as a corporation ❖ Avoids double taxation

Powers of an LLC An LLC has the same powers as an individual to do all things necessary or convenient to carry on its business or affairs: ❖ The power to own and transfer personal property ❖ Sell, lease and mortgage real property ❖ Make contracts and guarantees ❖ Borrow and lend money ❖ Issue notes and bonds ❖ Sue and be sued

Formation of an LLC ❖ Most LLCs are organized to operate businesses and real estate developments ❖ An LLC can be organized in only one state even though it can conduct business in all other states ❖ The name selected must meet the requirements of the LLC codes of the states that are under consideration

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Articles of Organization ❖ An LLC is formed by delivering articles of organization to the office of the secretary of state of the state of organization for filing ❖ The existence of an LLC begins when the articles of organization are filed ❖ The filing of the articles of organization by the secretary of state is conclusive proof that an LLC has been created

Duration ❖ At Will LLC – An LLC that has no specified term of duration ❖ Term LLC – An LLC that has a specified term of duration

Capital Contribution ❖ Member’s Capital Contribution – may be money, tangible or intangible property, services performed or promised to be performed, promissory notes, or other agreements to provide case or property ❖ A member’s obligation to contribute capital is not excused by the member’s death, disability, or other inability to perform

Certificate of Interest ❖ Document that evidences a member’s ownership interest in an LLC ❖ Acts the same was as a stock certificate issued by a corporation

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 ❖ The operating agreement may be amended by the approval of all the members unless otherwise provided in the agreement

Conversion of an Existing Business to an LLC (1 of 2) ❖ Some existing businesses (i.e., general partnerships, limited partnerships, and corporations) may want to convert to an LLC ❖ Want to obtain the tax benefits and limited liability shield of an LLC ❖ The law permits such conversions

Conversion of an Existing Business to an LLC (2 of 2) Agreement of Conversion – Document that states the terms for converting an existing business to an LLC ❖ The conversion takes effect when the articles of organization are filed with the secretary of state or at any later date specified in the articles of organization

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Dividing an LLC’s Profits and Losses ❖ Unless otherwise agreed, the ULLCA mandates that a member has the right to an equal share in the LLC’s profits [ULLCA § 405(a)] ❖ This is a default rule that members can override by agreement and is usually a provision in their operating agreement

Distributional Interest ❖ A member’s ownership interest in an LLC that entitles the member to receive distributions of money and property from the LLC ❖ A transferee of a distributional interest in an LLC receives the right to receive profit and other distributions of the LLC

Member-Managed LLC ❖ In a member-managed LLC, all members can bind the LLC to authorized contracts ❖ Each member has equal rights in the management of the business irrespective of the size of his or her capital contribution ❖ Any matter relating to the business of the LLC is decided by a majority vote of the members

Manager-Managed LLC ❖ In a manager-managed LLC, only the managers can bind the LLC to authorized contracts ❖ The members and non-members who are designated managers control the management of the LLC ❖ The members who are not managers have no rights to manage the LLC unless otherwise provided for in the operating agreement

Compensation and Reimbursement ❖ A non-manager member is not entitled to remuneration for services performed for the LLC (except for winding-up the LLC) ❖ Managers of an LLC are paid compensation and benefits as specified in their employment agreements with the LLC ❖ An LLC is obligated to reimburse members and managers for payments made on behalf of the LLC

Duty of Loyalty Owed to LLC(1 of 2) ❖ A duty owed by a member of a member-managed LLC and a Manager-managed LLC to be honest in his or her dealings with the LLC and not to act adversely to the interests of the LLC

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Duty of Loyalty Owed to LLC (2 of 2) Breaches of the duty of loyalty by a covered member or manager include: 1. Usurping an LLC opportunity 2. Making secret profits 3. Secretly dealing with the LLC 4. Secretly competing with the LLC 5. Representing any interest adverse to that of the LLC

❖ Nonmanager member of a manager-managed LLC owes no fiduciary duty to the LLC

Limited Duty of Care Owed to LLC (1 of 2) ❖ A duty owed by a member of a member-managed LLC and a manager of managermanaged LLC to not engage in conduct that injures the LLC:

o o o o

A known violation of law Intentional conduct Reckless conduct Grossly negligent conduct

Limited Duty of Care Owed to LLC (2 of 2) ❖ A member or manager of an LLC is not liable to the LLC for injuries caused to the LLC by his or her ordinary negligence ❖ The ordinarily negligent member or manager, and the LLC on whose behalf ❖ the member or manager was acting when the negligent act occurred, are liable to ❖ the injured third party

No Fiduciary Duty Owed by a Nonmanager Member ❖ A non-manager member of a managed LLC owes no fiduciary duties of loyalty, care, or good faith and fair dealing to the LLC or its members ❖ Basically, a non-manager member of a manager-managed LLC is treated equally to a shareholder in a corporation

Dissolution of an LLC ❖ The ULLCA gives a member of an LLC the power to disassociate him- or herself from the LLC ❖ This could cause the dissolution of the LLC ❖ A member who wrongfully disassociates from an LLC is liable to the LLC and to the other members for any damages caused by his or her wrongful disassociation ❖ Wrongful dissociation can give rise to damages ❖ Statement of disassociation can give constructive notice if filed ❖ LLC can be continued:

o Unanimous vote prior to expiration o Majority vote at will LLC

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Winding-Up an LLC’s Business ❖ The process of preserving and selling the assets of the LLC and distributing the money and property to creditors and members ❖ Creditors are paid first ❖ Thereafter, surplus amounts are distributed to members in equal amounts ❖ unless the operating agreement provides otherwise

Articles of Termination ❖ Document that is filed with the secretary of state (of the state in which the LLC is organized) that terminates the LLC as of the date of filing or upon a later effective date specified in the document

Limited Liability Partnership (LLP) 1) All partners are limited (no general partners) 2) Often restricted to professionals 3) “Flow-through” taxation

Franchising ❖ Franchising is an important method of distributing goods and services to the public ❖ In the United States, franchising accounts for over 25 percent of retail sales and 15 percent of gross domestic product (GDP)

❖ Joint Ventures – allow 2 or more businesses to combine their resources to pursue a single project ❖ Licensing – permits one business to use another business’s intellectual property in selling goods or services

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 goods and services ❖ Generally, the franchisor and the franchisee are established as separate corporations

Advantages to Franchising 1. The franchisor can reach lucrative new markets 2. The franchisee has access to the franchisor’s knowledge and resources while running an independent business 3. Consumers are assured of uniform product quality

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Types of Franchises (1 of 4) Distributorship Franchise The franchisor manufactures a product and licenses a retail franchisee to distribute the product to the public ❖ e.g., the Ford Motor Company manufactures automobiles and franchises independently owned ❖ dealers to sell them to the public

Types of Franchises (2 of 4) Processing Plant Franchise ❖ The franchisor provides a secret formula or process to the franchisee ❖ The franchisee manufactures the product and distributes it to retail dealers ❖ e.g., the Coca-Cola Corporation licenses regional bottling companies to manufacture and distribute soft drinks under the “Coca-Cola” and other brand names

Types of Franchises (3 of 4) 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 ❖ Most fast-food franchises use this form ❖ e.g., the Pizza Hut Corporation franchises ❖ independently owned restaurant franchises to make and sell pizzas to the public under the “Pizza Hut” name

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Types of Franchises (4 of 4) Area Franchise ❖ The franchisor grants the franchisee a franchise for an agreed-upon geographical area ❖ The franchise may determine where to locate the outlets in the designated area ❖ An area franchisee may be granted the authority to negotiate and sell franchises in the designated area on behalf of the franchisor ❖ Franchisee is also called the subfranchisor

State Disclosure Laws ❖ Many states have enacted statutes that require franchisors to make specific presale disclosures to prospective franchisee ❖ Some states use a uniform disclosure statement called the Uniform Franchise Offering Circular (UFOC)

Federal Trade Commission’s (FTC) Rule ❖ The FTC requires franchisors to make presale disclosures to prospective franchisees ❖ The franchisor must disclose assumptions underlying any estimates and hypothetical data ❖ The franchisor must provide a mandated precautionary statement ❖ Special disclosure required if: o Projections made based on actual figures of an existing merchandise o Projections based on hypothetical

Intellectually Property Issues ❖ Registration of trademarks and service marks under Landham Trademark Act ❖ Unauthorized use equals trademark infringement ❖ Misappropriation of trade secret is unfair competition

Franchise Agreement An agreement that the franchisor and the franchisee enter into that sets forth the terms and conditions of the franchise: ❖ Quality control standards ❖ Training requirements ❖ Covenant not to compete ❖ Arbitration clause ❖ Use of franchisor’s trade name, logo, and trademark ❖ Conditions for the termination of the franchise

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Franchise Fees Franchise fees payable by the franchise are usually stipulated in the franchise agreement: ❖ Initial license fee ❖ Royalty fee ❖ Assessment fee ❖ Lease fee ❖ Cost of supplies

Breach of the Franchise Agreement ❖ A lawful franchise agreement is an enforceable contract ❖ Each party owes a duty to adhere to and perform under the terms of the franchise agreement ❖ If the agreement is breached, the aggrieved party can sue the breaching party for rescission of the agreement, restitution, and damages

Trademarks ❖ A franchisor licenses the use of its trademarks and service marks to its franchisees in the franchise agreement ❖ Anyone who uses a mark without authorization from the franchisor may be sued for trademark infringement ❖ The franchisor can recover damages and obtain an injunction prohibiting further unauthorized use of the mark

Misappropriation of Trade Secrets ❖ Anyone who steals and uses a franchisor’s trade secret is liable for misappropriation of a trade secret ❖ The franchisor can recover damages and obtain an injunction prohibiting further unauthorized use of the trade secret

Contract and Tort Liability ❖ Franchisors and franchisees are liable for their own contracts ❖ Franchisors and franchisees are liable for their own tort liability ❖ e.g., if a person is injured by a franchisee’s negligence, the franchisee is liable

Independent Contractor Status ❖ If properly organized and operated, the franchisor and franchisee are separate legal entities ❖ The franchisor deals with the franchisee as an independent contractor ❖ A franchisee is not the agent of the franchisor ❖ The franchisor is not liable for the franchisee’s contracts and torts

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Actual Agency ❖ An arrangement that occurs where a franchisor expressly or implicitly by its conduct makes a franchisee its agent ❖ The franchisor is liable for the contracts entered into and torts committed by the franchisee while acting within the scope of its agency

Apparent Agency ❖ Agency that arises when a franchisor creates the appearance that a franchisee is its agent when in fact an actual agency does not exist ❖ The franchisor is liable for the contracts entered into and torts committed by the franchisee acting as an apparent agent Termination “For Cause” ❖ A franchisor can terminate a franchise agreement for “just cause” o e.g., nonpayment of franchise fees by the franchisee o e.g., continued failure to meet quality control standards

Termination at Will ❖ Most state and federal laws regarding franchising prohibit franchisors from terminating the franchises at will ❖ Prevents a franchisor from taking advantage of the good will developed at the franchise location by the franchisee

Wrongful Termination ❖ If a franchisor terminates a franchise agreement without just cause, the franchisee can sue the franchisor for wrongful termination wrongful termination ❖ The franchisee can recover damages caused by the wrongful termination and recover the franchise

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III. Text Materials Case 15.1. Siva v.1138 LLC Facts: Siva entered into a written lease agreement to lease property in Siva’s building to 1138 LLC. They operated a bar but was in default and breach 6 months later. Siva sued for damages but 1138 LLC had no money. Siva also sued Richard Hess, a member. Hess argued no personal liability. The trial court agreed and Siva appealed.

Issue: Is Hess, a member of 1138 LLC, personally liable for the debt owed by the LLC to Siva?

Decision: No. Reason: The LLC was not purposely undercapitalized nor was it formed to avoid paying creditors. The bar lost money. There was not a purpose to defraud creditors. Siva knew that the deal was with an LLC. Contemporary Environment: Accounting Firms Operate as LLP’s Once LLPs were permitted by law, all of the Big Five accounting firms changed their status from general partnerships to LLPs.

Case 15.2: Cislaw v. Southland Corp.

Facts: Timothy Cislaw, a 17 year old, died of respiratory failure on May 10, 1984. His parents filed a wrongful death action alleging Timothy’s death resulted from his use of Djarum Specials clove cigarettes sold at a Costa Mesa 7-Eleven store. Southland owns the 7-Eleven trademark and is the franchisor of California 7-Eleven stores. The Costa Mesa 7-Eleven was franchised to Charles Trujillo and Patricia Colwell-Trujillo. The complaint, seeking compensatory and punitive damages, stated causes of action for negligence, breach of implied and express warranty, product liability, and infliction of emotional distress.

The Cislaws relied solely on the franchise agreement, asserting it could be interpreted to demonstrate an employment or agency relationship. The trial court, asked to make a legal determination on uncontradicted facts, decided as a matter of law the Trujillos were independent contractors and granted Southland’s motion for summary judgment.

Issue: Was the Costa Mesa franchise an agent of Southland?

Decision: The Costa Mesa franchise was an independent contractor.

Reason: Sonenshire, J. The franchisor/franchisee arrangement does not create a principal/agent relationship unless the franchisor has the right to exercise substantial control over the operations of the franchisee. Although the franchise agreement gave Southland the right to establish the hours of operation of its franchises, to protect its “7-Eleven” trademark from misuse by the franchisee, and to set cleanliness and quality control standards at its franchises, the agreement did not give Southland the right to control the day-to-day operations of its Costa Mesa franchise. The court found that because the franchisee made all inventory, employment, and day-to-day operational decisions, it was an independent contractor.

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Case 15.3: Martin v. McDonald’s Corporation

Martin v. McDonald’s Corp.

Facts: This case arose from a murder and robbery that took place after closing hours at the McDonald’s restaurant in Oak Forest, Illinois, on November 29, 1979. On that evening, a sixwoman teenaged crew was working to clean up and close the restaurant. Laura Martin, Therese Dudek, and Maureen Kincaid were members of that crew. A person later identified as Peter Logan appeared in the back of the restaurant and ordered the crew into the refrigerator and the assistant manager, Therese Dudek, to open the safe and get him money. In the course of moving the crew into the refrigerator, Laura Martin was shot and killed, and Maureen Kincaid and Therese Dudek were assaulted by Logan. Laura Martin’s parents claimed damages from McDonald’s Corporation for the wrongful death of their daughter, and Therese Dudek and Maureen Kincaid claimed damages for the negligent infliction of emotional distress. The trial court awarded damages to all three victims, and McDonald’s Corporation appealed.

Issue: Is McDonalds liable for negligence?

Decision: McDonald’s was negligent for not making sure that security deficiencies it found at the Oak Forest franchise had been corrected.

Reason: McNulty, J. McDonald’s had voluntarily assumed a duty to the crew at the Oak Forest franchise by establishing and requiring the franchisee to implement certain security measures, and by obligating itself to inspect the restaurant to see that the required security measures were implemented. The court held that McDonald’s was liable for its own negligence due to the failure of security measures and the failure of its employee, Carlson, to follow up to determine that the security deficiencies at the Oak Forest franchise had been corrected.

International Law: International Franchising There is no question that international franchising has become the most visible form of economic cooperation around the world. Laws of other countries must, however, be considered.

See Law Case with Answer in the Text.

IV. Answers to Legal Environment Cases The first six questions in this section, unlike the material in other chapters, are not actual cases.

They cover various issues dealing with limited liability companies and would make great teaching tools.

Franchise Agreement 15.7. No, McDonald’s is not liable for breaching the franchise agreement with Libby-Broadway Drive-In, Inc. (Libby). When McDonald’s granted a franchise to a third party to operate a franchise restaurant on the west side of Turney Road, the franchise agreement granted Libby an exclusive territory in which the westernmost boundary was simply described as “Turney Road.” The court held that even assuming by this description the parties intended that Libby’s exclusive territory should extend to the western edge of Turney Road, it is undisputed that the new franchise is located to the west of that boundary. Therefore, the granting of this franchise did not infringe upon the exclusive territory granted to Libby in the franchise agreement. The court held that McDonald’s had not breached the franchise agreement, and affirmed the trial court’s grant of summary judgment in favor of McDonald’s. Libby-Broadway Drive-In, Inc. v. McDonald’s= System, Inc., 391 N.E.2d 1, 1979 Ill. App. Lexis 2698 (Ill.App.).

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Tort Liability 15.8. The trial court jury held the Seven-Up Company liable for the carton breaking and the Seven-Up bottle exploding, causing blindness in one of Sharon Koster’s eyes; the jury awarded her $150,000 in damages against Seven-Up. The law provides that a franchisor, like a manufacturer or supplier, may be liable to the consumer for its own negligence. Seven-Up alleged, however, that it could not be held liable for Koster’s injuries because it did not manufacture, handle, or require its franchisee, Brooks, to use the cartons manufactured by Olinkraft, Inc. The court rejected this argument, holding that a franchisor that retains the right to control the design of the product may be held liable for any injury that product may cause.

The court stated: In this case, the Seven-Up Company not only floated its franchisee and the bottles of its carbonated soft drink into the so-called “stream of commerce.” The Company also assumed and exercised a degree of control over the “type, style, size, and design” of the carton in which its product was to be marketed. The carton was submitted to Seven-Up for inspection.

With knowledge of its design, Seven-Up consented to the entry in commerce of the carton from which the bottle fell, causing the injury. The franchisor’s sponsorship, management, and control of the system for distributing 7-Up, plus its specific consent to the use of the carton, in our view, places the franchisor in the position of a supplier of the product for purposes of tort liability.

The court of appeals held that the case had been properly submitted to the jury based on the theory of breach of implied warranty. However, the court of appeals found that the trial court judge had given the jury an improper instruction regarding the doctrine of “inherently dangerous” products, and remanded the case for a new trial. Kosters v. Seven-Up Company, 595 F.2d 347, 1979 U.S. App. Lexis 15945 (6th Cir.).

V. Answers to Business Ethics Cases 15.9. Generally members are not liable for the debts (even from torts) of an LLC. He was probably improperly named as a defendant. This was also probably done to annoy Bone into paying.

15.10. KFC did not engage in an illegal tying agreement. In order to have an illegal tying agreement, there must be two separate products. KFC’s franchise is a distribution type where the franchisees simply serve as a conduit through which the special chicken is sold. The desirability of the franchise depends on the quality of the product being sold. Here, the KFC Seasonings are so closely related to the franchise itself, that they cannot be considered two separate products, so there can be no tying. KFC Corporation v. Marion-Kay Company, Inc., 620 F. Supp. 1160, 1985 U.S. Dist. Lexis 14766 (S.D. Ind. 1985.

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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 with 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 182 ..

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closely held corporation. Blacks 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 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.

Sarbanes-Oxley Act of 2002: 1) new rules for governance of corporations 2) more disclosures from corporations 3) restricts conflicts of interest 4) stricter penalties

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II. Topic Outline A Corporation is a separate legal entity.

Characteristics of Corporation 1. Limited Liability of Shareholders 2. Free Transferability of Shares 3. Perpetual Existence 4. Centralized Management

Classifications of Corporations (1 of 3) Profit Corporation ❖ A corporation created to conduct a business for profit ❖ Can distribute profits to shareholders in the form of dividends Nonprofit Corporation ❖ A corporation that is formed to operate charitable institutions, colleges, universities, and other not-for-profit entities

Classifications of Corporations (2 of 3) Public Corporation ❖ A corporation formed to meet a specific governmental or political purpose Private Corporation ❖ A corporation formed to conduct privately owned business Professional Corporation ❖ A corporation formed by lawyers, doctors, or other professionals Parent Corporation + Owns the controlling interest in a subsidiary corporation Subsidiary Corporation + Controlling interest is owned by another company

Classifications of Corporations (3 of 3) Publicly Held Corporation ❖ A corporation that has many shareholders ❖ It’s securities are often traded on national stock exchanges Closely Held Corporation ❖ A corporation owned by one or a few shareholders

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Types of Corporations Type of Corporation Domestic Foreign Alien

Description A corporation is a domestic corporation in the state in which it is incorporated A corporation is a foreign corporation in states other than the one in which it is incorporated A corporation is an alien corporation in the United States if it is incorporated in another country

Multinational Corporations: 1) operates in 2 or more countries 2) often uses a branch which is not a separate legal entity

Article of Incorporation include: 1) Name 2) # of shares authorized 3) Address and name of registered agent 4) Name and address of incorporators 5) Others

Financing the Corporation A corporation needs to finance the operation of its business: ❖ Equity securities (or stocks) – represent ownership rights in the corporation ❖ Debt securities – establish a debtor-creditor relationship in which the corporation borrows money from the investor to whom the debt security is issued

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 preferences over another class of preferred stock ❖ Preferred shareholders have limited liability

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Preferences: ❖ Dividends ❖ Liquidation ❖ Cumulative ❖ Profits ❖ Conversion

Types of Shares Type of Share Authorized Issued Treasury Outstanding

Description Shares authorized in the corporation’s articles of incorporation Shares sold by the corporation Shares repurchased by the corporation. They do have the right to vote.

Shares of stock that are in shareholder hands. These shares have the right to vote.

Debt Securities ❖ Debenture– A long-term unsecured debt instrument that is based on the corporation’s general credit standing ❖ Bond– A long-term debt security that is secured by some form of collateral ❖ Note– A debt security with a maturity of five years or less ❖ Terms are found in an indenture agreement.

Shareholders (1 of 2) ❖ A corporation’s shareholders own the corporation ❖ Shareholders are not agents of the corporation ❖ They cannot bind the corporation to contracts

Shareholders (2 of 2) Shareholders have 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’ Meeting – Meeting of the shareholders of a corporation that must be held annually by the corporation to elect directors and vote on other matters ❖ Shareholders do not have to attend the shareholders’ meeting to vote ❖ Shareholders may vote by proxy

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Voting Requirements ❖ At least one class of shares of the corporation must have voting rights ❖ Record date ❖ Quorum ❖ Straight voting ❖ Cumulative voting ❖ Supramajority voting requirement

Voting Agreements Voting Trusts ❖ The shareholders transfer their stock certificates to a trustee who is empowered to vote the shares ❖ Agreement must be in writing and cannot exceed 10 years ❖ Agreement must be filed with the corporation Shareholder Voting Agreements ❖ Agreement between two or more shareholders agreeing on how they will vote their shares ❖ These agreements are not limited in duration and do not have to be filed with the corporation

Transfer of Shares ❖ Generally, shareholders have the right to transfer their shares ❖ Article 8 of the UCC governs transfer of securities ❖ Usually, shares are transferred by indorsement and delivery of the shares to the new owner

Transfer Restrictions on Securities Shareholders may enter into agreements with one another to prevent unwanted persons from becoming owners of the corporation: ❖ Right of First Refusal Right of First Refusal ❖ Buy Buy-and and-Sell Agreement

Preemptive Rights ❖ Rights that give existing shareholders the option of subscribing to new shares being issued in proportion to their current ownership interests ❖ Such a purchase can prevent a shareholder’s interest in the corporation from being diluted

Right to Receive Information and Inspect Books and Records ❖ Shareholders have the right to be informed about the affairs of the corporation ❖ A corporation must furnish its shareholders with an annual financial statement ❖ Right of Inspection – A right that shareholders have to inspect the books and records of the corporation

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Dividends ❖ Dividends are not automatically paid to shareholders ❖ Dividends are paid at the discretion of the board of directors ❖ Record date – a date that determines whether a shareholder receives payment of a declared dividend ❖ Stock dividend – additional shares of stock paid as a dividend

Derivative Lawsuit ❖ A lawsuit a shareholder brings against an offending party when the corporation fails ❖ to bring the lawsuit ❖ A derivative lawsuit will be dismissed by the court if either a majority of independent directors or a panel of independent persons appointed by the court determines that the lawsuit is not in the best interests of the corporation

Liability of Shareholders ❖ Shareholders of a corporation generally have limited liability limited liability ❖ Liability that shareholders have only to the extent of their capital contribution ❖ Shareholders are generally not personally liable for the debts and obligations of the corporation

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: o Disregard the corporate entity, and o Hold the shareholder personally liable for the corporation’s debts and obligations

Express Powers of a Corporation ❖ A corporation has the same basic rights to perform acts and enter into contracts as a physical person ❖ A corporation’s express powers are found in: o (1) the U.S. Constitution, (2) state constitutions, (3) federal statutes, (4) state statutes, (5) articles of incorporation, (6) bylaws, and (7) resolutions of the board of directors ❖ Generally, a corporation has the power to: o Purchase, own, lease, sell, mortgage, or otherwise deal in real and personal property o Make contracts o Lend and borrow money o Incur liabilities o Issue notes, bonds, and other obligations o Invest and reinvest funds o Sue and be sued in its corporate name

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Implied Powers of a Corporation Powers beyond express powers that allow a corporation to accomplish its corporate purpose: ❖ e.g., a corporation has the implied power to open a bank account ❖ e.g., a corporation has the implied power to reimburse its employees for expenses

Ultra Vires Act ❖ An act by a corporation that is beyond its express or implied powers ❖ Shareholders can sue for an injunction to prevent the corporation from engaging in the act ❖ The corporation can sue the officers or directors who caused the act for damages ❖ The attorney general of the state of incorporation can sue to enjoin the act

Proxy Solicitation ❖ Corporate shareholders have the right to vote on the election of directors, mergers, and charter amendments ❖ They can exercise their power to vote either in person or by proxy ❖ Proxy Card – a written document signed by a shareholder that authorizes another person to vote the shareholder’s shares ❖ Can be used for voting for mergers, directors, charter amendments, etc.

Board of Directors ❖ A panel of decision makers elected by the shareholders ❖ The directors of a corporation are responsible for formulating the policy decisions affecting the corporation ❖ The board may initiate certain actions that require shareholders’ approval

Selecting Directors ❖ Inside Director – a member of the board of directors who is also an officer of the corporation ❖ Outside Director – a member of the board of directors who is not an officer of the corporation ❖ Term of Office – the term of a director’s office expires at the next annual shareholders’ meeting following his or her election unless terms are staggered

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Meetings of the Board of Directors (1 of 2) ❖ The directors can only act as a board ❖ They cannot act individually on the corporation’s behalf ❖ Every director has the right to participate in any meeting of the board of directors ❖ Each director has one vote ❖ Directors cannot vote by proxy

Meetings of the Board of Directors (2 of 2) ❖ Regular Meeting o A meeting held by the board of directors at the time and place established by the bylaws ❖ Special Meeting o A meeting convened by the board of directors to discuss new shares, merger proposals, etc. ❖ Quorum o The number of directors necessary to hold a board of directors’ meeting or transact business of the board

Committees of the Board of Directors ❖ The board of directors may create committees of the board and delegate certain powers to those committees ❖ All members of these committees must be directors ❖ An act of a committee pursuant to delegated authority is the act of the board of directors

Corporate Officers ❖ Officers – employees of the corporation who are appointed by the board of directors to manage the day-to-day operations of the corporation ❖ Agency Authority of Officers – officers and agents of the corporation have such authority as may be provided in the bylaws of the corporation or as determined by the resolution of the board of directors o Express authority o Implied authority o Apparent authority

Duty of Obedience (1 of 2) A duty that directors and officers of a corporation have to act within the authority conferred upon them by: ❖ The state corporation statute ❖ The articles of incorporation ❖ The corporate bylaws ❖ The resolutions adopted by the board of directors

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Duty of Obedience (2 of 2) ❖ Directors and officers who either intentionally or negligently act outside their authority are personally liable for any resultant damages caused to the corporation or its shareholders

Duty of Care ❖ Duty of Care o A duty that corporate directors and officers have to use care and diligence when acting on behalf of the corporation ❖ Negligence o Failure of a corporate director or officer to exercise the duty of care while conducting the corporation’s business ❖ Business Judgment Rule o Directors and officers are not liable to the corporation or its shareholders for honest mistakes of judgment ❖ Reliance on Others o Corporate directors and officers may rely on information and reports prepared by competent and reliable officers and employees, lawyers, accountants, other professionals, and committees of the board of directors

Duty of Loyalty (1 of 2) 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 ❖ Breach of the duty of loyalty usually occurs because of intentional conduct

Duty of Loyalty (2 of 2) Breaches of the duty of loyalty include unauthorized: 1. Self-dealing with the corporation 2. Usurping of a corporate opportunity 3. Competing with the corporation 4. Making a secret profit that belongs to the corporation

Liability for Crimes Liability of Directors and Officers ❖ Corporate directors and officers are personally liable for the crimes they commit while acting on behalf of the corporation ❖ Criminal sanctions include fines and imprisonment Liability of the Corporation ❖ Under the law of agency, corporations are liable for the crimes committed by its directors and officers while acting within the scope of their authority ❖ Criminal sanctions include monetary fines and loss of legal privileges

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Sarbanes-Oxley Act (2002) Federal statute enacted by Congress to: ❖ Improve corporate governance rules ❖ Establish independence between public accounting firms and the public companies they audit ❖ Eliminate conflicts of interest ❖ Auditing and accounting rules ❖ Corporate governance rules

Merger ❖ Occurs when one corporation is absorbed into another corporation and ceases to exist ❖ The surviving corporation gains all the rights, privileges, powers, duties, obligations, and liabilities of the merged corporation ❖ The shareholders of the merged corporation receive stock or securities of the surviving corporation as provided in the plan of merger

Consolidation ❖ Occurs when two or more corporations combine to form an entirely new corporation ❖ The new corporation is called the consolidated corporation ❖ The articles of incorporation of the new corporation replace the articles of the incorporation of the component corporations

Share Exchange ❖ When one corporation acquires all the shares of another corporation ❖ Both corporations retain their separate legal existence ❖ After the exchange, one corporation (parent corporation) owns all of the shares of the other corporation (subsidiary corporation) ❖ Often used to create holding companies

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Tender Offer ❖ An offer that an acquirer makes directly to a target corporation’s shareholders in an effort to acquire the target corporation ❖ The tender offeror’s board of directors must approve the offer o The shareholders do not have to approve ❖ The tendering corporation and the target corporation retain their separate legal status

Defensive Strategies and Tactics Against Hostile Tender Offers ❖ Persuasion of shareholders ❖ Delaying lawsuits ❖ Selling a crown jewel ❖ Adopting a poison pill ❖ White knight merger ❖ Pac-Man (or reverse) tender offer ❖ Issuing additional stock ❖ Creating an Employee Stock Ownership Plan (ESOP) ❖ Flip-over and Flip-in rights plans ❖ Greenmail and Standstill Agreements

Business Judgment Rule ❖ A rule that protects the decisions of the board of directors, who act on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the corporation and the shareholders ❖ In the context of a tender offer, the defensive measures chosen by the board must be reasonable in relation to the threat posed

State Antitakeover Statutes ❖ Statutes enacted by state legislatures that are aimed at protecting corporations that are either incorporated in or doing business within the state from hostile takeovers ❖ Many of these statutes have been challenged as unconstitutional because they violate the Williams Act and the Commerce and Supremacy clauses of the U.S. Constitution

Dissolution and Termination of Corporations The methods for dissolving and terminating corporations include: ❖ Voluntary Dissolution ❖ Administrative Dissolution ❖ Judicial Dissolution

Winding-up and Liquidation The process by which a dissolved corporation’s assets are collected, liquidated, and distributed to: ❖ Creditors ❖ Shareholders ❖ Other claimants

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Termination The ending of a corporation that occurs only after the: ❖ Winding-up of the corporation’s affairs ❖ Liquidation of its assets ❖ Distribution of the proceeds to the claimants

III. Text Materials Contemporary Environment: Revised Model Business Corporation Act Revised in 1984. Many states have adopted all or part.

Contemporary Environment: S Corporation This sets out the basic parameters under which the Sub-S rules of the Internal Revenue Code can be used to avoid double taxation by relatively small closely held corporations.

Contemporary Environment: Delaware and Nevada Corporation Laws These are the two states most often chosen. Advantages are discussed.

Contemporary Trend: Agreements Restricting the Transfer of Shares This box discusses the right of first refusal and buy-and-sell agreements.

Contemporary Environment: Straight Versus Cumulative Voting 2 different voting procedures are discussed.

Law Case with Answer: Smith v. Van Gorkom Facts: After a meeting with Jay A. Pritzker, Van Gorkom, acting as chairman of the board, proposed to his fellow directors that they accept a cash out merger offer by Pritzker, and that they not solicit other offers. Although none of the directors including Van Gorkom had actually read the merger agreement, they voted to accept the Pritzker offer after listening to a twenty-minute presentation by Van Gorkom.

Issue: Did Trans Union’s directors breach their duty of care?

Decision: Yes. Reason: A corporate director is protected by the business judgment rule only if he acted (1) on an informed basis, (2) in good faith, and (3) in the honest belief that the action taken was in the best interest of the corporation. Here, all of the directors breached their duty of care by not acting on an informed basis, i.e., by not reading the merger agreement they have neglected the shareholders’ interest. An ordinary person in the position of a director would have insisted upon a copy of the agreement and time to read it prior to voting.

Internet Law & Online Commerce: Google Takes Over YouTube This combination is discussed.

Case 16.1: Northeast Iowa Ethanol,LLC v. Drizin Facts: Local farmers decided to buld an Ethanol plant. They invested $2,365,000. They formed Northeast Iowa to hold the money and develop. William invested $1,000,000 and North Central invested $500,000. All money was placed in escrow and financing was needed for another $20,000,000. Drizin formed GSI to raise the financing. He had $250 capital. Drizin got investors but commingled funds with his own and orcgestrated a process where all the funds were

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stolen (mostly worthless investments). Northeast sued Drizin for civil fraud. Drizin argued GSI was liable but not him. Northeast argued that the corporate veil should be pierced.

Issue: Does the doctrine of piercing the corporate veil apply in this case?

Decision: Yes. Plaintiff was awarded $3,800,000 in compensatory damages and $7,600,000 in punitive damage against Drizin.

Reason: The corporate veil may be pierced in exceptional circumstances. In Iowa this might include undercapitalization, lack of separate books, commingling of funds, and promotion of fraud. Here there was undercapitalization and lack of separateness. The corporate veil could be pierced.

Internet & Technology: Corporate Codes Recognize Electronic Communications Most states allow electronic communications to shareholders and among directors.

IV. Answers to Legal Environment Limited Liability of Shareholders 16.1. No, the shareholders of USM cannot be held personally liable for the suit against the corporation. One of the most important features of a corporation is the limited liability of its shareholders. As separate legal entities, corporations are liable for their own contracts, debts, and torts. In a publicly held corporation shareholders are normally not responsible for a corporation’s debts, torts, claims, or contracts. USM was a publicly held corporation. Billy was injured in the course of his employment with USM. Since USM is considered a separate legal entity, Billy’s widow must look directly to the corporation to satisfy any judgment she may seek in a torts suit against USM. Billy v. Consolidated Mach. Tool Corp., 412 N.E.2d 934, 51 N.Y.2d 152, 1980 N.Y. Lexis 2638 (N.Y.App. 1980).

Corporation 16.2. Weldon Electric is a closely held corporation. A closely held corporation is one whose shares are owned by a few shareholders who are often family members, relatives, or friends.

The shareholders, who are usually involved with the management of the corporation, sometimes enter into buy/sell agreements that prevent outsiders from becoming shareholders.

Weldon Electronics was a corporation with only two shareholders, both friends and former partners. The two shareholders were also on the board of directors of the corporation and served as the corporation’s officers. Additionally, the corporation’s bylaws called for a buy/sell agreement to be reached to prevent outsiders from buying stock in the corporation.

Because of these characteristics, Weldon Electronic can be described as a closely held corporation. Balvik v. Sylvester, 411 N.W.2d 383, 1987 N.D. Lexis 392 (N.D. 1987).

Corporation 16.3. Florida Fashions was a domestic corporation in the state of Pennsylvania. This meant that Florida Fashions was a foreign corporation in the state of Florida, unlawfully doing business due to its failure to register. 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. Foreign corporations have to qualify, i.e., register, to conduct business in states other than their state of incorporation. Florida Fashions was illegally taking orders and doing business in Florida because the corporation had never qualified to conduct business in the state. Mysels v. Barry, 332 So.2d 38, 1976 Fla. App. Lexis 14344 (Fla.App. 1976).

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Preferred Stock 16.4. The one million shares of preferred stock issued by Commonwealth Edison on June 24, 1970, were shares of redeemable preferred stock. Redeemable preferred stock (or callable preferred stock) permits the corporation to redeem, i.e. buy back, the preferred stock at some future date. The terms of the redemption are established when the shares are issued.

Corporations will usually redeem the shares when the current interest rate falls below the dividend rate of the preferred shares. Commonwealth Edison had set the dividend rate of the one million preferred shares higher than it wanted due to market conditions. Thus, when the market changed, Edison was able to buy back the stock for $110 a share, $10 a share more than it had to sell the shares for, because the preferred stock was redeemable. By issuing redeemable preferred stock, the corporation is able to protect itself from changing market conditions. The Franklin Life Insurance Company v. Commonwealth Edison Company, 451 F.Supp. 602, 1978 U.S. Dist. Lexis 17604 (S.D.Ill. 1978).

Debt Securities 16.5. The most important difference between the stock issued by United Financial and the debenture bonds is that the stock represents an equity (ownership) interest in the corporation, while the debenture bonds do not. A debenture bond is a debt security, and as such, does not represent an ownership interest in the corporation. Instead, the corporation borrows money from an investor to whom the debt security is issued. A debenture bond is a long-term, unsecured debt instrument, which is based on the corporation’s general credit rating.

Therefore, if the corporation becomes insolvent, debenture holders are paid only after the secured creditors claims are met. In this case, those investing in United Financial received both shares of stock in the company, representing an ownership interest, and a debenture bond. While the debenture bonds paid a 5 percent interest rate, they did not represent an ownership interest in the company. Therefore, investors who bought one of the units offered

by United Financial received both debt and equity securities. Jones v. H.F. Ahmanson & Company, 1 Cal.3d 93, 81 Cal.Rptr. 592, 1969 Cal. Lexis 195 (Cal. 1969).

Special Shareholders’ Meeting 16.6. Shoenholtz wins since the special shareholders meeting was properly called. Special shareholder’s meetings may be called by the board of directors, or by the holders of at least 20 percent of the voting shares of the corporation. Special meetings may be held to consider important or emergency issues, such as a corporate merger, or the removal of a director. The corporation is required to give the shareholders written notice of the place, day, and time of annual and special meetings. If the meeting is a special meeting, the purpose of the meeting must also be stated. Since Shoenholtz owned over 10 percent of the voting shares of Rye Hospital, this gave him the right to request a special meeting. The notice given to Rye’s shareholders was adequate, in that it stated the time, date, and purpose of the meeting.

Because the special shareholders meeting was requested by an authorized party and proper notice was given to the shareholders, the meeting was properly called. Rye Psychiatric Hospital Center, Inc. v. Shoenholtz, 476 N.Y.S.2d 339, 1984 N.Y. App. Div. Lexis 178 (N.Y. App.).

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Dividends 16.7. Gay’s Super Markets wins the suit. The payment of dividends is at the discretion of the board of directors. The directors are responsible for determining when, where, how, and how much will be paid in dividends. Corporations often do not pay dividends, but retain profits in the corporation to be used for research expense, internal expansion, and other anticipated needs. Courts will only order a corporation to declare a dividend if the directors have abused their discretion in not paying. Gay’s Super Markets’ board stated valid reasons, such as expansion, for not granting a dividend at their January, 1972 meeting. This decision was well within the board’s discretion. Because Gay’s had usually decided to retain earnings due to increased competition and planned expansion, the court did not interfere with their decision.

Gay v. Gay’s Super Markets, Inc., 343 A.2d 577, 1975 M. Lexis 391 (Maine Sup.).

Duty of Loyalty 16.8. 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 (Ill.App.).

V. Answers to Business Ethics Cases 16.9. 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. Chelsea Industries, Inc. v.

Gaffney, 449 N.E.2d 320, 1983 Mass. Lexis 1413 (Mass. Sup.).

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16.10. Yes, Watters 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, Watters dominated the affairs of Wildhorn Ranch, Inc., and ran the corporation without observing any of the necessary corporate formalities. Watters 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 Watters failed to separate himself from the corporation, he was found liable for the corporation’s torts and other debts. Geringer v, Wildhorn Ranch, Inc., 760 F.Supp. 1442, 1988 U.S. Dist. Lexis 15701 (D. Colo.).

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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 debacle. 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 fore 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. Topic Outline

SEC: 1) adopts securities rules 2) investigates securities violations 3) regulates brokers and advisors

Definition of a Security ❖ A security must exist before securities laws apply ❖ Securities are defined as: o An interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant o An interest or instrument that is expressly mentioned in securities acts o An investment contract

Howey Test for investment contracts 1) investment of money 2) common enterprise 3) expectation of profits from others

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The Securities Act of 1933 ❖ Primarily regulates the issuance of securities by corporations, partnerships, associations, and individuals ❖ Section 5 of the Act requires securities offered to the public through the use of the mails or any facility of interstate commerce to be registered with the SEC

Registration Statement ❖ A covered issuer of securities must file a written registration statement with the SEC ❖ It contains required information about the issuer and the securities to be issued ❖ The SEC does not pass upon the merits of the registered securities ❖ It decides only whether the issuer has met the disclosure requirements

Descriptions of the following are required: 1) security 2) business 3) management (compensation, etc.)

4) pending litigation 5) use of proceeds 6) government regulation 7) industry competition 8) any special risk factors

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Sale of Unregistered Securities ❖ Sale of securities that should have been registered with the SEC but are not violates the Securities Act of 1933 ❖ Investors can rescind their purchases and recover damages ❖ Civil and criminal penalties can be imposed by the U.S. government

Regulation A Offerings ❖ A regulation that permits the issuer to sell securities pursuant to a simplified registration process ❖ Such offerings may have an unlimited number of purchasers o They do not have to be sophisticated investors ❖ There are no resale restrictions on the securities

Securities Exempt From Registration with the SEC ❖ Securities issued by any government in the U.S. ❖ Short-term notes and drafts that have a maturity date that does not exceed nine months ❖ Securities issued by nonprofit issuers ❖ Securities of financial institutions that are regulated by the appropriate banking authorities ❖ Securities issued by common carriers that are regulated by the Interstate Commerce Commission ❖ Insurance and annuity contracts issued by insurance companies ❖ Stock dividends and stock splits ❖ Securities issued in a corporate reorganization where one security is exchanged for another security

Private and Other Transactions Exempt from Registration ❖ Certain transactions in securities are exempt from registration ❖ Exempt transactions are subject to the antifraud provisions of the federal securities law ❖ The issuer must provide investors with adequate information ❖ Nonissuer exemption ❖ Intrastate offering exemption ❖ Private placement exemption ❖ Small offering exemption

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Resale Restrictions ❖ Certain resale restrictions are placed on securities issued pursuant to exemptions from registration ❖ Restricted Securities – securities that were issued for investment purposes pursuant to the intrastate, private placement, or small offerings exemptions o Rule 147 o Rule 144

Rule 144A (1990) ❖ Rule adopted by the SEC to increase the liquidity of the registered securities ❖ The rule permits “qualified institutional investors” to buy unregistered securities without being subject to the holding periods of Rule 144

Exemption Analysis: 1) There is a non-issuer exemption for most average investors.

2) There is also an intrastate offering exemption: a) resident issuer b) 80% from state test: assets, gross revenues and proceeds c) Resident purchasers 3) Exempt transactions should still provide: a) annual and quarterly reports b) proxy statements c) financial statements

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Violations of the Securities Act of 1933 ❖ SEC Actions: o Consent Order o Injunction o Request ancillary relief from the court ❖ Criminal Liability – Section 24 imposes criminal liability on any person who willfully violates the act or the rules or regulations adopted there under ❖ Private Actions – Private parties who have been injured by violations of the act have the following recourse against the violator: o Section 12 – civil liability o Section 11 – civil liability o Due diligence defense

Ethics Spotlight: Sarbanes-Oxley Act of 2002 ❖ Section 501 of the Act established rules for separating investment banking and securities advice functions of securities firms, thus eliminating many conflicts of interest

The Securities Exchange Act of 1934: Trading in Securities ❖ Federal statute that primarily regulates the trading in securities ❖ It provides the regulation of o Securities exchanges o Brokers o Dealers ❖ Contains provisions that assess civil and criminal liability on violators of the act

Section 10(b) ❖ A provision 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 prescribed by the SEC

Section 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 ❖ All transfers of securities are subject to this rule: o i.e., stock exchange, over-the-counter, private sale, merger

Note: civil and criminal liability are possible as well as SEC actions

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Insider Trading ❖ One of the most important purposes of Section 10(b) and Rule 10b-5 is to prevent insider training o When an insider makes a profit by personally purchasing shares of the corporation prior to public release of favorable information: or o By selling shares of the corporation prior to the disclosure of unfavorable information

Insiders Are Defined Under Section 10(b) and Rule 10b-5 as: ❖ Officers, directors, and employees at all levels of the company ❖ Lawyers, accountants, consultants, and other agents and representatives who are hired by the company on a temporary and non-employee status to provide services or work to the company ❖ Others who owe a fiduciary duty to the company

Insider Trading Sanction Act: civil liability up to 3X profits Misappropriation Theory may be of use below: Tipper – Tippee Liability ❖ Tipper o A person who discloses non-public information to another person o Liable for the profits made by the tippee ❖ Tippee o The person who receives material non-public information from a tipper o Liable for acting on material information that he or she knew (or should have known) was not public

Violations of the Securities Exchange Act of 1934 ❖ Criminal Liability – Section 32 imposes criminal liability on any person who willfully violates the act or regulations adopted thereunder ❖ SEC Actions o Consent order o Injunction o Seek court orders o Insider trading sanctions ❖ Private Actions – The courts have implied private right of action under Section 10(b) and Rule 10b-5: o Generally, a plaintiff may seek rescission of the securities contract or recover damages from a defendant who has engaged in manipulation and deceptive practices that have caused the plaintiff injury

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Short-Swing Profits: Statutory Insiders ❖ Section 16(a) of the 1934 act – 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

Short-Swing Profits: Section 16(b) ❖ Short-Swing Profits – profits made by statutory insiders on trades involving equity securities that occur within six months of each other ❖ Section 16(b) – a provision of the 1934 act that requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation

E-Securities Transactions: 1) Online 2) EDGAR 3) E-Public Offerings

State Securities Laws ❖ Most states have enacted securities laws that regulate the issuance and trading of securities ❖ These acts are often patterned after, and are designed to coordinate with, federal security laws ❖ The Uniform Securities Act (a model state statute) has been adopted by many states

III. Text Materials Case 17.1: U.S. V. Bhagat Facts: Nvidia’s CEO told the employees of a contract award and the following day said it should be confidential. A trading blackout was imposed. Bhagat, an employee, bought stock 20 minutes after the memo but 40 minutes before he read it. He tried to cancel but was too late. Bhagat’s friend, Gill, bought stock one-half hour after Bhagat who denied having told anyone about the contract. The SEC brought criminal charges against Bhagat for insider trading, tipping and obstruction of an SEC investigation. Bhagat appealed a conviction based on circumstantial evidence.

Issue: Is Bhagat criminally guilty of insider trading, tipping and obstruction of an SEC investigation?

Decision: Yes. Reason: The evidence showed that Bhagat traded on material nonpublic information; that it could reasonably be concluded that he gave this information to Gill; and, that he lied to the SEC investigators.

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Case 17.2: Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. Facts: Charter fraudulently issued financial statements affecting its securities value. Charter received help from Scientific (Sc) and Motorola (M),who supplied converter boxes to Charter.

They entered into a fraudulent arrangement in which Charter overpaid $20 for each box and then capitalized lease payments and spread the cost rather then immediately expensing them. Sc and M agreed to overpay on advertising from Charter to repay the overpayments. AA, the auditors did not discover the fraud. The certified financial statements were filed and the fraud was discovered. Charter was the primary fraudulent party and Sc and M were aiders and abettors. A civil suit was filed alleging violation of Section 10(b). The suit against SC and M was dismissed and the dismissal was affirmed. An appeal was made to the U.S. Supreme Court.

Issue: Is there an implied private civil cause of action against aiders and abettors under Section 10(b)?

Decision: No. Reason: Investors did not rely on Sc and M’s statements or representations. There is no private right of action for aiding and abetting misstatement of financial results under 10(b). Their acts are too remote to satisfy the reliance requirement. This would extend 10(b) beyond its present boundaries.

Internet Law & Online Commerce: Google’s E-IPO The SEC permits companies to issue securities over the Internet. Google’s E-IPO is discussed.

International Law: Chinese Bank Launches World’s Largest IPO ICDC’s IPO is discussed.

Law Case with Answer: Securities and Exchange Commission v. Texas Gulf Sulphur Co. Facts: On Nov. 12, 1963, Texas Gulf Sulphur Co. (TGS) drilled an exploratory hole, Kidd 55, in Canada. Assay reports indicated this sample to be remarkably high in certain metals. TGS did not own all the land surrounding Kidd 55, so it kept the results secret while it tried to purchase as much surrounding land as possible. Eventually, rumors of the rich strike surfaced. On Saturday, April 11, 1964, two newspapers printed unauthorized reports of the TGS drilling. On Monday, April 13, TGS issued a press release that tended to downplay the find. On April 16, 1964, at 10:00 am, TGS held a press conference that lasted for 10 minutes, in which they disclosed the richness of the Kidd 55 drilling. In early November 1963, TGS stock was trading at $17 3/8. On April 15, 1964, it closed at $29 3/8. Several officers, directors, and other employees of TGS bought stock during this period. By May 15, 1964, the stock was selling at $58 1/4. The SEC brought actions against several defendants for insider trading. The district court found one individual liable and dismissed complaints as to the rest. SEC appeals.

Issue: Were the individuals guilty of insider trading? Was TGS itself guilty of issuing a misleading press release on April 13, 1964, in violation of Section 10(b)?

Decision: Yes, as to individuals; No, as to TGS. Reason: (1) Crawford, an employee, telephoned his broker with orders to buy TGS stock at midnight on April 15, and again at 8:30 am on April 16. The material nonpublic information did not become public until 10:00 am on April 16, so Crawford intended to, and did, beat the public by trading on insider information. (2) Coates, an employee, placed his order to buy TGS stock at 10:20 am on the April 16, which was after the press conference. However, the press conference was just the first step in the process of publicly disseminating this nonpublic information. Coates had to wait, at least, until the news could have reasonably been expected to appear on the Dow Jones broad tape. Coates traded on inside information.

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Ethics Spotlight: Sarbanes-Oxley Act Erects a Wall Between Investment Bankers and Security Analysts This discusses section 501 rules for separating investment banking and advice transactions to try to avoid many conflicts of interests.

IV. Answers to Legal Environment Definition of a Security 17.1. 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.

Note: 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.Lexis 11903 (9th Cir.).

Definition of a Security 17.2. 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, 495 U.S. 56, 110 S.Ct. 945, 1990 U.S.Lexis 1051 U.S.Sup.Ct.)).

Intrastate Offering Exemption 17.3. 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 208 ..

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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 (D.Minn.).

Transaction Exemption 17.4. 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.

Note: On the witness stand, the defendants took the position that they operated at a level of corporate finance far above such “details” as securities laws and were too busy with “large affairs” as to bother themselves with such minor matters as securities laws. The court, obviously, rejected this defense. United States v. Wolfson, 405 F.2d 779, 1968 U.S.App. Lexis 4342 (2nd Cir.).

Insider Trading 17.5. No, Chiarella is not criminally liable for violating Section 10(b) of the Securities Exchange Act of 1934. The U.S. Supreme Court reversed the trial court’s judgment that had convicted Chiarella on all counts. The Court of Appeals affirmed the conviction by holding that anyone—an insider or not—who receives material nonpublic information may not use that information to trade in securities until the information is made public. The U.S. Supreme Court rejected this rule, holding that a person is not liable for insider trading under Section 10(b) unless he owes a duty to disclose the information. The Supreme Court held that this duty only arises if the person owes a fiduciary duty to the company in whose shares he has traded.

The Supreme Court held that Chiarella did not owe a fiduciary duty to the target companies of whose shares he purchased. The court stated: Not every instance of financial unfairness constitutes fraudulent activity under Section 10(b). The element required making silence fraudulent—a duty to disclose—is absent in this case. No duty could arise from Chiarella’s relationship with the sellers of the target company’s securities for Chiarella had no prior dealings with them. He was not their agent, he was not a fiduciary, and 209 ..

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he was not a person in whom the sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions. We hold that a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.

The U.S. Supreme Court reversed Chiarella’s conviction. Chiarella v. United States, 445 U.S. 222, 100 S.Ct. 1108, 1980 U.S.Lexis 88 (U.S.Sup.Ct.).

Section 10(b) 17.6. 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 commonlaw 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 (U.S.Sup.Ct.).

Insider Trading 17.7. The Sullair Corporation (Sullair) wins and, under Section 16(b) of the Securities Exchange Act of 1934, may recover the profits made by Hoodes on the sale and purchase of the securities of Sullair securities. The court held that Section 16(b) is a “flat rule” which imposes strict liability for profits earned by any officer or director or 10 percent shareholder who purchases and sells or sells and purchases equity securities of his corporation within a period of less than six months.

The court found that Hoodes, who was an officer of Sullair, was a statutory insider for purposes of Section 16(b). The court held that the Section 16(b) rule applied whenever the defendant held his position at the time of the initial transaction that gave rise to his liability.

The court found that the two transactions—the sale of securities by Hoodes on July 20 and the purchase of securities on August 20—had occurred within six months of each other and were covered by Section 16(b). The court held that the corporation could recover $11,350 from Hoodes—the difference between the price he sold the original 6,000 shares for on July 20, 1982 ($38,350) and the fair market value of the 6,000 shares he purchased on August 20, 1982 ($27,000). Sullair Corporation v. Hoodes, 672 F.Supp. 337, 1987 U.S.Dist. Lexis 10152 (N.D.Ill.).

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V. Answers to Business Ethics Questions 17.9. They all conspire to violate the securities laws. Criminal liability should not be a question.

Winans breached a fiduciary duty and acted unethically. Brant, however, while not acting in a manner popular to his co-conspirators did fulfill his ethical duty even though his motives may be questionable. [United States v. Carpenter, 484 U.S. 19, 108 S.Ct. 316, 1987 U.S. Lexis 4815 (1987)].

17.8. In United States v. O’Hagan, 521 U.S. 642 James O’Hagan, a partner in the law firm of Dorsey & Whitney, began purchasing call options for Pillsbury stock. Each option gave O’Hagan the right to purchase 100 shares. In the meantime, Grand Metropolitan hired Dorsey and Whitney to represent it in a secret tender offer for stock of Pillsbury. When the tender offer was publicly announced, Hagan had purchased 5,000 shares at $39 per share; those shares went to $60. The SEC investigated, and the Justice Department charged O’Hagan with criminally violating Section 10(b) and Rule 10b-5. O’Hagan lost.

The issue in this case was can a defendant be criminally convicted of violating Section 10(b) and Rule 10b-5 based on misappropriation theory?

The court answered in the affirmative. They reasoned that the misappropriation theory comports with Section 10(b)’s language, and it was property applied in this case.

Note, O’Hagan did not act ethically because of at least the concepts of conflict of interests and misappropriation.

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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 tort), 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 Second Restatement of Agency as: The fiduciary relation 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 uniqueness of personal services or on public policy grounds that forbid 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 help 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?

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authority. In all events, once that authority line has been drawn, the question of the legal consequences to the 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. Topic Outline Agency ❖ Agency relationships are formed by the mutual consent of a principal and an agent ❖ Agency is the fiduciary relationship 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.”

Summary: Kinds of Employment Relationships Type of Relationship Employer-Employee Principal-Agent

Description The employer has the right to control the physical conduct of the employee.

The agent has the authority to act on behalf of the principal as authorized by the principal and implied from the agency.

An employee is often the agent of his employer.

Formation of an Agency Relationship An agency and the resulting authority of an agent can arise in any of these four ways: 1. Express agency 2. Implied agency 3. Apparent agency 4. Agency by ratification

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Summary: Formation of Agency Relationships Type of Agency Express Implied

Apparent

By Ratification

Definition

Enforcement of the Contract

Authority is expressly given to the agent by the principal.

Authority is implied from the conduct of the parties, custom and usage of trade, or act incidental to carrying out the agent’s duties.

Authority created when the principal leads a third party into believing that the agent has authority.

Acts of the agent committed outside the scope of his authority.

Principal and third party are bound to the contract.

Principal and third party acts are bound to the contract.

Principal and third party are bound to the contract.

Principal and third party are not bound to the contract unless the principal ratifies the contract.

Principal’s Duties (1 of 2) 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 reimburse ❖ A duty that a principal owes to repay money to an agent if the agent spent his or her own money during the agency on the principal’s behalf

Principal’s Duties (2 of 2) Duty to indemnify ❖ A duty that a principal owes to protect the agent for losses the agent suffered during the agency because of the principal’s misconduct Duty to cooperate ❖ A duty that a principal owes to cooperate with and assist the agent in the performance of the agent’s duties and accomplishment of the agency Agent’s Duties (1 of 3) Duty of performance 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

Agent’s Duties (2 of 3) Duty of notification An agent’s duty to notify the principal of information he or she learns from a third party or other source that is important to the principal Imputed Knowledge – most information learned by an agent in the course of the agency is imputed to the principal

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Agent’s Duties (3 of 3) Duty of accountability A duty that an agent owes to maintain an accurate accounting of all transactions undertaken on the principal’s behalf Duty of loyalty An agent owes a fiduciary duty not to act adversely to the interests of the principal If this duty is breached, the agent is liable to the principal

Contract Liability of Principals and Agents to Third Parties ❖ Fully Disclosed Agency o The principal is liable to the third party o The agent is not liable o An agent is liable on the contract if he or she guarantees that the principal will perform the contract ❖ Partially Disclosed Agency o Both the principal and the agent are liable to the third party if the principal fails to perform the contract o This is because the third party must rely on the agent’s reputation, integrity, and credit because the principal is unidentified ❖ Undisclosed Agency o The third party is unaware of either the existence of an agency of the principal’s identity o Both the principal and the agent are liable to the third party if the principal fails to perform the contract

Tort Liability to Third Parties ❖ The principal and the agent are each personally responsible for their own tortious conduct ❖ The principal is liable for the tortuous conduct of an agent who is acting within the scope of his or her authority ❖ The agent is liable for the tortious conduct of the principal if he or she directly or indirectly participates in or aids and abets the principal’s conduct

Sources of Tort Liability for Principals and Agents ❖ Misrepresentation ❖ Intentional misrepresentation ❖ Innocent misrepresentation ❖ Negligence ❖ Respondent superior ❖ Frolic and detour ❖ “Coming and going” rule ❖ Dual-purpose mission ❖ Intentional Torts

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Intentional Tort ❖ Motivation Test: Principal liable if agent was promoting principal’s business. ❖ Work-related Test: Principle liable if agent was within work-related time and space.

Liability for Independent Contractor’s Torts ❖ Principal employs a person who is not an employee of the principal ❖ The independent contractor has authority only to enter into contracts authorized by the principal ❖ Generally, principals are not liable for the tortuous conduct of independent contractors ❖ Independent contractors are personally liable for their own torts

Independent Contractor Test: See degree of control.

Look at: 1) occupation vs. business 2) time, length and amount 3) supplier of tools 4) payment method 5) other control issues

Termination by Acts 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 4. Occurrence of a specified event

Termination 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 6. War between the principal’s and agent’s countries

Notice Upon Termination: 1) direct to those with prior dealings 2) constructive to those with no prior dealings

Wrongful Termination of an Agency or Employment Contract ❖ The termination of an agency contract in violation of the terms of the agency contract ❖ The nonbreaching party may recover damages from the breaching party ❖ The distinction between the power and the right to terminate an agency is critical

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III. Text Materials Case 18.1. Bosse v. Brinker Restaurant Corporation, d.b.a.Chili’s Grill and Bar Facts: Bosse and Griffin and others at a $56 meal at Chili’s. They left without paying . An unidentified patron chased than and called the Chili’s manager who called the police. Bosse’s car hit a wall and Bosse and Grifin were seriously injured. They sued Chili’s for compensatory damages arguing an agency relationship between Chili’s and the patron making him liable under respondeat superior. Chili’s files a motion for summary judgment.

Issue: Was the patron an agent of Chili’s?

Decision: No. Summary judgment was granted.

Reason: To be an agent, there must be consent by Chili’s, retaining of control, and action to benefit Chili’s. Here there was no preliminary communication so any consent is tenuous at best.

By using the phone intervention, Chili’s was merely reporting a petty crime that the patron was pursuing. Agency need not exist in this case and it did not.

Case 18.2. Keating v. Goldick and Lapp Roofing and Sheet Metal Company, Inc. Facts: Lapp, an Ohio company, sent Goldick and others to do a roofing job in Wilmington.

Company policy prohibits use of company vehicles for personal uses. Goldick was given a company van for transportation of workers to the site and for necessities while in Wilmington.

Goldick and McNeese (both Lapp employees) went to eat and drink and were ejected. Goldick drove onto a curb and struck people in various places. He was charged and pleaded guilty to criminal assault. Keating and others injured filed this personal injury suit. Lapp says they were not liable because Goldick was outside the scope of his employment.

Issue : Was Goldick’ s negligence within the scope of his employment at Lapp?

Decision: No. Summary judgment was granted.

Reason: A reasonable person would not assign liability to a company based on an employee using a company van to drink at night. If the accident occurred after using the van for a necessity, there would probably be a different result. This conduct, however, was completely unrelated to Lapp’s business, outside of working hours and does not benefit Lapp in any way. This was a purely personal activity.

Contemporary Environment: Power of Attorney The distinction between a general power of attorney and a special power of attorney is discussed.

Ethics Spotlight: Agent’s Breach of Duty of Loyalty This box discusses breaches of loyalty that can be committed by an agent including self-dealing, usurping an opportunity, competing with the principal, misuse of confidential information, and dual agency Law Case with Answer: Desert Cab Inc. v. Marino Facts: On October 6, 1986, respondent Maria Marino, a cab driver with Yellow-Checker Cab Company, and appellant James Edwards, a cab driver with appellant Desert Cab Company, parked their cabs at the taxicab stand of the Sundance Hotel and Casino in Las Vegas to await fares. Marino’s cab occupied the first position in the line and Edwards occupied the third. As Marino stood alongside her cab conversing with the drive of another taxi, Edwards began verbally harassing her from inside his cab. When Marino approached Edwards to inquire as to the reason for the harassment, he jumped from his cab, grabbed Marino by her neck and shoulders, began choking her, and threw her onto the front of his taxicab. A bystander intervened, pulled Edwards off of Marino and escorted her back to her cab.

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Marino sustained injuries that rendered her unable to work for a time. Before she could return to work, Yellow-Checker Cab terminated her. Marino subsequently filed a wrongful termination suit against her former employer. Edwards was convicted of misdemeanor assault and battery for his attack on Marino. Marino brought this personal injury action against James Edwards and Desert Cab. Issue: Is Desert Cab liable for the intentional tort of its employee?

Decision: Desert Cab was liable for the intentional tort of its employee.

Reason: Under the doctrine of respondeat superior, an employer is liable for the intentional torts committed by its employees within the scope of their employment. For liability to be imposed on the employer, the intentional tort must be work related. The court held that Edwards’ intentional conduct of assault and battery against Marino was work related, and Desert Cab was therefore liable to Marino.

Ethics Spotlight: Principal Liable for Repo Man’s Tort This box discusses how a principal cannot escape liability by hiring an independent contractor to do a task. The act of repossessing an auto is an inherently dangerous act and a non-delegable duty, and the principal could not escape liability for hiring an independent contractor to do this task.

IV. Answers to Legal Environment Cases Creation of an Agency 18.1. No, the unidentified patron was not an agent of the nightclub. The relation of principal and agent arises wherever one person—expressly or by implication—authorizes another to act for him. The court found no proof of agency by express agreement or by implication from the circumstances of the case. A review of the record persuaded the court that the unidentified person who caused Ginn’s injuries was merely an individual patron of the nightclub who was acting on his own. There was no evidence that the nightclub manager requested the patron to assist him in dealing with Ginn or that the manager ratified the patron’s actions. Because there was no agency, the nightclub is not liable for the actions of the patron who injured Ginn. The appellate court affirmed the trial court’s grant of a directed verdict in favor of defendant nightclub. Ginn v. Renaldo, Inc., 359 S.E.2d 390, 1987 Ga.App. Lexis 2023 (Ga.App.).

Independent Contractor 18.2. No, Butler Telephone Company, Inc., is not liable for Pugh’s death. Whether a relationship is that of an independent contractor or master/servant depends on whether the entity for which the work is being performed has reserved the right of control over the means by which the work is done. Here Butler only retained the right to inspect the work for compliance with the terms of the contract. The court found no evidence that Butler exercised any control or retained any right of control over the manner in which Sandidge performed any of its work on the project. The court held that Sandidge was an independent contractor and that Butler was not liable for the negligence of Sandidge. The court affirmed a grant of summary judgment in favor of Butler.

An independent contractor is liable for injuries caused by its own negligence. Thus, if it is established that Sandidge was negligent in not shoring up or sloping the walls of the excavation or otherwise violated general safety standards that caused Pugh’s death, it will be liable for damages to Pugh’s parents and estate. Pugh v. Butler Telephone Company, Inc., 512 So.2d 1317, 1987 Ala. Lexis 4468 (Ala.).

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Power of Attorney 18.3. King was an agent with a specific duty. He performed the duty using his best judgment. He did not breach trust or his fiduciary duty and therefore should not be liable to Howard.

Fiduciary Duty 18.4. Yes, E.F. Hutton is liable for the fraudulent activities of its employee, Johnson. A principal can be held liable for an agent’s tortious conduct even if such conduct falls outside the scope of the agent’s employment if the principal ratifies such conduct. The court held that because the manager of E.F. Hutton had knowledge of Johnson’s activities and took no action to prevent this conduct, E.F. Hutton ratified the agent’s tortious acts. The court held E.F. Hutton liable to Pusateri for $120,000 compensatory damages and $160,000 punitive damages. Punitive damages can be awarded against a principal for an act of an agent if the employer ratifies his tortious activity. Pusateri v. E.F. Hutton & Co., Inc., 180 Cal. App. 3d 247, 1986 Cal.App. Lexis 1502 (Cal.App.).

Independent Contractor 18.5. No. Samuelson is not liable. African Adventures (AA) is an independent contractor, not under any degree of control from Samuelson. Samuelson is not liable for the torts of an independent contractor. Samuelson might also be considered an agent for AA and an agent is not liable for the torts of a principal.

Imputed Knowledge 18.6. Yes, Boulevard Investment Company (Boulevard) is liable to Iota Management Corporation (Iota) for breach of contract. The knowledge of an agent of corporate principal regarding matters within the agent’s scope of employment and authority is imputed to the principal.

The court held that Cecil Lillibridge, who was Boulevard’s maintenance supervisor, had acquired knowledge of the condition of the pipes through his work at the hotel, clearly within the scope of his employment and authority. The court held that this knowledge was imputed to the corporate principal, Boulevard. The appellate court affirmed the trial court’s decision that permitted Iota to rescind the contract. Iota Management Corporation v. Boulevard Investment Company, 731 S.W.2d 399, 1987 Mo.App. Lexis 4027 (Mo.App.).

Duty of Loyalty 18.7. Yes, Shields breached his fiduciary duty of loyalty to his principal, Production Finishing, by usurping a corporate business opportunity. Shields, as president and a member of the board of directors of Production Finishing, was an agent of the corporation. A corporate officer or director is an agent of the corporation and under a fiduciary duty not to divert a corporate business opportunity for his own personal gain. If an agent acquires any pecuniary advantage to himself from third parties by breaching his fiduciary duties, he is accountable to his employer for the profit made. The court held that Shields breached his fiduciary duty of loyalty and honesty to his principal by diverting the Ford contract to him. The Court of Appeals affirmed the trial court’s granting of summary judgment in favor of Production Finishing and remanded the case for a determination of damages. Production Finishing Corporation v. Shields, 405 N.W.2d 171, 1987 Mich.App. Lexis 2379 (Mich.App.).

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Contract Liability 18.8. Both Elvin Grinder personally and G. Elvin Grinder Construction, Inc., are liable to Bryans Road Building & Supply Co., Inc. This is a situation of an undisclosed principal. An agent who makes a contract in his own name without disclosing his agency and the identity of the principal is liable on the contract to the other party. The principal is liable because the contract was made for his benefit. The court held that a creditor who contracts with the agent for an undisclosed principal does not obtain alternative liability, but that he may proceed to judgment against both, and that he is limited to one satisfaction. The court held that Grinder was the agent for an undisclosed principal, and that Bryans is entitled to take judgment against Grinder personally in addition to its unsatisfied judgment against the corporation.

Grinder v. Bryans Road Building & Supply Co., Inc., 432 A.2d 453, 1981 Md. Lexis 246 (Md.App.).

Tort Liability 18.9. Since Rogers was basically on the job and the accident occurred during work time, the principal is liable for the intentional tort of the agent. NAC is liable.

Tort Liability 18.10. Yes, Intrastate Radiotelephone, Inc. is liable to Largey for the injuries caused by its agent, Kranhold. Generally, a principal is responsible to third persons for the negligence of its agents, including acts committed by such agents while acting within the scope of their employment. Ordinarily, while an employee is going to or coming from his place of employment, he is outside the scope of his employment during that period. There is an exception to the “coming and going” rule—if it is an implied or express condition of the agent’s employment that he use his vehicle in attending to his duties, then the employer will be vicariously liable for any accidents incurred while the employee is driving to or from work. The court held that there was sufficient and substantial evidence for the jury to have inferred that Kranhold was acting within the scope of his employment when the accident in question occurred. Therefore, the exception to the coming and going rule applies in this case.

The appellate court affirmed the judgment of the trial court that was entered in favor of Largey against Intrastate. Largey v. Intrastate Radiotelephone, Inc., 136 Cal.App.3d 660, 186 Cal.Rptr. 520, 1982 Cal.App. Lexis 2049(Cal.App.).

V. Answers to Business Ethics Cases 18.11. Nabisco is liable for the intentional assault and battery of Lange by its employee Lynch.

The Minnesota rule is that where it is shown that “the employee’s acts were motivated by a desire to further the employer’s business,” liability will be imposed. However, in developing a test for application of the rule the court stated, “the focus should be on the basis of the assault rather than the motivation of the employee.” Applying this test, the court held, as a matter of law, that the employer is liable where an assault or battery has its origin in an argument concerning the work being done by the employee. Lynch was found to have been originally motivated to become argumentative in the furtherance of his employer’s business.

The court held an employer is liable for an assault by his employee when the source of the attack is related to the duties of the employer and the assault occurs within work related limits of time and place. Lange v. National Biscuit Company, 211 N.W. 2d 783, 1973 Minn. Lexis, 1106 (Minn.).

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18.12. Yes, the agency agreement was terminated when the Hagues sent the termination letter to Hilgendorf on August 13, 1976. Since an agency is a consensual relationship, a principal has the power to terminate an agency, except those coupled with an interest, 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 are therefore 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 recover his lost profits as ordinarily measured by the commission he would have earned.

The appellate court affirmed the trial court’s award of the commission to Hilgendorf.

Hilgendorf v. Hague, 293 N.W.2d 272, 1980 Iowa Sup. Lexis 882 (Iowa 1980).

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Why is discrimination wrong?

I. Teacher to Teacher Dialogue Today’s students appear far more divided on employment issues than in the past. Perhaps it is the tight job market or the polarization, which comes from crime, economic disparities, and the like.

As a possible way to break the barriers, try to initially clearly define the terms. Second, try 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, attempt to have students engage in open debate. Allowing all sides an opportunity to be heard is a fair approach. 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. *No single American legal issue is 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, was the first major system of self-governance 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.

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. For example, you cannot expect the average man on the street to play golf as well as Tiger Woods.

He, in turn, is duly rewarded for these talents.

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. None of us can afford to look the other way and say: “It’s not my problem.” Wrongful discrimination against any group is a wrong upon the society at large. Almost everyone appreciates that fact intuitively, if not intellectually.

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a changed culture. Until then, law and our courts will continue to be the testing grounds for this necessary change in the social order.

II. Topic Outline Landmark Law(as amended by the Equal Employment Opportunity Act of 1972): Title VII of the Civil Rights Act of 1964 ❖ Intended to eliminate job discrimination based on five protected classes: 1. Race 2. Color 3. Religion 4. Sex 5. National Origin

❖ EEOC is federal agency usually charged with enforcing ❖ 1866 Act deals with rights to make and enforce contracts

Scope of Coverage of Title VII (1 of 2) Title VII applies to: ❖ Employers with 15 or more employees ❖ All employment agencies ❖ Labor unions with 15 or more members ❖ State and local governments and their agencies ❖ Most federal government employment ❖ Indian tribes and tax-exempt private clubs are expressly excluded from coverage

Forms of Title VII Actions ❖ Disparate Treatment Discrimination o Occurs when an employer discriminates against a specific individual because of his or her race, color, national origin, sex, or religion ❖ Disparate Impact Discrimination o Occurs when an employer discriminates against an entire protected class o Often, this is proven through statistical data about the employer’s employment practices Race, Color and National Origin Discrimination - Never a BFOQ

Sex Discrimination - based on gender: either direct or quid pro quo - can’t discriminate due to pregnancy (Pregnancy Discrimination Act of 1978)

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Same-Sex Discrimination ❖ The U.S. Supreme Court has held that same-sex sexual harassment and sex sexual harassment and discrimination violate Title VII ❖ Many state and local laws also prohibit this form of discrimination and harassment in the workplace

Damages awarded: - compensatory if intentional - punitive if with malice or reckless indifference

Religious Discrimination ❖ Reasonable accommodation ❖ Sometimes permitted in religious groups

Defenses to a Title VII Action: Merit ❖ Employers can select or promote employees based on merit ❖ Merit decisions are often based on work, educational experience, and professionally developed ability tests ❖ To be lawful under Title VII, the requirement must be job related

Defenses to a Title VII Action: Seniority ❖ An employer may maintain a seniority system that rewards long-term employees ❖ e.g., higher wages, fringe benefits, and other preferential treatment ❖ Such systems are lawful if they are not the result of intentional discrimination

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Defenses to a Title VII Action: Bona Fide Occupational 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

Landmark Law: Civil Rights Act of 1866 ❖ Section 1981 of the Civil Rights Act of 1866 expressly prohibits racial discrimination ❖ It has also been held to forbid discrimination based on national origin

Equal Pay Act of 1963 Protects both sexes from pay discrimination based on sex The act prohibits disparity in pay for jobs that require: ❖ Equal skill ❖ Equal effort ❖ Equal responsibility ❖ Similar working conditions

Criteria That Justify a Differential In Wages The Equal Pay Act Equal Pay Act expressly provides four criteria that justify a differential in wages: ❖ Seniority ❖ Merit ❖ Quantity or quality of product ❖ Any factor other than sex ❖ The employer bears the burden of proving these defenses

Age Discrimination in Employment Act (ADEA) of 1967 (1 of 2) ❖ Prohibits age discrimination in all employment decisions, including: o Hiring o Promotions o Payment of compensation o Other terms and conditions of employment ❖ The Older Workers Benefit Protection Act (OWBPA) amended ADEA to prohibit age discrimination with regard to employee benefits

Age Discrimination in Employment Act (ADEA) of 1967 (2 of 2) ❖ ADEA applies to employees who are 40 years of age and older ❖ Covered employers cannot establish mandatory retirement ages for their employees ❖ ADEA is administered by the EEOC

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Landmark Law: Americans with Disabilities Act (ADA) of 1990 ❖ The ADA imposes on employers and providers of public transportation, telecommunications, and public accommodations to accommodate individuals with disabilities ❖ Title I of the ADA prohibits employment discrimination against qualified individuals with disabilities

Title I of the ADA requires an employer to make reasonable accommodations to individuals with disabilities that do not cause undue hardship to the employer

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 ❖ Key issues o Affirmative action plans o Reverse discrimination o Race norming

Affirmative Action ❖ Explanations: o Narrowly tailored for compelling interest o No quotas o Reversed discrimination not actionable

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III. Text Materials Law Case with Answer: NAACP v. Town of Harrison, New Jersey Facts: The town of Harrison had followed a policy, and later adopted an ordinance, requiring that all officers and employees of the town be residents of the town. The town had virtually no black residents and none of its employees were black. Harrison is a small, industrial community in Hudson County, but is closely aligned with the contiguous Essex County and the City of Newark. In fact, 22.1 percent of the private employees in Hudson County were black, virtually all of whom came from outside Hudson County. Further, there was evidence that approximately 22.2 percent of the black population proximate to Harrison was qualified for jobs as firefighters or police officers.

Issue: Does the residency requirement violate Title VII of the Civil Rights Act of 1964?

Decision: Yes. Reason: The court found that: (1) the proportion of blacks hired by Harrison did not fit the racial makeup of the pool of qualified applicants from the four county labor market; (2) the residency requirement was the cause of at least a substantial part of this disparity; and (3) the business reasons for this employment practice could be met in other, nondiscriminatory ways, such as requiring all police and firemen to live within a reasonable response time of Harrison. This is an example of a racially neutral policy that has a disparate impact on a protected group.

Ethics Spotlight: Walgreen to Pay $24 million in Race Discrimination Lawsuit This is a good example of furthering the agency’s E-Race initiative pursuing high-profile cases.

Internet Law & Online Commerce: E-Mails That Cause Sexual Harassment The problems with sexual harassment and email are discussed.

Case. 19.1: PA State Police v. Suders Facts: Suders was subject to sexual harassment by supervisors causing eventual resignation.

The harassment included talking about sex with animals; young girls’ instruction on oral sex; sitting inappropriately; and, obscene gestures. She reported it to the equal employment officer of the PSP. After no resolution in Suders’ eyes, she resigned.

Issue: Can an employer be held vicariously liable when sexual harassment is so severe to cause a resignation.

Decision: Yes. To make a case for “constructive discharge” the plaintiff must show resignation was a fitting response under the circumstances.

Reason: this case shows harassment up to a breaking point caused by a member of the company.

Case 19.2: International Union Etc. v. Johnson Controls, Inc. Facts: A primary ingredient in Johnson Control’s battery manufacturing process is lead, occupational exposure to which entails health risks, including the risk of harm to any fetus carried by a female employee. After eight of its employees became pregnant while maintaining blood lead levels exceeding that were noted by the Occupational Safety and Health Administration (OSHA) as critical for a worker planning to have a family, respondent announced a policy barring all women, except those whose infertility was medically documented, from jobs involving actual or potential lead exposure exceeding the OSHA standard. Petitioners, a group including employees affected by respondent’s fetal-protection policy, filed a class action in the District Court, claiming that the policy constituted sex discrimination violating Title VII of the Civil Rights Act of 1964, as amended. The court granted summary judgment for respondent, and the Court of Appeals affirmed. The latter court held that the proper standard for evaluating the policy was the business necessity inquiry applied by other Circuits and that respondent was entitled to summary judgment because petitioners had failed to satisfy their burden of persuasion as to each 227 ..

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of the elements of the business necessity defense. Respondent was entitled to summary judgment because its fetal-protection policy is reasonably necessary to further the industrial safety concern that is part of the essence of respondent’s business.

Issues: Is Johnson Control’s fetal-protection policy a BFOQ? Decision: Title VII, as amended by the Pregnancy Discrimination Act (PDA), forbids sexspecific fetal-protection policies.

Reason: Blackmun, J. By excluding women with childbearing capacity from lead-exposed jobs, respondent’s policy creates a facial classification based on gender and explicitly discriminates against women on the basis of their sex under Sec. 703(a) of Title VII. Moreover, in using the words “capable of bearing children” as the criterion of exclusion, the policy explicitly classifies on the basis of potential for pregnancy, which classification must be regarded, under the PDA, in the same light as explicit sex discrimination. The Court of Appeals erred in assuming that the policy was facially neutral because it had only a discriminatory effect on women’s employment opportunities, and because the asserted purpose, protecting women’s unconceived offspring, was ostensibly benign. The policy is not neutral because it does not apply to male employees in the same way as it applies to females, despite evidence about the debilitating effect of lead exposure on the male reproductive system. Also, the absence of a malevolent motive does not convert a facially discriminatory policy into a neutral policy with a discriminatory effect.

Respondent cannot establish a BFOQ. Fertile women, as far as appears in the record, participate in the manufacture of batteries as efficiently as anyone else. Moreover, respondent’s professed concerns about the welfare of the next generation do not suffice to establish a BFOQ of female sterility.

Title VII, as amended by the PDA, mandates that decisions about the welfare of future children be left to the parents who conceive, bear, support, and raise them rather than to the employers who hire those parents or the courts. An employer’s tort liability for potential fetal injuries and its increased costs due to fertile women in the workplace do not require a different result. The incremental cost of employing members of one sex cannot justify a discriminatory refusal to hire members of that gender.

Case 19.3: PGA Tour, Inc. v. Martin Facts: Casey Martin is a talented amateur golfer who has Klippel-Trenaunay-Weber Syndrome, a degenerative circulatory disorder that obstructs the flow of blood from his right leg to his heart.

When he turned professional, he qualified for the PGA Tour. He requested to use a golf cart while playing in PGA tournaments, but the PGA Tour denied his request. Martin sued the PGA in violation of the ADA for not making reasonable accommodations for his disability. Martin won at the district court and court of appeals levels.

Issue: Does the Americans with Disabilities Act of 1990 require the PGA Tour to accommodate Casey Martin, a disabled professional golfer, by permitting him to use a golf cart while playing in PGA sponsored golf tournaments?

Decision: Yes. Reason: Golf is a game where 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. The ADA requires that the PGA Tour accommodate Casey Martin by allowing him to use a golf cart.

Contemporary Environment: Affirmative action Affirmative action plans and reverse discrimination are discussed.

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IV. Answers to Legal Environment Equal Pay Act 19.1. Yes, the wage practices by Corning violated the Equal Pay Act. In order to establish a violation of the Act, it must be shown that an employer pays different wages to employees of opposite sexes “for equal work on jobs the performance of which requires equal skill, effort, and responsibility, and which are performed under similar working conditions.” Here, the Supreme Court held: 1. The term “working condition” encompasses only physical surroundings and hazards and not the time of the day worked. Thus, the original pay differential between the day (female) shift and the night (male) shift violated the Act. 2. The violation was not cured when Corning began hiring women to work the night shift because the higher “red circle” rate paid to previously hired male night shift workers perpetuated the discrimination.

Corning Glass Works v. Brennan, Secretary of Labor, 417 U.S. 188, 94 S.Ct. 2223, 1974 U.S. Lexis 62 (U.S.Sup.Ct.).

Sex Discrimination 19.2. Yes, the practice of requiring female employees to make larger contributions to the pension fund than male employees constitutes sex discrimination in violation of Title VII. Although the Supreme Court acknowledged that, as a class, women do live longer than men, it is not true that all individuals of the respective classes will do so. In fact, many women do not live as long as the average man and many men outlive the average woman. It is clear that any individual’s life expectancy is based on a number of factors, of which sex is only one.

Note: Although the Supreme Court found a violation of Title VII, it reversed the District Court’s award of retroactive relief to the entire class of female employees and retirees. In doing so, the court cited the potential economic impact that such an award would cause to insurance companies and pension plans. Thus, the challenged practice was only outlawed in the future. City of Los Angeles Department of Water and Power v. Manhart, 435 U.S. 702, 98 S.Ct. 1370, 55 L.Ed.2d 657, 1978U.S. Lexis 23 (U.S. Sup.Ct.).

Hostile Work Environment 19.3. Yes, the conduct of the male employees and manager of RDC in this case constitutes sexual harassment in violation of Title VII by creating a hostile work environment. The court held that an employer can be held liable for sexual harassment of its employees under the doctrine of respondeat superior (let the master answer) if the employer either (1) had actual knowledge of the harassment or (2) the harassment was so pervasive that an inference of constructive knowledge arises. In this case, Huddleston made out a prima facie case against RDC for the sexual harassment attributable to the sales manager of RDC. Huddleston v.

Roger Dean Chevrolet, Inc., 845 F.2d 900, 1988 U.S.App. Lexis 6823 (11th Cir.).

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National Origin Discrimination 19.4. Yes, the FBI is liable for a pattern or practice of discrimination in violation of Title VII. The court held that the FBI’s actions constituted unlawful national origin discrimination against Hispanic agents. As a remedy, the court ordered that those Hispanic agents who had been discriminated against would be awarded additional seniority to make them whole had such discrimination not occurred. The court ordered that an independent panel be created to decide these claims. In addition, the court ordered the FBI to overhaul its system of promoting Hispanic agents and those from other minority groups to eliminate any discriminatory practice. The court did not grant an award of back pay. Perez v. Federal Bureau of Investigation, 714 F.Supp. 1414, 1989 U.S.Dist. Lexis 8426 (W.D. Texas).

Religious Discrimination 19.5. 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 (U.S. Sup.Ct.).

Bona Fide Occupational Qualification 19.6. The city and county of Honolulu are not liable for violating Title VII. The court held that the ability to communicate clearly in English was a bona fide occupational qualification (BFOQ) for the position. Because of the required contact with a sometimes-contentious public, the ability to speak clear English was one of the most important skills required for the position. Since Fragante’s English oral skills were hampered by his accent and manner of speaking, he did not meet the bona fide occupational qualification for the job, and was therefore properly denied the position. The court found that the inability to communicate well in English was not a cover for unlawful discrimination. Fragante v. City and County of Honolulu, 888 F.2d 591, 1989 U.S.App. Lexis 2636 (9th Cir.).

Affirmative Action 19.7. Machakos wins. The court found clear evidence of racial discrimination in the unlawful priority preference policy. Machakos, however, “should not reap ‘an advantage’ over the typical Title VII plaintiff.”

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V. Answers to Business Ethics Cases 19.8. Rawlinson proved a prima facie case of sex discrimination by showing that the racially neutral height and weight restrictions disparately impacted upon women. The trial court found that the height rule excluded over 32 percent of women but less than 2 percent of men.

The weight requirement excluded over 22 percent of women but less than 2.5 percent of men.

Together, these restrictions would exclude over 41 percent of women but less than 1 percent of men. Dothard argues that height and weight are job related, because they have a relationship to strength that is required. The court held that a strength test should be given to establish strength, rather than using height and weight, for which there was no correlation proven.

The essence of a prison guard’s job is to maintain order. A woman’s relative ability to maintain order in a male, maximum security, unclassified prison could be directly reduced by her womanhood. There is a basis for expecting that sex offenders who have attacked women before would do so again in prison. Also, there is a real risk from other prisoners who are deprived of a normal, heterosexual environment. This is a threat not only to the victim, but also to the safety of the other inmates. Thus, in this case, the applicant’s womanhood directly undermines her ability to do the job. (NOTE: Generally, the woman should be able to decide what employment risks she wants to take. Here, it is not her safety that the court is protecting; it is the safety of the other inmates. ALSO NOTE: There is no evidence that women guards are more subject to attacks than men guards; this was an assumption made by the state.) Dothard, Director, Department of Public Safety of Alabama v. Rawlinson, 433 U.S. 321, 97 S.Ct. 2720, 1977 U.S. Lexis 143 (US.Sup.Ct.).

19.9. Fite wins the lawsuit. At age 57, Fite was protected by the Age Discrimination in Employment Act. The court held that the Association engaged in unlawful age discrimination when it retired Fite. The court found that the Association’s stated reason for retiring Fite—his poor job performance—was a mere pretext for engaging in age discrimination. This was also not ethical. Fite made a prima facie case of age discrimination against the association. The court affirmed a jury award of $270,000 damages and $71,373 attorneys’ fees against the Association. Fite v. First Tennessee Production Credit Association, 861 F.2d 884, 1989 U.S.App. Lexis 14759 (6th Cir.).

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Chapter 20 Employment Compensation and Worker Protection Law

How do we protect employment?

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. Topic Outline Employment at Will ↓ Exceptions Statutory

Contract

Public Policy

Tort

Workers’ Compensation Acts ❖ Act that compensate workers and their families if workers are injured in connection with their jobs

Employment-Related Injuries ❖ Out of and in the course of employment ❖ Cafeteria or business lunch included ❖ Personal lunch or off-premises not included

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Occupational Safety and Health Act ❖ Enacted in 1970 to promote safety in the workplace ❖ Established the Occupational Safety and Health Administration (OSHA) ❖ Generally, all private employers are within the scope of the act ❖ Federal, state, and local governments are exempt ❖ The act imposes record keeping and reporting requirements on employers ❖ Employers are required to post notices in the workplace informing employees of their rights under this act ❖ OSHA is empowered to administer the act and adopt rules and regulations to interpret and enforce it ❖ OSHA is empowered to inspect places of employment for health hazards and safety violations ❖ If a violation is found, OSHA can issue a written citation o Requires the employer to abate or correct the situation

There are specific and general duty standards.

Fair Labor Standards Act (FLSA) of 1938 (and subsequent amendments) ❖ Federal act enacted to protect workers o Prohibits child labor o Establishes minimum wage requirements o Establishes overtime pay requirements

Child Labor ❖ Under 14 – only newspaper delivery ❖ 14 & 15 – non hazardous jobs (limited hours) ❖ 16-17 – non hazardous jobs (unlimited hours) ❖ 18 and over – no restrictions

Other Worker Protection Laws Law Employee Retirement Income Security Act (ERISA) Consolidated Omnibus Budget Reconciliation Act (COBRA) Family and Medical Leave Act (FMLA)

Description Prevents fraud and other abuses associated with private pension plans.

Permits employees and their beneficiaries to continue their group health insurance after an employee’s employment has ended.

Guarantees workers unpaid time off from work for medical emergencies, birth, or adoption of child. No loss in pay, benefits, and status upon returning to work Immigration Reform Makes it unlawful for employers to hire illegal immigrants. and Control Act Employers are required to complete INS Form I-9 attesting legal (IRCA) U.S. citizenship or legal alien status of each employee

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Government Programs: Unemployment Compensation 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 ❖ State governments administer unemployment compensation programs under general guidelines set by the federal government

Government Programs: Social Security ❖ A Federal system that provides limited retirement and death benefits to covered employees and their dependents ❖ Federal Insurance Contributions Act (FICA) – a federal act that says employees and employers must make contributions into social security ❖ Self-Employment Contributions Act – a federal act that says self-employed persons must pay Social Security taxes equal to the combined employer amount III. Text Materials Case 20.1: Medrano v. Marshall Electrical Contracting Inc. Facts: Medrano, an electrician, attended an apprenticeship night class and was killed in a car accident on the way home. His family filed for workers’ compensation benefits (death Benefits).

An ALJ said he was not in the scope of employment. The Commission reversed.

Issue: Was Medrano within the scope of his employment?

Decision: Yes. Reason: The mutual benefit doctrine controls. It says that an injury suffered by an employee while performing an act for the mutual benefit of the employer and employee is usually compensable. Here the classroom instruction was an example of such an act he was encouraged to attend the class.

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Case 20.2: Simmons v. Bob Mears Florist Facts: While working and using Mears’ truck, Simmons purchased alcohol and stopped to drink it. He had an accident and was hurt because of the alcohol. Simmons filed for workers’ compensation and was granted benefits by an ALJ. The Commission said no because it was an alcohol-related frolic not within the course of employment.

Issue: Was Simmons within the course of his employment during the accident?

Decision: No. Reason: Simmons was on a personal frolic, in violation of the employer’s policy, not in a working location and not heading to a work location. He had not returned to the course of his employment.

Ethics Spotlight: Company Violates OSHA’s Safety Rule This case involves a roofing company being sued by OSHA for violating a safety rule.

Ethics Spotlight: FLSA Definition of compensable time under the FLSA is discussed.

Ethics Spotlight: Microsoft Violates Employment Law This box discusses the use of special workers at Microsoft and whether they were employees or independent contractors.

IV. Answers to Legal Environment Workers’ Compensation 20.1. Wilson wins because his participation in the off-duty activity was reasonably expected of his employment by the City. The court stated a two-part test to determine whether the activity was “a reasonable expectation of employment:” (1) whether the employee subjectively believes his or her participation in the activity is expected by the employer, and (2) whether that belief is objectively reasonable.” In this case, Wilson met the first requirement as indicated by his statements that his superiors told him that off-duty conditioning was required to meet the SERT qualifications. Wilson also satisfied the second part of the test, since all members of SERT were made aware that off-duty workouts are necessary, and it would be unrealistic to conclude that off-duty running was not expected of any member who wanted to pass the test of running two miles in 17 minutes. Furthermore, Wilson benefited his employer by being in the SERT unit. Wilson v. Workers’ Compensation Appeals Board, 196 Cal.App.3d 302, 239 Cal.Rptr.719, 1987 Cal. App. Lexis 2382 (Cal. App.).

Workers’ Compensation 20.2. Albanese wins. In general, if an employee is incapacitated by a mental or emotional disorder causally related to a series of specific stressful work related incidents, the employee is entitled to compensation. In defining whether an employee has a “mental or emotional disorder,” the terms are used in a general sense rather than a specific one. Although Albanese had been employed by Atlantic Steel Company for approximately twenty years, the court determined that his current condition was not the result of general stress or the wear and tear of working, but specific stressful episodes. These specific stressful episodes which occurred over a relatively short period of time as compared to his twenty years of employment, combined with the casual nexus between Albanese’s working conditions and his emotional 235 ..

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disorder, entitles Albanese to compensation under the Workers’ Compensation Act. Albanese’s Case, 389 N.E.2d 83, 1979 Mass. Lexis 795 (Mass).

Occupational Safety 20.3. 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 (5th Cir.).

ERISA 20.4. The Secretary of Labor wins because the trustees breached their fiduciary duty in violation of the Employee Retirement Income Security Act (ERISA). ERISA requires that an administrator or trustee of a pension benefit plan administer the plan as a fiduciary. A fiduciary is required to perform his duties regarding the plan with the “care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in like capacity and familiar with such matters would use in the conduct of an enterprise of like character and with like aims.” The court held that the obligation to act prudently requires the plan fiduciaries to act as a prudent man participating in a similar transactions such as by obtaining a fair return commensurate with prevailing or market rates on planned investments.

In the present case, the trustees failed to act prudently. They failed to require evidence of the borrower’s ability to repay the loans, to charge fair market rates of interest, to enter into a written agreement describing the terms and conditions of the loans, and to repay the loans when they became due. Thus, the court found that the trustees had violated their fiduciary duties and required them to resign their positions as trustees of the plan. McLaughlin v.

Rowley, 698 F. Supp. 1333, 1988 U.S.Dist. Lexis 12679 (N.D. Tex.).

Unemployment Benefits 20.5. The CTA wins. The court following Sec. 602(A) of the Unemployment Insurance Act stated “an individual shall be ineligible for benefits for the week (or time period) in which he has been discharged for misconduct connected with his work.” The court defined misconduct as behavior that is willful or a wanton disregard of an employer’s interests. Such interests include the intentional and substantial disregard of the employee’s duties and obligations to his employer. In this case, Devon Overstreet’s use of cocaine prior to reporting for work constituted a deliberate violation of her employer’s policy and indicated a disregard of the standards of behavior that the employer had the right to inspect. Overstreet v. Illinois Department of Employment Security, 522 N.E.2d 185, 1988 U.S.App. Lexis 10091 (Ill.App.).

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V. Answers to Business Ethics Cases 20.6. Workers cannot receive workers’ compensation and sue the employer in tort. It is the only remedy. One exception is if the employer intentionally injured the worker. The management may have found a safe way to test but they were not unethical. The employer was responsible. Nordyne, Inc. should win with no “intentional tort” exception.

20.7. 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. Whirlpool Corp. v. Marshall, Secretary of Labor, 445 U.S. 1, 100 S.Ct. 883, 1980 U.S.Lexis 811 (U.S. Sup. Ct.).

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Chapter 21 Immigration and Labor 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. Topic Outline Major Federal Labor Law Statutes ❖ Norris-LaGuardia Act of 1932 ❖ National Labor Relations Act of 1935 ❖ Labor-Management Relations Act of 1947 ❖ Labor-Management Reporting and Disclosure Act of 1959 ❖ Railway Labor Act of 1926 (amended in 1934)

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Landmark Law:

Organizing a Union ❖ Section 7 of the NLRA – gives employees the right to join together to form a union ❖ Appropriate Bargaining Unit – the group that the union is seeking to represent: ❖ Must be defined before the union can petition for an election ❖ Managers and professional employees may not belong to unions formed by employees whom they manage ❖ Elections can be contested, by consent for decertification ❖ Solicitation on company property can be restricted to employees’ free time ❖ It is unfair labor practice to influence joining or not joining a union or to interfere with election

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Ethics Spotlight:

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 ❖ The employer and the union must bargain with each other in good faith

Subjects ❖ Compulsory subjects o Wages, etc. ❖ Permissive subjects o Not compulsory or illegal ❖ Illegal subjects o Closed shops, etc.

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Union Security Agreements ❖ Union Shop o Employee must join the union within a certain number of days after being hired o Employees who do not join must be discharged by the employer upon notice from the union o Union members pay union dues to the union o Union shops are lawful ❖ Agency Shop o Employees do not have to become union members o They do have to pay an agency fee (an amount equal to union dues) to the union o Agency shops are lawful Check-Off Provision Upon proper notification by the union, union shop and agency shop employers are required to: 1. Deduct union dues and agency fees from employees’ wages, and 2. Forward these dues to the union This is called a check-off provision State Right-to-Work Laws Section 14(b) of the Taft Hartley Act – allows states to enact right-to-work laws that outlaw union or agency shops: ❖ Individual employees cannot be forced to join a union or pay union dues and fees even though a union has been elected by other employees ❖ 21 states have enacted right-to-work laws

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Illegal Strikes are: ❖ Violent strikes ❖ Sit-Down strikes ❖ Partial or Intermittent strikes ❖ Wildcat strikes ❖ Strikes during the 60-day cooling-off period ❖ Strikes in violation of a No-Strike Clause

Crossover Worker Individual members of a union do not have to honor the strike They may: 2. Choose not to strike, or 3. Return to work after joining the strikers for a time

Replacement Workers ❖ Workers who are hired to take the place of striking workers ❖ They can be hired on either a temporary or permanent basis ❖ If replacement workers are given permanent status, they do not have to be dismissed when the strike is over

Immigration Law (administered by ICE) 1) Immigration Reform and Control Act of 1986 2) Immigration Act of 1990 3) Form I-9 is required for verification.

4) H-1B Visa is a no-immigrant visa allowing employment of skilled employees in specialty occupations.

III. Text Materials Case 21.1: Lechmere, Inc. v. National Labor Relations Board Facts: The National Labor Relations Act (NLRA) guarantees employees “the right to selforganization, to form, join, or assist labor organizations,” and makes it an unfair labor practice for an employer “to interfere with, restrain, or coerce employees” in the exercise of their Sec.7 rights.

Petitioner Lechmere, Inc., owns and operates a retail store located in a shopping plaza in a large metropolitan area. Lechmere is also part owner of the plaza’s parking lot, which is separated from a public highway by a 46-foot-wide grassy strip, almost all of which is public property. In a campaign to organize Lechmere employees, non-employee union organizers placed handbills on the windshields of cars parked in the employees’ part of the parking lot. After Lechmere denied the organizers access to the lot, they distributed handbills and picketed from the grassy strip. The union filed an unfair labor practice charge with respondent National Labor Relations Board (Board), alleging that Lechmere had violated the NLRA by barring the organizers from its property. An administrative law judge ruled in the union’s favor, recommending that Lechmere be ordered to cease and desist from barring the organizers from the parking lot. The Board affirmed. The Court of Appeals enforced the Board’s order.

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Issue: Did Lechmere commit an unfair labor practice by barring non-employee union organizers from its property?

Decision: Lechmere did not commit an unfair labor practice.

Reason: By its plain terms, the NLRA confers rights only on employees, not on unions or their non-employee organizers. Thus, as a rule, an employer cannot be compelled to allow nonemployee organizers onto his property.

The law simply does not protect non-employee union organizers except in the rare case where “the inaccessibility of employees makes ineffective the reasonable attempts by non-employees to communicate with them through the usual channels.” It is only when reasonable access to employees is not feasible that it becomes appropriate to balance the law and private property rights.

The facts in this case do not justify application of the inaccessibility exception. Because Lechmere’s employees do not reside on its property, they are presumptively not “beyond the reach” of the union’s message. The fact that they live in a large metropolitan area does not render them “inaccessible.” Because the union failed to establish the existence of any “unique obstacles” that frustrated access to Lechmere’s employees, the Board erred in concluding that Lechmere committed an unfair labor practice by barring the non-employee organizers from its property.

Case: 21.2. NLRB v. Exchange Parts Company Facts: Exchange Parts had previously been nonunion. In November 1959, a union notified Exchange Parts that it would seek to organize its workers. Within 6 months after that notification, but before the election, Exchange Parts held a dinner for its employees, announced a new holiday for employees, announced a new increased overtime pay and extended vacation plan, and sent employees a letter stating that only the company, not the union, could put things in their pay envelopes. The union lost the election and filed a complaint with the NLRB, which ordered a new election. The court of appeals reversed. NLRB appeals.

Issue: Is it an unfair labor practice for an employer to confer new economic benefits on its employees on the eve of a union election?

Decision: Yes. Reason: The NLRA prohibits interference with the exercise of union rights. Interference includes not only coercion, but also conferring benefits, the effect of which is like the fist in the velvet glove. Employees are not likely to miss the inference that the source of the economic benefits now conferred is also the source from which future benefits must flow. This is an unfair labor practice.

Law Case with Answer: Marquez v. Screen Actors Guild, Inc. Facts: The Screen Actors Guild (SAG) is a labor union that represents performers in the entertainment industry. In 1994, Lakeside Productions, an entertainment production company, signed a collective bargaining agreement with SAG making SAG the exclusive union for performers that Lakeside hired for its productions. Naomi Marquez, a part-time actress, auditioned for a one-line role in a TV episode and got the part. She did not pay the $500 membership in SAG. Because of that, Lakeside hired another actress. Marquez sued SAG and Lakeside, claiming that the union security clause was unlawful. The district court held for SAG. Issue: Does the union security clause negotiated between Lakeside and SAG violate federal labor law?

Decision: No. Reason: Section 8 (a)(3) permits unions and employers to require that employees pay the fees and dues necessary to support the union’s activities as the employees’ exclusive bargaining representative. Therefore, the union security clause was lawful.

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Contemporary Environment: State Right-to-Work Laws This statute represents a test of a state’s loyalty to or opposition to unionization within its borders.

There is a perception that the less a state does to control the activities of business entities within its borders, the more likely will business choose to move there. These laws often outlaw union and agency shops.

Ethics Spotlight: Labor Union Conducts Mock Funeral A mock funeral procession at a work site is not illegal secondary boycott picketing with coercion, threats, etc.

IV. Answers to Legal Environment Unfair Labor Practice 21.1. 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. NLRB v. Gissel Packing Co., 395 U.S. 575, 89 S.Ct. 1918, 1969 U.S. Lexis 3172 (U.S.Sup.Ct.).

Right-to-Work Law 21.2. 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 (U.S.Sup.Ct.).

Plant Closing 21.3. No, Arrow Automotive Industries, Inc. (Arrow) does not have to bargain with the union regarding its decision to close the Hudson, Massachusetts, plant. Congress has limited the subjects of mandatory bargaining to “wages, hours, and other terms and conditions of employment.” The court held that the company’s decision to close down the Hudson plant was not a mandatory subject of collective bargaining.

The court found that the company had justifiable economic reasons for closing the plant, and that the decision was not based on antiunion animus. The court held that although jobs would be eliminated by the decision, this does not make it a mandatory subject of negotiation. The board of directors of a company should be able to make such significant economic and policy

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decisions such as closing an unprofitable plant without first having to bargain with the union over the decision. Making such a decision a mandatory subject of bargaining would give the union a powerful tool for delay. As the court stated, “the union’s practical purpose in participating will be largely uniform: it will seek to halt or delay the closing.” The court found that the management of a company must be free to make a decision of the magnitude of a plant closing without the constraints imposed by mandatory bargaining. Thus, the closing of a plant is a permissible subject of collective bargaining, and the company in this case rightfully chose not to bargain over this issue.

Note: Under the Plant Closing Act, today the company would have to give the employees at least 60 days notice if the plant closing resulted in a loss of employment of 50 or more employees. Arrow Automotive Industries, Inc. v. NLRB, 853 F.2d 223, 1989 U.S. App. Lexis 10091 (4th Cir.).

Unfair Labor Practice 21.4. 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. NLRB, 386 U.S. 612, 87 S.Ct. 1250, 1967 U.S. Lexis 2858 (U.S.Sup.Ct.).

Unfair Labor Practice 21.5. Union’s rule is lawful. It was looking for actual work for its workers and not just stand-by pay. It is just protecting its members.

Employer Lockout 21.6. 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. NLRB, 380 U.S. 300, 85 S.Ct. 955, 1965 U.S. Lexis 2310 (U.S.Sup.Ct.).

Replacement Workers 21.7. 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

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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. NLRB v. Erie Resistor Company, 373 U.S. 221, 83 S.Ct. 1139, 1963 U.S. Lexis 2492 (U.S.Sup. Ct.).

Secondary Boycott 21.8. No, the picketing of the five neutral title insurance companies is not lawful. The Supreme Court held that the picketing of the neutral employers constituted an illegal secondary boycott in violation of the National Labor Relations Act. Although in Tree Fruits, 377 U.S. 58, 84 S.Ct. 1063 (1964), the court held that secondary picketing against a struck product is lawful, the picketing becomes an illegal secondary boycott if the picketing threatens, coerces, or restrains a person from buying or using the services of the neutral employer.

The product picketed in Tree Fruits (apples) was but one item among the many that made up the grocery store’s trade. If the appeal against the product succeeds, it simply induces the neutral retailer to reduce its orders for the product or to drop the item as a poor seller. Under this circumstance, the incidental injury to the neutral employer will be tolerated. However, in this case the five local title insurance companies sell only the primary employer’s product.

Secondary picketing against consumption of the primary employer’s product leaves responsive consumers no realistic option other than to boycott the five local title companies altogether. The court held that the union did more than merely follow the struck product; it created a separate dispute with the secondary employers. The Supreme Court upheld the NLRB’s decision that ordered the union to cease picketing the five local title insurance companies. NLRB v. Retail Store Employees Union, Local 1001, Retail Clerks International Association, AFL-CIO, 447 U.S. 607, 100 S.Ct. 2372, 1980 U.S. Lexis 133 (U.S.Sup.Ct.).

IV. Answers to Business Ethics Cases 21.9. Yes, Whitcraft’s discharge of the employees was unlawful. If union solicitation is being conducted by fellow employees, an employer may restrict solicitation activities to the employees’ nonworking time and in nonworking areas. Employers may dismiss employees who violate the rule. The court found that the conduct of the two employees plainly violated the valid no-solicitation rule, and held that they were properly discharged from their employment because of their misconduct. Whitcraft Houseboat Division, North American Rockwell Corporation v. International Association of Machinists and Aerospace Workers, AFL-CIO, 195 NLRB 1046 (N.L.R.B.).

21.10. No, the employees who engaged in the walkout cannot get their jobs back. The employee 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. It seems that the company had a right to fire while the employees were not being reasonable. NLRB v. Shop Rite Foods, Inc., 430 F.2d 786, 1970 U.S.App. Lexis 7613 (5th Cir.).

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Chapter 22 Intellectual Property and Cyber Piracy

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, trade secrets, and the like 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. Topic Outline Intellectual Property Rights Intellectual property rights include: ❖ Patents ❖ Copyrights ❖ Trademarks ❖ Trade Secrets ❖ Trade Names ❖ Domain Names These are very valuable business assets protected by federal and state laws from misappropriation and infringement

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Trade Secrets (1 of 3) ❖ A product formula, pattern, design, compilation of data, customer list, or other business secret ❖ Many states have adopted the Uniform Trade Secrets Act Trade Secrets Act to give statutory protection to trade secrets

Trade Secrets (2 of 3) ❖ 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 ❖ Plaintiff can sue to recover profits or damages or to get an injunction

Trade Secrets (3 of 3) ❖ 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 Note: Reverse-engineering is the lawful discovering of a trade secret by re-creating the secret recipe.

Online Commerce and Internet Law: Economic Espionage Act of 1996 ❖ Makes it a federal crime to steal another’s trade secrets It is 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

Landmark Law: Federal Patent Statute of 1952 ❖ This law is intended: ❖ to provide an incentive for inventors to invent and to make their inventions public; and ❖ to protect patented inventions from infringement ❖ Federal patent law is exclusive ❖ There are no state patent laws

Changes in U.S. Patent Law (1995) The General Agreement on Tariffs and General Agreement on Tariffs and Trade (GATT) Trade (GATT) caused the following changes in U.S. patent law: ❖ Patents are valid for 20 years 20 years, instead of the previous term of 17 years ❖ The patent term begins to run from the date the patent application is filed instead of when the patent is issued as was previously the case

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Patenting an Invention To be patented, an invention must be: ❖ Novel ❖ Useful ❖ Nonobvious Only certain subject matters can be patented

Patentable subject matter includes: ❖ Machines ❖ Processes ❖ Compositions of matter ❖ Improvements to: ❖ Existing machines ❖ Processes Designs for an article of manufacture ❖ Asexually reproduced plants ❖ Living material invented by a person

Patent Infringement ❖ Unauthorized use of another’s patent ❖ A patent holder may recover damages and other remedies against a patent infringer ❖ Patent holders own exclusive rights to use and exploit their patent

One-Year “On Sale” Doctrine ❖ A patent may not be granted if the invention was used by the public for more than one year prior to filing of the patent application ❖ This doctrine forces inventors to file their patent applications at the proper time

The American Inventors Protection Act ❖ Federal statute that permits inventors to file a provisional application provisional application with the PTO, ❖ Requires the PTO to issue a patent within three years in most circumstances ❖ Provides for contested reexaminations within the PTO

Copyrights and Internet Law: Copyright Revision Act of 1976 ❖ Establishes the requirements for obtaining a copyright ❖ Protects copyrighted works from infringement ❖ To be protected under federal copyright law, the work must be the original work of the author ❖ Only tangible writings are subject to copyright registration and protection

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Copyright ❖ Created when author produces work ❖ May be registered in U.S. Copyright Office ❖ Berne Convention (an international treaty) eliminated need for symbol or word

Registration of Copyrights To be protected under federal copyright law: ❖ The work must be the original work of the author ❖ A copyright is created when an author produces her work ❖ Published and unpublished works may be registered with the U.S. Copyright Office ❖ Registration is permissive and voluntary and can be effected at any time during the term of the copyright

Copyright Terms (Sonny Bono Copyright Term Extension Act) Individual Copyright Holder Individual Copyright Holder – life of author plus 70 years Corporate Copyright Holder Corporate Copyright Holder – 95 years from the year of first publication or 120 years from the year of creation, whichever is shorter

Copyrighting Software Key legislation to afford protection to software and computer chips: ❖ Computer Software Copyright Act of 1980 ❖ Semiconductor Chip Protection Act of 1984

Copyright Infringement ❖ Occurs when a party copies a substantial and material part of the plaintiff’s copyrighted work without permission ❖ A copyright holder may recover damages and other remedies against the infringer ❖ Involves secondary liability on parties who knowingly contribute to another party’s copyright infringement (assisting in copyright infringement)

The Fair Use Doctrine (1 of 3) ❖ The copyright holder’s rights in the work are not absolute ❖ The law permits certain limited unauthorized use of copyrighted materials

The Fair Use Doctrine (2 of 3) The following are protected under this doctrine: 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

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The Fair Use Doctrine (3 of 3) 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 6. Reproduction of a work in a legislative or judicial proceeding

Online Commerce and Internet Law: ❖ No Electronic Theft Act (NET Act) of 1997 ❖ Digital Millennium Copyright Act (DMCA) of 1998 Landmark Law: Lanham Trademark Act of 1946 (as amended) ❖ Establishes the requirements for obtaining a federal mark ❖ Protects marks from infringement ❖ Trademarks are registered with the U.S. Patent and Trademark Office (PTO) ❖ Provides legal protection for names, slogans and logos

Trademark Law ❖ The original registration of a mark is valid for 10 years ❖ 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

Registration of Trademarks ❖ 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

Distinctiveness of a Mark To qualify for federal protection, ❖ A mark must be distinctive– i.e., a brand name that is unique and fabricated; or ❖ Have acquired a “secondary meaning” – i.e., when an ordinary term has become a brand name

Marks That Can Be Trademarked (1 of 2) 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

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Marks That Can Be Trademarked (2 of 2) 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 Mark – used by cooperatives, associations, and fraternal organizations ❖ e.g., Boy Scouts of America

Marks That Cannot Be Registered ❖ The flag or coat of arms of the United States, any state, municipality, or foreign nation ❖ Marks that are immoral or scandalous ❖ Geographical names standing alone ❖ Surnames standing alone ❖ Any mark that resembles a mark already registered with the federal PTO Trademark Infringement ❖ The owner of a mark can sue a third party for the unauthorized use of a mark ❖ The owner must prove that: ❖ The defendant infringed the plaintiff’s mark by using it in an unauthorized manner, and ❖ Such use is likely to cause confusion, mistake, or deception of the public as to the origin of the goods or services

Generic Names ❖ Generic name – a trademark that that becomes a common term for a product line or type of service ❖ Once a trademark becomes a generic name, the term loses its protection under federal trademark law because it has become descriptive rather than distinctive

Federal Dilution Act of 1995 (1 of 2) ❖ Protects famous marks from dilution ❖ The act provides that owners of marks have a valuable property right in their marks that should not be eroded, blurred, tarnished, or diluted tarnished, in any way by another ❖ The act is designed to stop those who attempt to benefit from the time and money spent by a company to develop and promote its famous marks

Federal Dilution Act of 1995 (2 of 2) The act has three fundamental requirements: 1. The mark must be famous 2. The use by the other party must be commercial 3. The use must cause dilution of the distinctive quality of the mark

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International Protection of Intellectual Property Rights 1. Paris Convention 2. Berne Convention 3. WIPO Copyright Treaty 4. WIPO Phonogram Treaty

The Internet ❖ The Internet – collection of millions of computers that provide a network of electronic connections between computers ❖ E-mail – written communication between individuals using computers connected to the Internet ❖ Worldwide Web – electronic collection of millions of computers that support a standard set of rules for the exchange of information ❖ Domain name – a unique name that identifies an individual’s or company’s web site

III. Text Materials Ethics Spotlight: Coca-Cola Employee tries to Sell Trade Secret to Pepsi-Cola The conspiracy to steal trade secrets of Coca-Cola by an employee and sell them to Pepsi-Cola is discussed. The verdict was guilty.

Case22.1: BMG Music v. Gonzalez Facts: Gonzalez downloaded 1370 copyrighted songs using KaZaA. BMG sued for infringement. Gonzalez said that downloading was lawful. The district court granted summary judgment for BMG assessing damages and issuing an injunction. Gonzalez appealed.

Issue: Did Gonzalez engage in copyright infringement?

Decision: Yes. Judgment was affirmed.

Reason: A downloaded copy is a substitute for a purchased copy that should be paid for. No fee was paid here so the authors received nothing. This is not “fair use”.

Internet Law & Online Commerce: Patenting Business and E-Commerce Methods Many persons have filed for and received patents for business and financial plans and models that are used over the Internet.

Ethics Spotlight: Patent Infringement: Inventor Wipes Windshields Clean This box discusses the ethics of patent infringement.

Internet Law & Online Commerce: DMCA DMCA prohibits unauthorized access to copyrighted digital works by circumventing the protections as well as the manufacture and distribution of technology to accomplish this. There are some exceptions.

Ethics Spotlight: Trade Dress Certain forms of trade dress are protected.

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Case 22.2: Menashe v. Victoria’s secret Stores, Inc. Facts: In Fall, 2002, Victoria’s Secret (VS) named a line of lingerie “SEXY LITTLE THINGS”, and began selling them. In 2004, Menashe name a line of lingerie “SEXY LITTLE THINGS”. They filed an ITV application with the USPTO. They denied knowledge of VS’s line. Later in 2004, VS applied to register the phrase with the USPTO whey they learned of Menashe’s ITO application. VS sent a cease and desist order stating the phrase was a trademark before the ITV application. Menashe stopped production and filed suit against Menashe seeking a declaratory judgment that there was no trademark infringement and asking for damages. The USPTO suspended act on VS’s application pending disposition of the ITV application.

Issue: Should Menashe be granted a declaratory judgment of trademark non-infringement for using the terms “SEXY LITTLE THING” and “SEXY LITTLE THINGS” for their lingerie?

Decision: No. VS had priority. Petition and case was dismissed.

Reason: VS made bona fide trademark use of “SEXY LITTLE THINGS” in commerce before Menashe filed their ITV application.

See Law Case with Answer in Text.

III. Answers to Legal Environment Cases Trade Secret 22.1. Yes, a customer list is a trade secret under the Uniform Trade Secret Act, which has been adopted in the State of Indiana. Trade secrets are types of information that set one business apart from their competitors. Trade secrets may be product formulas, pattern designs, compilation of data, or other business secrets. Trade secrets do not have to be patented, copyrighted, or trademarked to be protected. Many states, including Indiana, have adopted the Uniform Trade Secrets Act to give statutory protection to trade secrets. In this case, the court held that CRA-MAR’s customer list was a trade secret, and therefore was deserving of protection. Because the customer list was information that CRA-MAR had developed in the course of business, and was the type of information that set CRA-MAR apart from its competitors, the court held that it was a trade secret. Based upon its status as a trade secret under the Uniform Trade Secret Act, the court enjoined Koach’s from further use of CRAMAR’s list. Koach’s Sales Corporation v. CRA-MAR Video Center, Inc., 478 N.E.2d 110, 1985 Ind. App. Lexis 2432 (Ind.App.).

Patent 22.2. The court could award up to $3.6 billion or treble damages if action was found to be intentional Smith Internat’l Inc. v. Hughes Tool Co., 775 F.2d 1572.

Copyright 22.3. Harper & Row wins. The United States Supreme Court held that The Nation engaged in copyright infringement in violation of federal copyright law when it published unauthorized verbatim quotes from President Gerald Ford’s soon-to-be published memoirs. President Ford and his publisher, Harper & Row, owned the copyright to the memoirs. The Nation obtained a prepublication copy of the memoirs and knowingly published the words verbatim from the memoirs.

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news, or other fair use. The Supreme Court rejected this defense. The Court balanced all of the factors involved in this case and found that the fair use doctrine did not protect The Nation. The court found that the unpublished nature of the work, the contract that President Ford had with Harper & Row to publish the memoirs, the commercial nature of the work, and the verbatim use of the words from the work, all worked against The Nation’s claims of fair use. The Supreme Court found that The Nation’s liberal use of the verbatim excerpts posed substantial potential for damage to the marketability of the copyrighted works. The Supreme Court reversed the appellate court’s decision and upheld the district court’s finding that The Nation had engaged in copyright infringement. Harper & Row, Publishers v. Nation Enterprises, 471 U.S. 539, 105 S.Ct. 2218, 1985 U.S. Lexis 17 (U.S.Sup.Ct.).

Copyright Fair Use Doctrine 22.4. The National Broadcasting Company wins the suit based upon the fair use doctrine. A copyright holder’s rights in a work are not absolute. The law permits certain limited unauthorized uses of copyrighted materials under the fair use doctrine. Examples of uses that are protected under the doctrine are quotations for review or criticism, use in a parody or satire, and quotations in news reports. Where a fair use is found, the copyright holder cannot recover for copyright infringement. In this case, the court found that the plaintiff, Eismere Music, held a valid copyright for the song “I love New York.” Neither NBC nor Saturday Night Live sought Elsmere’s permission before using the “I love New York Song” in their skit. However, the court held that the use of the tune was in the form of a parody of New York City’s advertising campaign. Because the use of copyrighted material in a parody is protected under the fair use doctrine, Elsmere could not recover from NBC or Saturday Night Live. The court dismissed the suit, and the court of appeals affirmed the decision. Elsmere Music Inc. v. National Broadcasting Company, Inc., 623 F.2d 252, 1980 U.S.App. Lexis 16820 (2nd Cir.).

Trademark 22.5. Yes, the slogans “Hair Color So Natural Only Her Hair Dresser Knows For Sure” and “Does She or Doesn’t She?” could be validly trademarked. A trademark is a distinctive mark, symbol, name, word, motto, or device that identifies the goods of a particular business.

A trademark distinguishes the business and its products from those of its competitors. To qualify for protection, a mark must be distinctive or have taken on a “secondary meaning.” A secondary meaning cannot be trademarked. The court held that the two Clariol slogans had become distinctive. Through the use of an advertising campaign that cost over $22 million, the two slogans had become associated with the products of Clariol, Inc. Both slogans had taken on a secondary meaning, and therefore the words in the slogans were not merely descriptive. Because the slogans had taken on a secondary meaning, the court granted Clariol a trademark. Roux Laboratories. Inc. v. Clairol Incorporated, 427 F.2d 823, 1970 CCPA Lexis 344 (Cust.Pat.App.).

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Dilution 22.6. Toyota wins and can use the name “Lexus” for its line of automobiles. The trial court had held in favor of Mead Data Central, Inc. (Mead), which owned the mark “Lexis” which was used as the name for its computerized legal research system. The appellate court reversed the trial court’s decision, holding that Toyota’s “Lexus” name did not dilute Mead’s “Lexis” name. The appellate court found that the two marks were not substantially similar in that Mead’s “Lexis” mark applied to computer research and Toyota’s “Lexus” mark applied to automobiles. Further, evidence showed that only one percent of the public associated the name Lexis with computerized legal research, and half of this one percent were lawyers.

Thus, the court found that the public would not be confused by the use of the two marks in commerce. Further, the court found that the two words had different meanings; “Lexis” is based on “lex” which is Latin for law and “is” of information systems, whereas “Lexus” is an artificial name created by Toyota. Because of these reasons, the appellate court held that Toyota’s mark “Lexus” did not infringe or dilute Mead’s “Lexis.” Mead Data Central, Inc. v. Toyota Motor Sales, U.S.A., Inc., 875 F.2d 1026, 1989 U.S.App. Lexis 6644 (2d Cir.).

Generic Name 22.7. The term “Lite” to identify reduced calorie beer is a generic name that does not qualify for trademark protection under the Lanham Act. Prior to this lawsuit by Miller Brewing Company against Falstaff Brewing Corporation, Miller had also sued G. Heileman Brewing Co. and Joseph Schlitz Brewing Co. for using the term “Lite” to identify their reduced calorie beer. Miller contended that the word lite in the “Miller Lite” name for its reduced calorie beers was subject to trademark protection under the Lanham Act. The court, in both Heileman and Schlitz cases, held against Miller and found that the word “lite” was a generic term not subject to trademark protection. The courts held that the term “lite” was used by consumers to mean all reduced calorie beers no matter from what brewery. Therefore, Miller could not claim a trademark is a generic term. The court in this case relied on the prior holdings in the Heileman and the Schlitz cases and held in favor of Falstaff, finding that Falstaff could use the word “lite” to identify its reduced calorie beer. The court dismissed Miller’s case against Falstaff. Miller Brewing Company v. Falstaff Brewing Corporation, 655 F.2d 5, 1981 U.S.App. Lexis 11345 (1st Cir.).

V. Answers to Business Ethics Cases 22.8. Digital Transactions Inc. misappropriated ICM’s trade secrets. A trade secret can exist in a combination of characteristics and components, each of which, by itself, is in the public domain, but the unified process, design, and operation of which, in unique combination, affords a competitive advantage and is a protectable secret. Integrated Cash Management Services, Inc. v. Digital Transactions, Inc., 920 F.2d 171, 1990 U.S.App. Lexis 20985 (2d Cir.).

22.9. Carson wins. A celebrity has a right to protect his pecuniary interest in the commercial exploitation of his identity. The use of a person’s name or likeness is not necessary for such exploitation. The defendant was aware of the association between the phrase and Carson and intended to appropriate for its pecuniary gain. This interfered with Carson’s interest, and therefore, it is a misappropriation. Carson v. Here’s Johnny Portable Toilets, Inc., 698 F.2d 831 (6th Cir. 1983).

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Chapter 23 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 like 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 over 90 percent of the market for oil products in the U.S. By the time the trust was “busted” in 1911, over 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, i.e., illegal joining together to restrain trade.

(2) To control markets thought to have a monopoly, i.e., 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,

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speak to much more specific objectives. The objectives arose out of discriminatory practices aimed at getting the little guy.

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 as we enter the twenty-first century. A free and open market is not measured now on regional or even national scales, 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 while provisions like price discrimination look good in theory, they are difficulty 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. Topic Outline Antitrust Laws ❖ A series of laws enacted to limit anticompetitive behavior in almost all industries, businesses, and professions operating in the United States

Federal Antitrust Laws ❖ Sherman Act of 1890 ❖ Clayton Act of 1914 ❖ Federal Trade Commission (FTC) Act of 1914 ❖ Robinson-Patman Act of 1930

Landmark Law: ❖ Sherman Act – restraints of trade and monopolistic acts ❖ Clayton Act – mergers and exclusive dealing arrangements ❖ FTC Act – unfair methods of competition ❖ Robinson-Patman Act – price discrimination

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Antitrust Enforcement ❖ The federal antitrust statutes are broadly drafted to: o Reflect the government’s enforcement policy o Allow the government to respond to economic, business, and technological changes ❖ Each administration adopts an enforcement policy for antitrust laws ❖ Antitrust laws are enforced more stringently at some times than at other times

Antitrust Enforcement ❖ Government Actions: criminal (Sherman Act) & civil damages (maybe treble) ❖ Private Actions: civil damages (sometimes treble) ❖ Injunctions

Antitrust Penalties ❖ Federal antitrust laws provide the following penalties: o Criminal sanctions o Civil penalties o Private civil actions o Effect of a government judgment

Section 1 of the Sherman Act: Restraints of Trade ❖ Prohibits contracts, combinations, and conspiracies in restraint of trade ❖ To violate Section 1, the restraint must be found to be unreasonable under either of two tests: o Rule of reason o Per se rule ❖ Requires the concerted action of two or more parties

Contemporary Environment: Rules to Determine Lawfulness of a Restraint ❖ Rule of Reason a rule that holds that only unreasonable restraints of trade violate Section 1 of the Sherman Act ❖ Per Se Rule a rule that is applicable to those restraints of trade considered inherently anticompetitive

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

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Horizontal Restraints of Trade Include: ❖ Price-Fixing occurs where competitors in the same line of business agree to set the price of the goods they sell. A per se violation. ❖ Division of Markets occurs when competitors agree that each will serve only a designated portion of the market. A per se violation ❖ Group Boycott – occurs when two or more competitors at one level of distribution agree not to deal with others at another level of distribution

Vertical Restraint of Trade ❖ Occurs when two or more parties on different levels of distribution enter into a contract, combination, or conspiracy to restrain trade

Forms of Vertical Restraint ❖ Resale Price Maintenance (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 that either sets or stabilizes prices o A per se violation of Section 1 of the Sherman Act ❖ Nonpice Vertical Restraints – are unlawful under Section 1 of the Sherman Act if their anticompetitive effects outweigh their pro-competitive effects o Includes situations where a manufacturer assigns exclusive territories to retail dealers, or o Limits the number of dealers that may be located in a certain territory

Defenses to Section 1 of the Sherman Act ❖ Unilateral Refusal to Deal o A unilateral choice by one party not to deal with another party o This does not violate Section 1 of the Sherman Act because there is no concerted action with others o This rule was announced in United State v. Colgate & Co. o Often referred to as the Colgate doctrine ❖ Conscious Parallelism o Occurs when two or more firms act the same but without concerted action o This does not violate Section 1 because there has been no concerted action ❖ Noerr Doctrine o Two or more parties may petition the government to enact laws or to take other action

Section 2 of the Sherman Act: Monopolization ❖ Prohibits the act of monopolization as well as attempts and conspiracies to monopolize o Can be violated by the conduct of one firm ❖ The following elements are necessary to prove a defendant in violation of Section 2: o Relevant market o Monopoly power o Act of monopolizing

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Defining the Relevant Market ❖ Relevant product or service market includes substitute products or services that are reasonably interchangeable with the defendant’s products or services ❖ Relevant geographical market – the area in which the defendant and its competitors sell the product or service

Monopoly Power ❖ The power to control prices or exclude competition ❖ Measured by the market share the defendant possesses in the relevant market

Willful Act of Monopolizing ❖ A required act for there to be a violation of Section 2 of the Sherman Act o e.g., predatory pricing ❖ Possession of monopoly power without such an act does not violate Section 2 of the Sherman Act ❖ Watch for Predatory Pricing as an example. Attempts or conspiracies to monopolize are violations.

Defenses to Monopolization ❖ Innocent Acquisition o Superior business acumen o Monopoly that is acquired by superior skill, foresight, or industry ❖ Natural Monopoly o Monopoly that is thrust upon the defendant o Small market that can support only one competitor

Section 7 o the Clayton Act: Mergers ❖ Section 7 of the Clayton Act provides that it is unlawful for a person or business to acquire the stock or assets or 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.” ❖ The following elements are necessary to prove a violation of Section 7 of the Clayton Act: o Line of commerce – the market that will be affected by the merger o Section of the country – geographical market that will be affected by the merger o Probability of a substantial lessening of competition

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Types of Mergers (1 of 2) ❖ Horizontal Mergers o A merger between two or more companies that compete in the same business and geographic market o United States v. Philadelphia National Bank established the presumptive illegality test ❖ Vertical Mergers o A merger that integrates the operations of a supplier and a customer o Backward vertical merger o The customer acquires the supplier o Forward vertical merger o The supplier acquires the customer

Types of Mergers (2 of 2) ❖ Market Extension Mergers o A merger between two companies in similar fields whose sales do not overlap o Geographical market extension merger o Product market extension merger ❖ Conglomerate Mergers o A merger that does not fit into any other category o A merger between firms in totally unrelated businesses o Unfair advantage theory

Premerger Notification ❖ Hart-Scott-Rodino Antitrust Improvement Act of 1976 o An act that requires certain firms to notify the FTC and the Department of Justice in advance of a proposed merger o Unless the government challenges the proposed merger within 30 days, the merger may proceed

Section 3 of the Clayton Act: Tying Arrangements ❖ A tying arrangement is 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 ❖ Section 3 of the Clayton Act prohibits tying arrangements involving sales and leases of goods o i.e., tangible personal property

❖ Section 1 of the Sherman Act prohibits tying arrangements involving goods, services, intangible property, and real property ❖ A tying arrangement is lawful if there is some justifiable reason for it

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Section 2 of the Clayton Act: Price Discrimination ❖ Commonly referred to as the Robinson-Patman Act ❖ Sellers often offer favorable terms to their preferred customers ❖ Price discrimination occurs if the seller does this without just cause ❖ Illegal if it results in substantially lessening competition or creating a monopoly in any line of commerce

Direct Price Discrimination ❖ To prove a violation of Section 2(a), the following elements must be shown: 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

Indirect Price Discrimination ❖ A form of price discrimination that is less readily apparent than direct forms of price discrimination ❖ E.g., favorable credit terms, freight charges, and such to favored customers ❖ These are violations of the Robinson-Patman Act

Defenses to Section 2(a) Actions ❖ The Robinson-Patman Act establishes three statutory defenses to Section 2(a) liability: 1. Cost justification defense 2. Changing conditions defense 3. Meeting the competition defense

Landmark Law: Section 5 of the Federal Trade Commission Act: Unfair Methods of Competition ❖ Section 5 of the FTC Act – prohibits unfair methods of competition and unfair or deceptive acts or practices in or affecting commerce ❖ Section 5 is broader than the other antitrust laws ❖ The FTC is exclusively empowered to enforce the FTC Act

Exemptions From Antitrust Laws ❖ Statutory Exemptions exemptions from antitrust laws that are expressly provided in statutes enacted by Congress ❖ Implied Exemptions – exemptions from anti-trust laws that are implied by the federal courts ❖ State Action Exemptions – business activities that are mandated by state law are exempt from federal antitrust laws

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State Antitrust Laws ❖ Most states have enacted antitrust statutes ❖ State statutes are usually patterned after the federal antitrust statutes ❖ State antitrust laws are used to attack anti-competitive activity that occurs in intrastate commerce

III. Text Materials Ethics Spotlight: The Department of Justice Flunks the Ivy League Schools For years, the administrators of eight Ivy League schools traded information about applicants seeking scholarships. The Justice Department alleged that these schools had conspired and engaged in a horizontal restraint of trade in violation of Section 1 of the Sherman Act. Internet Law & Online Commerce: U.S. v. Microsoft Corporation This box discusses the government case against Microsoft. Many commentators believe that Microsoft basically “won” this case.

See Law Case with Answer in Text.

IV. Answers to Legal Environment Cases Price Fixing 23.1. 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 (U.S.Sup.Ct.).

Division of Market 23.2. The United States wins. The U.S. Supreme Court held that Topco and its members engaged in illegal geographical division of markets which constituted a per se violation of Section 1 of the Sherman Act. The Supreme Court held that the per se rule, and not the rule of reason, applies to horizontal division of markets. The court stated that after considerable experience in examining these types of relationships, it found that division of markets stifled competition. The court held that when the Topco members agreed to divide the country into exclusive geographical markets and not sell Topco products in other members’ territories, they engaged in a geographical division of markets. The Supreme Court held that the Topco members’ geographical division of markets was an unreasonable restraint of trade and a per

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se violation of Section 1 of the Sherman Act. United States v. Topco Association, Inc., 405 U.S. 596, 92 S.Ct. 1126, 1972 U.S.Lexis 167 (U.S.Sup.Ct.).

Tying Arrangement 23.3. Metrix Warehouse, Inc. (Metrix) 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, Inc. v. Mercedes-Benz of North America, Inc., 828 F.2d 1033, 1987 U.S.App. Lexis 12341 (4th Cir.).

Resale Price Maintenance 23.4. Simpson, the franchised dealer, wins. The U.S. Supreme Court held that Union Oil Company (Union Oil) had engaged in resale price maintenance, which in this case constituted unreasonable restraint of trade in violation of Section 1 of the Sherman Act. Resale price maintenance occurs when a manufacturer or distributor sets the price at which retailers may sell products to consumers. In this case, Union Oil had set the price at which Simpson and other franchised service station dealers could sell Union Oil gasoline and other products.

Union Oil terminated Simpson when he sold gasoline to the public at less than the retail price set by Union Oil. The U.S. Supreme Court held that the resale price maintenance, or vertical price fixing, in this case was coercively applied by Union Oil and constituted a per se violation of Section 1 of the Sherman Act. Simpson v. Union Oil Company, 377 U.S. 13, 84 S.Ct. 1051, 1964 U.S.Lexis 2378 (U.S.Sup.Ct.).

Note: Not all vertical price fixing constitutes a per se violation of Section 1 of the Sherman Act. In Monsanto Company v. Spray-Rite Service Corporation, 465 U.S. 752, 104 S.Ct. 1464 79 L.Ed.2d 775 (1984), the U.S. Supreme Court held that in less egregious and coercive situations, resale price maintenance is to be examined using the rule of reason.

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Monopolization 23.5. Greyhound Computer Corporation, Inc. (Greyhound) wins. First, the court defined the relevant section of the country to be the nation and the relevant product market to be the leasing of computers. The court rejected IBM’s assertion that the relevant market was the sale and leasing of computers. Second, the court found that IBM, which controlled approximately 80 percent of the leasing market for computers, possessed the requisite monopoly power in the relevant market. Third, the court held that IBM had engaged in the willful organization and maintenance of monopoly power in violation of Section 2 of Sherman Act. The court found that IBM, by reducing the discounts at which it sold computers to leasing companies with the stated reason of increasing its market share of the leasing market engaged in an act of monopolization. The court reasoned that although IBM was under no duty to originally offer substantial discounts on its computers, once it did, it could not abruptly reduce the discounts without causing anticompetitive effects. Fourth, the court held that Greyhound had suffered antitrust injury because of IBM’s actions. The court held that IBM had engaged in the act of monopolization that violated Section 2 of the Sherman Act. Greyhound Computer Corporation, Inc. v. International Business Machines Corporation, 559, F.2d 488, 1977 U.S.App. Lexis 11957 (9th Cir.).

Merger 23.6. 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, as well as the Justice Department Merger Guidelines computed by using the Herfindhal index.

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 (2nd Cir.).

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Antitrust Injury 23.7. No, Brunswick is not liable to Pueblo Bowl for violating Section 7 of the Clayton Act. The U.S. Supreme Court held that in order for a defendant to be liable under Section 7, the plaintiff must have suffered an “antitrust injury.” The Supreme Court noted that any combination of two firms may cause some economic injury to competitors, particularly if the newly merged firm enjoys economies of scale from the merger that allows it to sell goods or services at lower prices to its customers. However, the court stated that this is not the type of injury that the antitrust laws were designed to prohibit.

The Supreme Court stated: At base, respondent Pueblo Bowl complains that by acquiring the failing bowling centers, petitioner Brunswick preserved competition, thereby depriving respondent of the benefits of increased competition. The damages respondent obtained from the judgment of the trial court would have been realized had competition been reduced. The antitrust laws, however, were enacted for the protection of competition, not competitors. It is inimical to the purposes of these laws to award damages for the type of injury claimed here.

The Supreme Court held that the plaintiff must allege and prove “antitrust injury” in order to prove a violation of Section 7 of the Clayton Act and recover treble damages from the defendant. The court found that Pueblo Bowl had not suffered antitrust injury from Brunswick’s repossession and operation of bowling centers; instead, the court found that Pueblo Bowl had only suffered damages that would have resulted if any party had continued to operate the bowling centers in competition with Pueblo Bowl. The Supreme Court reversed the judgment of the trial court that had awarded Pueblo Bowl $7 million in damages and $446,000 in attorneys’ fees. Brunswick Corporation v. Pueblo Bowl-O-Mat, Inc., 429 U.S. 477, 97 S.Ct. 690, 1977 U.S.Lexis 37 (U.S.Sup.Ct.).

Price Discrimination 23.8. 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 Refining Company v. Federal Trade Commission, 324 U.S. 726, 65 S.Ct. 961, 1945 U.S. Lexis 2749 (U.S.Sup.Ct.).

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V. Answers to Business Ethics Cases 23.9. Du Pont’s ownership of 23 percent of the stock of GM constitutes a vertical merger that gives Du Pont an illegal preference over competitors in the sale of finishes and fabrics to General Motors in violation of the Clayton Act. The issue is whether Du Pont’s position as the leading supplier of finishes and fabrics to GM came about because of competition alone, or because of its acquisition of GM stock. The court found that automotive finishes and fabrics are distinct enough to comprise a single line of commerce for relevant market purposes. The court also found that the market affected is substantial. The court found that Du Pont’s commanding position as a GM supplier was not achieved until after its sizable purchase of GM stock. In fact, a major consideration in purchasing that stock was to obtain this market. “The inference is overwhelming that Du Pont’s commanding position was promoted by its stock interest and was not gained solely on competitive merit.” Du Pont was later ordered to sell its stock in GM. United States v. E. I. Du Pont de Nemours & Co., 353 U.S. 586, 77 S.Ct. 872, 1957 U.S. Lexis 1755 (U.S.Sup.Ct.).

23.10. The meeting the competition defense probably protects Falls City from liability for price discrimination. The court generally reviews the meeting the competition defense. The defendant must only show that its lower price was made in good faith to meet a competitor’s price. The lower price may come about not only from a reduction of price, but also from an increase lesser than that to other customers. The price reduction may be made on a territorial basis, rather than on a customer-by-customer basis, but the defendant must prove that this was a reasonable way to do it. Case was remanded for proceedings consistent with this opinion. Falls City Industries, Inc. v. Vanco Beverage, Inc. 460 U.S. 428, 103 S.Ct. 1282, 1983 U.S. Lexis 148 (1983).

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Chapter 24 Consumer Protection and Global Product Safety

Why must the buyer beware?

I. Teacher to Teacher Dialogue This chapter covers 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 generally 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 contract, 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.

II. Topic Outline Federal Food, Drug, and Cosmetic Act (FDCA) of 1938 (as amended) ❖ Provides the basis for the regulation of much of the testing, manufacture, distribution, and sale of foods, drugs, cosmetics, and medicinal products and devices in the United States ❖ Administered by the Food and Drug Administration (FDA) ❖ The FDA is empowered to regulate food, food additives, drugs, cosmetics, and medicinal devices

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Regulation of Food ❖ The FDCA prohibits the shipment, distribution, or sale of adulterated food ❖ The FDCA prohibits false and misleading labeling of food products ❖ It mandates affirmative disclosure of information on food labels ❖ A manufacturer may be held liable for deceptive labeling or packaging

Nutrition Labeling and Education Act ❖ A federal statute that requires food manufacturers and processors to provide nutritional information on most foods ❖ It prohibits them from making unscientifically unsubstantiated health claims ❖ FDA regulations require food processors to provide uniform information about serving sizes and nutrients on labels

Regulation of Drugs ❖ The FDCA gives the FDA the authority to regulate the testing, manufacture, distribution, and sale of drugs ❖ The Drug Amendment to the FDCA gives the FDA broad powers to license new drugs in the United States ❖ The manufacture, distribution, or sale of adulterated or misbranded drugs is prohibited ❖ The law requires all users of prescription and nonprescription drugs to receive: 1. Proper directions for use 2. Including method and duration of use 3. Adequate warnings about any related side effects

Regulation of Cosmetics ❖ The FDA has issued regulations that require cosmetics: 1. To be labeled 2. To disclose ingredients 3. To contain warnings if they are carcinogenic or otherwise dangerous to a person’s health ❖ The manufacture, distribution, or sale of adulterated or misbranded cosmetics is prohibited ❖ The FDA may remove from commerce cosmetics that contain unsubstantiated claims 1. e.g., preserving youth 2. e.g., growing hair

Regulation of Medicinal Devices ❖ The Medicinal Device Amendment to the FDCA gives the FDA authority to regulate medicinal devices and equipment ❖ The mislabeling of medicinal devices is prohibited ❖ The FDA is empowered to remove “quack” devices from the market

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Product Safety: Consumer Product Safety Act (CPSA) of 1972 ❖ Federal statute that regulates potentially dangerous consumer products ❖ Created the Consumer Product Safety Commission (CPSC) ▪ Independent federal regulatory agency empowered to: 1. Adopt rules and regulations to interpret and enforce the CPSA 2. Conduct research on safety 3. Collect data regarding injuries

Lemon Laws ❖ Provide a procedure for consumers to follow to correct recurring problems in vehicles ❖ Establish an administrative procedure that is less formal than a court proceeding ❖ Require that an arbitrator decide the dispute between a consumer and car dealer

Unfair and Deceptive Practices: Section 5 of the Federal Trade Commission Act ❖ Prohibits unfair and deceptive practices including: o False and deceptive advertising o Bait and switch o Abusive sales tactics o Consumer fraud ❖ Deceptive o Misinformation or omission likely to mislead reasonable customer or o Unsubstantiated claim

Door-to-Door Sales ❖ Many states have enacted statutes that permit consumers to rescind contracts made at home with door-to-door sales representatives within a three-day period after signing the contract

Debtor Protection Law 1) Truth-in-Lending Act → - Regulations → sets specific disclosures 2) Consumer Leasing Act → extends TILA coverage to leases 3) Fair Credit & Charge card Disclosure Act → requires specific disclosures on credit and charge card solicitations and applications.

4) Equal Credit Opportunity Act → no discrimination in the extension of credit.

5) Fair Credit Reporting Act → sets guidelines for consumer reporting agencies 6) Fair Debt Collection Practices Act → no abusive, deceptive and unfair practices can be used by debt collectors.

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III. Text Materials Contemporary Environment: Safety of Foods This box discusses how many insect fragments constitute contaminants in various kinds of foods.

Ethics Spotlight: Animal Testing The FDA’s position on animal testing is discussed.

Ethics in Business: Lemon Laws Lemon laws provide a procedure for consumers to follow to correct recurring problems in a vehicle.

Case 24.1: U.S.A. v. LaGrou Distribution Systems, Inc. Facts: LaGrou operated a cold storage facility for raw, fresh, and frozen meat, poultry, and other food owned by customers. There was a rat problem. When rats gnawed at the food, the product was thrown out but the customers were lied to as to the reason. USDA and FDA inspectors discovered the problem and the warehouse was ordered shut down. 8 of 22 million pounds were found to be adulterated and were destroyed. The rest were strictly treated. LaGrou appealed from a U.S. District Court ruling ordering restitution.

Issue: Did LaGrou knowingly violate federal food safety laws?

Decision: Yes. The fine was slightly reduced, however.

Reason: Officers, managers and several employees of LaGrou knew of the terrible conditions.

LaGrou had knowingly stored the items under unsanitary conditions.

Case 24.2: FTC v. Colgate-Palmolive Company Facts: Colgate manufactures and sells a shaving cream called “Rapid Shave.” In a television commercial promoting Rapid Shave, a person is shown shaving what was called sandpaper. This sandpaper was in fact a simulated prop of Plexiglas with sand glued on. The FTC issued a complaint against Colgate for false and deceptive advertising.

Issue: Was this commercial false and deceptive advertising in violation of the Federal Trade Commission Act? Decision: Yes. Reason: The court found this to be a material deceptive practice. Colgate could have labeled this as a demonstration, or, they could have found another advertisement. The fact that some products do not lend themselves to television commercials does not allow the manufacturer to be deceptive. This case is distinguishable from the case where ice cream companies use mashed potatoes instead of ice cream in their commercials, because the potatoes are not used as additional proof of the claims being made. Here, the sandpaper is being used to give the viewer objective proof of the claims being made. Finally, the FTC order to Colgate not to use such methods in advertising any other products in the future is permissible.

Ethics Spotlight: Kraft No Longer the “Big Cheese” Kraft’s calcium advertisements were materially unfair and deceptive.

Internet Law & Online Commerce: Do-Not-Call Registry Consumers can place their names here to free themselves from most unsolicited commercial telephone calls.

International Law: Product Recalls of Foreign-Made Goods This deals with companies that have their products made in foreign countries. Lawsuits have been filed.

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International Law: United Nations Biosafety Protocol for Genetically Altered Foods This box discusses the Biosafety protocol.

See Law Case with Answer in text.

IV. Answers to Legal Environment Cases Food Regulation 24.1. 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(E.D.N.Y).

Regulation of Drugs 24.2. The FDA wins the case, based upon the Drug Amendment to the Food, Drugs, and Cosmetics Act. This amendment gives the FDA broad powers to license new drugs in the United States. To market a new drug in this country, FDA approval must be obtained. A new drug application must be filed with the FDA. The FDA will then hold a hearing and investigate the merits of the application. A new drug application becomes effective if the FDA approves the application. The Court held that Dey had properly applied for permission to market a new drug in the U.S. When the FDA informed Dey that the application to market the inhalant would not be approved, Dey should have ceased manufacturing AIS. When Dey began to market the inhalant despite the fact that the FDCA had never licensed the drug for use in this country, Dey was violating the Drug Amendment to the FDA. Because of this violation, the FDCA had the right to seize Dey’s product. U.S. v. Atropine Sulfate 1.0 mg.

(Article of Drug), 843 F.2d 860, 1988 U.S.App. Lexis 5819 (5th Cir.).

Cosmetics Regulation 24.3. 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 (2d Cir.).

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Drug Regulation 24.4. Wahba wins since H & N Prescriptions Center and its subsidiary, Zuckerman’s Pharmacy, had violated the Poison Prevention Packaging Act. This Act requires manufacturers to provide “child proof” containers and packages for all household products, including prescription drugs. Congress enacted the act to prevent children from suffering injury or death by opening household products and inhaling, ingesting, or otherwise mishandling dangerous products. Zuckerman’s Pharmacy had violated the act when it dispensed the Wahba’s Lomotil Prescription in a regular plastic container. The Act required that potentially dangerous drugs such as Lomotil be placed in a special “child proof” container. When Zuckerman’s failed to comply with the PPPA, the exact type of tragedy that Congress was seeking to prevent, the accidental poisoning of a child, occurred. Wahba v. H & N Prescription Center, Inc., 539 F.Supp. 352, 1982 U.S.Dist. Lexis 12327 (E.D.N.Y.).

IV. Answers to Business Ethics Cases 24.5. The Federal Trade Commission wins the case. The FIC was created in 1915 to enforce the Federal Trade Commission Act. Section 5 of the FTC Act prohibits the use of deceptive or unfair advertising. Deceptive advertising occurs where a seller makes a misrepresentation in an advertisement that is likely to mislead a “reasonable consumer.” Deceptive advertising also occurs where a seller makes an objective claim about its product that it cannot substantiate. The court held that both the name and advertising of rejuvenescence cream were deceptive. The name and advertising of the cream both suggested that the product would restore moisture in the user’s skin and give the skin a healthy, youthful look. The FTC’s experts reported that it was impossible for any cosmetic product to achieve these results. Therefore, Charles of the Ritz was making objective claims in its advertising it could not substantiate. Because the appellate court found the name and advertising of rejuvenescence cream to be deceptive, the appellate court upheld the FTC’s cease and desist order. Charles of the Ritz Distributing Corp. v. FTC, 143 F.2d 676, 1944 U.S.App. Lexis 3172 (2nd Cir.).

24.6. Bait and switch happens when a seller advertises items of a low-discounted cost to attract customers but are pressured into switching to more expensive items. This is an unethical violation of trust. The FTC ruled here that the conduct was bait and switch because the company did not mention an exam. The Court said that this was the “bait” but that there was no direct evidence of a “switch”. However, the given sales statistics along with the “bait” was enough to support the inference of a “switch”. Tashof v. FTC, 437 F.2d 707.

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Chapter 25 Environmental Protection and Global Warming

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 want to know more about what our government is doing to protect its citizens from harm. From the teaching point of view, it is nice for a change to have such a jump start on a teaching assignment.

The materials in this chapter can be quite extensive in that they literally cover the earth! Try to focus on one illustrative issue from each area of air, land, and water. The more you can localize the issues to your own area, the more your students will become engaged in the learning process. Possibly explain how pollution is inevitable and try to clarify the options. Move from tort to statute to unsolved problems keeping the purpose in mind.

II. Topic Outline Environmental Protection: Environmental Protection Agency ❖ An administrative agency created by Congress in 1970 to coordinate the implementation and enforcement of the federal environmental protection laws ❖ The EPA has broad rule-making powers ❖ The EPA has adjudicative powers ❖ The EPA can initiate judicial proceedings in court against suspected violators of federal environmental laws

Environmental Protection: National Environmental Policy Act (NEPA) ❖ A federal statute enacted in 1969 that mandates that the federal government consider the adverse impact a federal government action would have on the environment before the action is implemented ❖ Created the Council on Environmental Quality ❖ Does not apply to action by state or local governments or private parties

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Environmental Impact Statement ❖ The NEPA and rules adopted thereunder must require that an environmental impact statement (EIS) must be prepared for all proposed legislation or major federal action that significantly affects the quality of the human environment ❖ The purpose of the EIS is to provide enough information about the environment to enable the federal government to determine the feasibility of the project ❖ The EIS is also used as evidence in court whenever a federal action is challenged as violating the NEPA or other federal protection laws ❖ Once an EIS is prepared, it is subject to public review ❖ Most states and many local governments have enacted laws that require an EIS to be prepared regarding the proposed state and local government action as well as private development

Air Pollution: Clean Air Act ❖ A federal statute enacted in 1963 to assist states in dealing with air pollution o Pollution caused by factories, homes, vehicles, and the like that affects the air ❖ The Clean Air Act, as amended (1970, 1977, 1990), provides comprehensive regulation of air quality in the United State

National Ambient Air Quality Standards ❖ The Clean Air Act directs the EPA to establish national ambient air quality standards (NAAQS) for certain pollutants ❖ Standards are set at two levels: o Primary – to protect human beings o Secondary – to protect vegetation, matter, climate, visibility, and economic values ❖ Nonattainment areas are regions that do not meet air quality standards. Compliance plans must be submitted.

Water Pollution (1 of 3) ❖ River and Harbor Act of 1886 ❖ National Discharge Pollutant Discharge Elimination System (NPDES)of 1972 ❖ Federal Water Pollution Control Act (FWPCA) of 1948 (as amended): o Clean Water Act of 1972 o Clean Water Act of 1977 o Clean Water Quality Act of 1987

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Water Pollution (2 of 3) ❖ Water Pollution o Pollution of lakes, rivers, oceans, and other bodies of water ❖ Point Sources of Water Pollution o Sources of water pollution such as paper mills, manufacturing plants, electric utility plants, and sewage plants ❖ Thermal Pollution o Heated water or material discharge into waterways that upsets the ecological balance and decreases the oxygen content ❖ Wetlands o Areas that are inundated or saturated by surface water or ground water that support vegetation typically adapted for life in such conditions

Safe Drinking Water Act of 1972, 1986 ❖ Authorizes the EPA to establish national primary drinking water standards ❖ Prohibits the dumping of wastes into wells used for drinking water ❖ The states are primarily responsible for enforcing the act

Marine Protection, Research, and Sanctuaries Act of 1972 ❖ Extended environmental protection to the oceans ❖ Requires a permit for dumping wastes and other foreign materials into ocean waters ❖ Establishes marine sanctuaries in ocean waters and in the Great Lakes and their connecting waters

Water Pollution (3 of 3) ❖ Ocean Dumping o Marine Protection, Research, and Sanctuaries Act (1972)- extends environmental protection to the oceans o The Clean Water Act authorizes the U.S. government to clean up oil spills and spills of other hazardous substances in ocean waters within 12 miles of the shore and on the continental shelf and to recover the clean up costs from responsible parties

Toxic Substances ❖ Chemicals used for agricultural, industrial, and mining uses that cause injury to humans, birds, animals, fish, and vegetation ❖ Key federal laws: o Toxic Substance Control Act of 1976 o Insecticide, Fungicide, and Rodenticide Act of 1947 (as amended in 1972)

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Toxic Substances Control Act of 1976 ❖ 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 ❖ The EPA may limit or prohibit the manufacture and sale of toxic substances, or remove them from commerce, if it finds they pose an imminent hazard or an unreasonable risk of injury to human health or the environment

Insecticide, Fungicide, and Rodenticide Act of 1947 (as amended) ❖ Requires pesticides, herbicides, fungicides, and rodenticides to be registered with the EPA ❖ The EPA may deny, suspend, or cancel registration

Hazardous Waste ❖ Hazardous Waste o 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 ❖ Land Pollution o Pollution of the land that is generally caused by hazardous waste being disposed of in an improper manner ❖ Resource Conservation and Recovery Act (RCRA) of 1976 o Federal statute that authorizes the EPA to regulate facilities that generate, treat, store, transport, and dispose of hazardous wastes o States have primary responsibility for implementing the standards established by the act and EPA regulations

Nuclear Waste ❖ Radiation Pollution o Emissions from radioactive wastes that can cause injury and death to humans and other life and can cause sever damage to the environment ❖ Nuclear Waste Policy Act of 1982 o A federal statute that says the federal government must select and develop a permanent site for the disposal of nuclear waste ❖ Nuclear Regulatory Commission o Licenses the construction and opening of commercial nuclear plants o Continually monitors the operation of nuclear power plants and may close a plant if safety violations are found ❖ Environmental Protection Agency (EPA) o Empowered to set standards for radioactivity in the environment and to regulate the disposal of radioactive waste o Regulates thermal pollution from nuclear power plants o Regulates emissions from uranium mines and mills

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Endangered Species Act of 1973 (as amended) ❖ Protects endangered and threatened species of animals ❖ The Secretary of the Interior is empowered to declare a form of wildlife as endangered or threatened ❖ The Act requires the EPA and the Department of Commerce to designate critical habitats for each endangered and threatened species ❖ The Act prohibits the taking of any endangered species

Other Federal Laws That Protect Wildlife: ❖ Migratory Bird Treaty Act ❖ Bald Eagle Protection Act ❖ Wild Free-Roaming Horses and Burros Act ❖ Marine Mammal Protection Act ❖ Migratory Bird Conservation Act ❖ Fishery Conservation and Management Act ❖ Fish and Wildlife Coordination Act ❖ National Wildlife Refuge System

State Environmental Protection Laws ❖ Many state and local governments have enacted statuses and ordinances to protect the environment ❖ States are entitled to set pollution standards that are stricter than federal requirements

III. Text Materials Case 25.1: Whitman, Administrator of Environmental Protection Agency v. American Trucking Association Facts: Section 109 of the Federal Clean Air Act requires the administrator of the EPA to set national ambient air quality standards for air pollutants. The American Trucking Assn. sued the EPA, arguing that the EPA must consider the cost caused to trucking firms before issuing the air standards. The Trucking Assn. won at the district court level; but lost at the court of appeals level.

Issue: Under Section 109 of the Federal Clean Air Act, must the Environmental Protection Agency consider the cost imposed on trucking firms before setting national ambient air quality standards for ozone and particulate emissions from trucks?

Decision: No. Reason: The EPA has the power to set standards that affect public health regardless of the cost to a particular industry.

Contemporary Environment: Indoor Air Pollution This box discusses “sick building syndrome.” The two chief causes are over insulation with sealed windows and hazardous chemicals and construction materials.

Ethics Spotlight: The Exxon Valdez Oil Spill The oil spill is discussed as are the various legal maneuverings.

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Case 25.2: Solid Waste Agency of Northern Cook County, IL v. United Stats Army Corps of Engineers Facts: Sec. 404 of the Federal Clean Water Act regulates the discharge of dredged or fill material into navigable waters. Solid Waste Agency owned a parcel of real property that was a closed sand and gravel pit mining operation that was long since abandoned. It contained water ponds, but they were not connected to any tributaries. The Agency sued the Corps arguing that it had no jurisdiction over the site because it did not contain any navigable waters.

Issue: Does the gravel and sand pit contain navigable waters that give the Army Corps of Engineers jurisdiction over the site?

Decision: No. Reason: The Corps had no authority over the ponds because they were not navigable waters as defined by Section 404 of the Clean Water Act. Ethics in Business: Illegal Dumping of Pollutants Irby exercised decision-making authority in directing the employees of the wastewater treatment plant to discharge the untreated sewage into the Reedy River. The offense resulted in an ongoing, continuous, and repetitive discharge of pollutants into the environment, thus justifying the imposition of the 33 months of jail time. The court stated: “There was absolutely no acceptance of responsibility in this case. No remorse whatsoever was shown by Irby.” Was this ethical?

Landmark Law: Superfund This statute gave the federal government a mandate to deal with hazardous wastes that have been spilled, stored, or abandoned. The EPA can recover from (1) waste generator, (2) waste transporter, (3) site owner at the time of disposal, and (4) current site owner and operator.

Landmark Law: Tennessee Valley Authority v. Hill Facts: The TVA is a wholly owned public corporation of the U.S. In 1976, the TVA, with appropriations from Congress, began building the Tellico Dam. In 1973, a new 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. Also in 1973, the Secretary of the Interior declared the snail darter an endangered species and its habitat a critical habitat. Opening the dam would destroy the habitat and make the snail darter extinct. Knowing this, Congress continued to appropriate funds for construction of this dam. In 1976, a group brought this action to obtain a permanent injunction prohibiting the dam from operation. The district court held in favor of the TVA. The court of appeals reversed.

Issue: Would the TVA be in violation of the Endangered Species Act if it operated the Tellico Dam? Decision: Yes. Reason: The Endangered Species Act clearly requires that actions of the federal government do not jeopardize an endangered species or its habitat. There are no exceptions. The legislative history of the Act supports this conclusion. It was meant to signal all Government agencies that endangered species protection was the first priority. Operating the dam would make the snail darter obsolete; therefore, it cannot operate.

BE AWARE OF MANY STATE AND LOCAL ENVIRONMENTAL PROTECTION STATUTES AND ORDINANCES. International Law: Kyoto Protocol This is a treaty to reduce greenhouse gases.

See Law Case with Answer in Text.

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IV. Answers to Legal Environment Cases Environmental Impact Statement 25.1. Yes, an environmental impact statement is required. The Forest Service is authorized by statute to manage the national forests for “outdoor recreation, range, timber, watershed, and wildlife and fish purposes.” In deciding whether to issue a permit to the ski resort developer, the Forest Service has a three-step process. First, the Forest Service examines the general environmental and financial feasibility of the project. Next, the Service selects a developer for the project. Last, in the final stage of review, there is a final approval of the master plan for the development, construction, and operation of the project.

In the first stage, the Forest Service prepares an Environmental Impact Statement (EIS). An EIS provides the information required to evaluate the potential of the ski resort. The EIS prepared in this case evaluated five alternative levels of development that might be authorized for use of this land. This ranged from not developing the property at all to creating the ski resort with sixteen ski lifts. In generating this report, the study also outlined certain steps that may be used to mitigate any adverse effects on the environment.

In general, this section of the report is divided into two categories, on-site impact and off-site impact. The on-site study considered the effect of each level of development on the water resources, soil, wildlife, air quality, vegetation, and visual quality, as well as land use and transportation. Additional factors such as demographic shifts, economic market of skiing in the winter, and the energy requirements necessary to run the development were also considered. Off-site considerations included the effect that each alternative may have on community facilities, socioeconomic, and other environmental conditions. Thus, in order to develop the ski resort, an environmental impact statement was necessary. Robertson v.

Methow Valley Citizens Council, 490 U.S. 332, 109 S.Ct. 1835, 1989 U.S.Lexis 2160 (U.S.Sup.Ct.).

Clean Air Act 25.2. The United States prevails. In this case, pursuant to the Clean Air Act (CAA), it is illegal to sell unleaded gasoline that contains a lead concentration in excess of that proscribed by law.

Since Pilot was engaged in the business of reselling and distributing gasoline to the individual retailers where samples were taken that revealed a violation of the CAA, the court found Pilot liable. United States v. Pilot Petroleum Associates, Inc., 712 F.Supp. 1077, 1989 U.S.Dist Leixs 6119 (E.D.N.Y.).

Wetlands 25.3. The Army Corps of Engineers (Army Corps) prevails 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 (9th Cir.).

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Clean Water Act 25.4. 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 (8th Cir.).

Hazardous Waste 25.5. 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 (9th Cir.).

Nuclear Waste 25.6. These are 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 allegations of People Against Nuclear Energy (PANE). Metropolitan Edison Co. v. People Against Nuclear Energy, 460 U.S. 766, 103 S.Ct. 1556, 1983 U.S.Lexis 21 (U.S.Sup. Ct.).

Endangered Species 25.7. The Sierra Club is granted the injunction to prevent the Forest Service from leasing these national forests for lumbering. In the present case, the court held that the conduct of the Forest Service had a detrimental impact upon the red-cockaded woodpecker in violation of the Endangered Species Act. By allowing the Forest Service to lease several national forests for lumbering in Texas, this action would have jeopardized the survival of the woodpecker.

Thus, since the Forest Service’s management practices are similar to the monitoring of an endangered species, the court properly issued an injunction to protect the red-cockaded woodpecker from extinction in Texas. Sierra Club v. Lyng, Secretary of Agriculture, 694 F.Supp. 1260, 1990 U.S.Dist. Lexis 9203 (E.D. Tex.).

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V. Answers to Business Ethics Cases 25.8. The West Michigan Environmental Action Council (WMEAC) prevails. The court held that the WMEAC demonstrated the likelihood of the impairment or destruction of the natural resources in the areas, specifically of the elk, as a result of the proposed drilling of the ten exploratory wells. Based upon an Environment Impact Statement that indicated that elk would (1) avoid roads even when there is no traffic, (2) avoid the impact areas for at least 40 to 50 years, and (3) result in further shrinkage of the already diminishing elk population, the court determined that this constitutes an impairment or destruction of a natural resource.

Although virtually all human activities can be found to adversely impact natural resources in some way or another, the present case does not justify the destruction of the elk population for the exploration of oil and gas deposits. West Michigan Environmental Action Council, Inc. v. Natural Resource Commission, 275 N.W.2d 538, 1979 Mich.Lexis 347 (Mich.).

25.9. Wetlands are areas that are inundated or saturated by surface or ground water that support vegetation typically adapted for life in such conditions. Riverside was damaging the wetlands. The Court ruled that this property was subject to the permit system. U.S. v.

Riverside Bayview Homes, Inc. 474 U.S. 121.

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Chapter 26 Estates, Leaseholds, and Regulation of Property

What do we really own?

I. Teacher to Teacher Dialogue Real Property 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

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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 coownership of property. Most of us, sooner or later, will get involved with coownership of property. Anyone who is married is a likely coowner. Anyone who shares property interests by gift, inheritance, or earnings is likely to be a coowner. Even if one’s property is entirely his own, he or she will need to know the rules of the coownership game for purposes of credit, finance, business planning, and the like. How, when, and where coownership rights and duties are created is as important as the basic terms of real property law itself.

Landlord-Tenant Relationship One sure way to engage student interest in a topic is to build on their personal experiences outside the classroom. The most difficult topic of negotiable instruments is made much easier by illustrating the rules of the UCC as they relate to the student’s own checking account relationship with his or her bank. So too can you generate interest and discussion regarding landlord/tenant law by asking students to tell their own war stories of finding housing at college.

An interesting comparative measure of the U.S. way of life is the percentage of home ownership versus rental. Our economy has traditionally boasted of a high percentage of home ownership relative to most any other part of the world. In many countries, the percentage of home ownership is very low. Even in more highly developed parts of the world like Western Europe, the percentage has been much lower than in the U.S. This achievement has been one of the foundations of the great middle class dream of Americans and certainly a stabilizing influence in our society.

The disturbing aspect of this particular economic and sociological measure is that recent history has witnessed a decline in the number of Americans who can realistically aspire to own their own homes. As the percentage goes down, the laws involving the rights, duties, and obligations of persons involved in nonfreehold estates of all sorts become increasingly important.

With over half of our population now living under someone else’s roof, the law of leasing needs constant and fair reexamination and updating. As in any such process, the legitimate claims of both sides must be listened to.

The landlord is entitled to a fair return on his or her investment. This includes not only a financial return but also a return on the investment. Income property should be protected from waste and harm just like any other property.

Conversely, the bargaining power between landlord and tenant has never been entirely equal. Between market limitations of supply and the tenant’s lesser economic bargaining position, the common law can hardly have been accused of being the tenant’s friend in the past. More modern attitudes and statutory enactments have given the tenant a more even playing field, but not real parity.

This chapter also examines some of the main land use statutes used in this country. Here, the law moves away from its first and second tier treatment based on ownership and looks instead more to the common good. The days of wide-open spaces are long gone, and along with them is the notion that an owner can do whatever he or she wants with his property. Land use is simply too important and too interwoven with the rights of others to adapt a laissez-faire attitude.

Various branches of government must perform the constant balancing act. On the owner’s and user’s side of the equation, public policy wants free, quiet, environmentally sensitive uses of land.

Good zoning controlled growth and other governmental regulations can and do provide enlightened measures towards those goals.

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of the American Dream. Zoning laws have been criticized as an invidious subterfuge to extend governmental control too far into our personal lives. We must, however, keep in mind that the government does have the duty to assure the health, safety, and welfare of its citizenry through the use of its police power on land use.

II. Topic Outline Real Property ❖ The land itself as well as buildings, trees, soil, minerals, timber, plants, and other things permanently affixed to the land: o Land o Buildings o Subsurface Rights o Plant Life and Vegetation o Fixtures o Air Rights Estates in Land ❖ Ownership rights in real property ❖ The bundle of legal rights that the owner has to possess, use, and enjoy the property ❖ The type of estate that an owner possesses is determined from the deed, will, lease, or other document that transferred the ownership rights to him or her Freehold Estate ❖ An estate where the owner has a present possessory interest in the real property ❖ Estates in Fee o Fee simple absolute o Fee simple defeasible ❖ Life Estates o Estate pour autre vie Estates in Fee ❖ Fee Simple Asbolute o Highest form of ownership of real property o Ownership; o Is infinite in duration o Has no limitation on inheritability o Does not end upon the occurrence or non-occurrence of an event ❖ Fee Simple Defeasible o Grants owner all of the incidents of a fee simple absolute except that it may be taken away if a specified condition occurs or does not occur Life Estate ❖ Interest in property that lasts for the life of a specified person ❖ A life estate terminates upon the death of a named person and reverts back to the grantor or his or her estate or other designated person

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Concurrent or Co-ownership ❖ When two or more persons own a piece of real property ❖ Forms of concurrent ownership: o Joint tenancy o Tenancy in common o Tenancy by the entirety o Community property

Summary: Concurrent Ownership Form of Ownership Joint Tenancy

Tenancy in Common Tenancy by the Entirety Community Property

Right of Survivorship

Tenant May Unilaterally Transfer His or Her Interest Yes. Tenants may transfer his or her interest without the consent of co-tenants. Transfer severs joint tenancy.

Yes. Tenant may transfer his or her interest without the consent of co-tenants. Transfer does not sever tenancy in common.

No. Neither spouse may transfer his or her interest without the other spouse’s consent.

Yes. Deceased tenant’s interest automatically passes to co-tenants.

No. Deceased tenant’s interest passes to his or her estate.

Yes. Deceased tenant’s interest automatically passes to his or her spouse.

Yes. When a spouse dies No. Neither spouse may transfer his or her the surviving spouse interest without the other spouse’s consent. automatically receives onehalf of the community property. The other half passes to the heirs of the deceased spouse as directed by a valid will.

Condominium ❖ Common form of ownership in a multiple-dwelling building ❖ Purchases of a condominium: o Have title to their individual units o Own the common areas as a tenant in common with the other condominium owners ❖ Owners may sell or mortgage their units without the permission of the other owners

Cooperative ❖ Form of co-ownership of a multiple-dwelling building o A corporation owns the building o The residents own shares in the corporation ❖ Each cooperative owner then leases a unit in the building from the corporation under a renewable, long-term, proprietary lease

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Future Interest ❖ The right to possess property in the future ❖ The interest that the grantor retains for him- or herself or a third party ❖ Reversion – a right of possession that returns to the grantor after the expiration of a limited or contingent estate ❖ Remainder – a right of possession that goes to a third party upon the expiration of a limited or contingent estate

Transfer of Ownership of Real Property: Sale of Real Estate ❖ The passing of title from a seller to a buyer for a price ❖ Also called a conveyance ❖ Closing – the finalization of a real estate sales transaction that passes title to the property from the seller to the buyer

Transfer of Ownership of Real Property: Tax Sale ❖ A method of transferring property ownership that involves a lien on property for unpaid property taxes ❖ If the lien remains unpaid after a certain amount of time, a tax sale is held to satisfy the lien ❖ Any excess proceeds are paid to the taxpayer ❖ The buyer receives title to the property

Transfer of Ownership of Real Property: Gift, Will, or Inheritance ❖ Gift o A transfer of property from one person to another without exchange of money ❖ Will or Inheritance o If a person dies with a will, his or her property is distributed to the beneficiaries as designated in the will o If a person dies without a will, his or her property is distributed to the heirs as stipulated in the state’s intestate statute

Transfer of Ownership of Real Property: Adverse Possession (1 of 2) ❖ Occurs when a person who wrongfully possesses someone else’s real property obtains title to that property if certain statutory requirements are met ❖ Property owned by federal and state governments are not subject to adverse possession

Transfer of Ownership of Real Property: Adverse Possession (2 of 2) ❖ To obtain title under adverse possession, the wrongful possession must be: 1. For a statutorily prescribed period of time 2. Open, visible, and notorious 3. Actual and exclusive 4. Continuous and peaceful 5. Hostile and adverse

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Transfer of Ownership of Real Property: Deed ❖ A writing that describes a person’s ownership interest in a piece of real property o Warranty Deed o Quitclaim Deed ❖ Grantor – the party who transfers an ownership interest in real property ❖ Grantee – the party to whom an interest in real property is transferred

Transfer of Ownership of Real Property: 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 ❖ Quiet title action – a party concerned about ownership rights in a parcel of real property can have a court determine the extent of those rights

Transfer of Ownership of Real Property: Marketable Title (Good Title) ❖ Title that is free from any encumbrances or other defects that are not disclosed but would affect the value of the property ❖ The three most common ways of assuring marketable title: o Attorney’s Opinion o Torrens System o Title Insurance

Nonpossessory Interests: Easements ❖ A given or required right to make limited use of someone else’s land without owning or leasing it o Easement Appurtenant – created when the owner of one piece of land is given an easement over an adjacent piece of land o Easement in Gross – authorizes a person who does not own adjacent land the right to use another’s land

Nonpossessory Interests: License ❖ Grants a person the right to enter upon another’s property for a specified and usually short period of time ❖ A license does not transfer any interest in the property ❖ A license is a personal privilege that may be revoked by the licensor at any time

Nonpossessory Interests: Profit ❖ Grants a person the right to remove something from another’s real property o e.g., gravel, minerals, grain, or timber o Profit Appurtenant – grants the owner of one piece of land the right to go onto another’s adjacent land and remove things from it o Profit in Gross – authorizes someone who does not own adjacent land the right to go onto another’s property and remove things from it

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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) ❖ Nonfreehold Estate – an estate in which the tenant has a right of possession of the property but not title to the property ❖ Leasehold – a tenant’s interest in the property ❖ Landlord – the owner who transfers the leasehold ❖ Tenant – the party to who the leasehold is transferred

Types of Tenancy Type of Tenancy Tenancy for Years

Periodic Tenancy

Tenancy at Will

Tenancy at Sufferance

Description Continues for the duration of the lease and then terminates automatically without notice.

It does not terminate by the death of either party.

Continues from payment interval to payment interval.

It may be terminated by either party with adequate notice.

It does not terminate upon the death of either party.

Continues at the will of the parties.

It may be terminated by either party at any time with adequate notice.

It terminates upon the death of either party.

Arises when a tenant wrongfully occupies real property after the expiration of another tenancy or life estate.

It continues until the owner either evicts the tenant or holds the tenant over for another term.

It terminates upon the death of the tenant.

Landlord’s Duties: Possession ❖ A lease grants the tenant exclusive possession of the leased premises: (1) for the term of the lease or (2) until the tenant defaults on the obligations under the lease ❖ A landlord may not enter leased premises unless the right is specifically reserved in the lease

Landlord’s Duties: Covenant of Quiet Enjoyment ❖ The law implies a covenant of quiet enjoyment in all leases ❖ The landlord may not interfere with the tenant’s quiet and peaceful possession, use, and enjoyment of the leased premises ❖ Wrongful Eviction – a violation of the covenant of quiet enjoyment Landlord’s Duties: Duty to Maintain Leased Premises ❖ Building Codes – state and local statutes that impose specific standards on property owners to maintain and repair leased premises ❖ Implied Warranty of Habitability – a warranty that provides that the leased premises must be fit, safe, and suitable for ordinary residential use

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Tenant’s Duties 1. Duty to pay rent 2. Duty not to use leased premises for illegal or nonstipulated purposes 3. Duty not to commit waste 4. Duty not to disturb other tenants

Transferring Rights to Leased Property ❖ Landlords may sell, gift, devise, or otherwise transfer their interests in the leased property o If complete title is transferred, the property is subject to the existing lease ❖ The tenant’s right to transfer possession of the leased premises to another depends on the terms of the lease o Assignment of the lease o Sublease

Land Use Regulation ❖ Generally, the ownership of property entitles the owner to use that property as the owner wishes ❖ Such use is subject to limitations imposed by government regulation ❖ Land Use Regulation – the collective term for the laws that regulate the possession, ownership, and use of real property

Zoning Ordinances (1 of 3) ❖ Local laws that are adopted by municipalities and local governments to regulate land use within their boundaries ❖ Adopted and enforced to protect the health, safety, morals, and general welfare of the community ❖ Zoning is the primary form of land use regulation in the United State

Zoning Ordinances (2 of 3) ❖ Zoning ordinances generally: 1. Establish use districts within the municipality (e.g., residential, commercial or industrial) 2. Restrict the height, size, and location of buildings on a building site 3. Establish aesthetic requirements or limitations for the exterior of buildings

Zoning Ordinances (3 of 3) ❖ Variance – an exception that permits a type of building or use in an area that would not otherwise be allowed by a zoning ordinance ❖ Nonconforming Uses – uses and buildings that already exist in the zoned area that are permitted to continue even though they do not fit within new zoning ordinances

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Compensable Taking of Real Property ❖ Eminent Domain – the power and process by which the government acquires private property for public use ❖ Just Compensation Clause – a clause of the U.S. Constitution that mandates that the government compensate the property owner (and possibly others) just compensation when the government exercises its power of eminent domain

Statutes Affecting Real Estate Transfer: 1) Civil Rights Act 2) Fair Housing Act 3) ADA

III. Text Materials Contemporary Environment: Air Rights Even today, the owners of land may sell or lease air space parcels above their land. Air rights are often developed so that historic building can be preserved.

Case 26.1: Witt v. Miller The Facts: Witt purchased land in 1967 adjacent to a 4-acre tract kept by the Shaughnessey’s after they had purchased and divided adjacent property. Witts built a house and moved in. In 1968 they cleared land extending 40 feet onto the 4-acre tract on which they had made many outward improvements. Neither party realized that there was an encroachment. In 1988, the Shaughnessey’s sold the 4-acre tract to Miller whose survey showed the Witts’ encroachment.

Miller sued to quiet title. The court held no adverse possession.

Issue: Had the elements for adverse possession been met?

Decision/Remedy: Yes. The decision was reversed and an order issuing quiet title in favor of the Witts was entered.

Reason: The following elements of adverse possession had been met: • Notorious and open occupation • Actual and exclusive • Hostile and adverse • Continuous and peaceful • Far over the statutory period of 10 years.

Case 26.2: Walker v. Ayres Facts: Elizabeth Ayres and Clara Quillen own, in fee simple absolute, a tract of land in Sussex County known as “Bluff Point.” The tract is surrounded on three sides by Rehoboth Bay and is landlocked on the fourth side by land owned by Irvin C. Walker. At one time, the tracts were held in common. In 1878, Bluff Point was sold in fee simple absolute apart from the other holdings, thereby land locking the parcel. Ayres and Quillen sought an easement to use a narrow public road, the only means of access, and Walker objected. The trial court granted the easement.

Issue: Should Ayres’ and Quillen’s estate be granted an easement against Walker’s estate?

Decision: Yes. Reason: An easement appurtenant had been created between two adjacent parcels of property when Bluff Point was separated from the rest of the holdings in 1878. The easement was created by necessity because Bluff Point was landlocked and its only access was over Walker’s property.

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Contemporary Environment: Rent Control This box discusses rent control. Landlords oppose rent control.

Contemporary Environment: The Kelo “Taking” Case Public Use was tested. General benefit from economic growth is “public use”.

See Law Case with Answer.

IV. Answers to Legal Environment Subsurface Rights 26.1. The Mid-Ohio Coal Company wins. It is well settled that the owner of land possesses the subsurface rights to the earth located beneath the land and that such rights may be sold separately from the surface rights. In this case, McIlwee specifically gave the whole fee to the coal company and reserved the surface rights for the grantor and his heirs. Accordingly, the court held that Mid-Ohio owns the subsurface rights to the property and the Minniches own the surface rights. Minnich v. Guernsey Savings and Loan Company, 521 N.E.2d 489, 1987 Ohio App.Lexis 10497 (Ohio App.).

Life Estate and Remainder 26.2. The Bowles children win. Generally an interest in property that lasts for the life of a specified person creates a life estate in such property. The life estate terminates upon the death of the named person and reverts to the grantor, his estate, or other designated persons.

In this case, the court held that the devise to the Bowles children implied that the devise to Julianita was only to infer that the testator intended Julianita and her heirs to continue to receive one-half of the income from the property in perpetuity. The court concluded that such an arrangement would lead to serious complications over the future management of the property. Accordingly, the heirs of Julianita have no ownership interest in the property. In the Matter of the Estate of Bowles, 764 P.2d 510, 1988 N.M.App. Lexis 93 (N.M.App.).

Reversion 26.3. 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 (Ill.App.).

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Joint Tenancy 26.4. Bertha steward wins and may keep the real property. Generally, a surviving joint tenant takes real property free from the claims of the heirs or creditors of the deceased joint tenant in this case, the court held that Verna and Bertha were joint tenants and that absent a showing of intent to defraud creditors, bertha took real property free of any debts of Verna. The court further held that nay change to the general rule based on p9olicy grounds would have to come from the state legislature. Accordingly, the real property could not be sued to satisfy Verna’s debts. Rembe v. Stewart, 387 N.W.2d 313, 1986 Iowa Sup. Lexis 1177 (Iowa).

Tenancy by the Entirety 26.5. Cora’s guardian wins. To create a tenancy by the entirety the tenants must be married and their interests must be equal with respect to time, title, interest and possession. Generally, a tenancy by the entirety can only be severed by destruction of one of the four unities or by divorce. However, some jurisdictions have recognized that a tenancy by the entirety may also be served either by an agreement between the parties or by judicial intervention to prevent injustice. In this case, the court held that the unity between the parties had been dissolved by the husband’s case, felonious act and that there exist strong equitable principles to order a partition of the property. The court stated that to hold otherwise would allow the husband to benefit from his own wrongful acts. Accordingly, the lower court’s order to partition the real property was affirmed. Eichman v. Paton, 393 So.2d 655, 1981 Fla.App. Lexis 19454 (Fla.App.) Community Property 26.6. Since neither spouse may transfer his or her interest in community property without the other’s consent and since Mrs. Yu did not agree, there is no contract and Yu wins.

Adverse Possession 26.7. 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 a 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 Nolan’s lot occupied by the Naabs’ garage. Naab v. Nolan, 327 S.E.2d 151, 1985 W.Va. Lexis 476 (W.Va.).

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Zoning 26.8. Berkley, the building commissioner, prevails. The court upheld the commissioner’s denial of the petitioner’s permit to construct the modern home. In reaching this determination, the commission considered three factors: (1) whether the proposed house meets the customary architectural requirements in appearance and design for a house of the particular type that is proposed (Colonial, English Tudor, French Provincial, or Modern), (2) whether the proposed house is in general conformity with the style and design of surrounding structures, and (3) whether the proposed house lends itself to the proper architectural development of the city.

In applying this standard, the commission determined that the petitioner’s plans did not fall within the general conformity of the style and structure of the surrounding homes in the neighborhood, and would not add to the architectural development of the city. Since the plans failed to meet those requirements, the court agreed with the commissioner’s findings.

State of Missouri v. Berkley, 458 S.W.2d 305, 1970 Mo.Lexis 902 (Mo.).

Implied Warranty of Habitability 26.9. Yes, Sharon Love lawfully terminated her lease. In general, when a landlord does not comply with either the rental agreement or statutory duties such as maintaining the premises in a habitable manner the lessee may terminate the lease. When the landlord breaches this duty a tenant may terminate the lease for material noncompliance. The court indicated that a residential lease is essentially a contract containing reciprocal rights and obligations on the part of the lessor and lessee. Thus, the court held that since the landlord failed to maintain the premises in a habitable manner free from termites and roaches, Sharon Love properly terminated her lease. Love v. Monarch Apartments, 771 P.2d 79, 1989 Kan.App. Lexis 219 (Kan.App.).

V. Answers to Business Ethics Cases Lease 26.10. Park Doral Apartments (Park Doral) prevail under the theories of ejectment and recovery of rent. Ejectment is the appropriate means of recovering possession of leased premises from a tenant for nonpayment of rent or forfeiture of the lease by a breach of its conditions. Thus, the court held that the ejectment action brought by Park Doral did not preclude recovery of future rents. In addition, in this case the lease agreement had a savings clause which provided that “if the lessee shall neglect or fail to make any of the payments of the rent, or any part thereof, within ten (10) days after the same become due, or if the lessee shall neglect or fail to perform or observe any of covenants.” The court in determining the validity of the savings clause, indicated that the lessee’s liability for rent for the balance of the leased term continued. Thus, the court properly held that Park Doral was entitled to the difference in rent between the $420 and the $280 for the months of February and March, and the full amount until the end of the leased term. Nylen v. Park Doral Apartments, 535 N.E. 2d 178, 1989 Ind. App. Lexis 185 (Ind.App. 1989).

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V. Answers to Business Ethics Cases 26.11. 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. Doenz had moved the fence more than ten years after the Garbers acquired the land but less than ten years from when the Garbers filed their deed. The time period began running when the Garbers moved onto the property and began using it. Thus, the ten-year period had run before Doenz had moved the fence. Therefore, the Garbers have acquired the land by adverse possession. Doentz v. Garber, 665 P.2d 932, 1983 Wyo. Lexis 339 (Wy.).

26.12. The tenants were constructively evicted. Constructive eviction is an act done with intention that has the effect of substantially interfering with the tenant’s beneficial enjoyment of the leased property. It is a wrongful act by the landlord that makes the premises unsafe, unfit, or unsuitable for occupancy for the purposes for which they were leased. The evidence shows that the number of customers dropped drastically after the renovation began and that the shops in the area appeared to be closed because of the elimination of sidewalks and parking. The premises had become unsafe, unfit, and unsuitable for occupancy. Therefore, the tenants were constructively evicted. Bermuda Avenue Shopping Center Associates v.

Rappaport, 565 So. 2d 805, 1990 Fla. App. Lexis 5354 (Fla. App. 1990).

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