Business law essay questions

DO NOT POST YOUR ASSIGNMENT AS PDF. only words document.

Basic citing could be class textbook: you need to mention the name of book, author, and page # as well.

Please answer chapter one essay question and make sure to cite your answers. (without citing less points)

Chapter one assignment : Essay question s #2,3,4,5- page 20-21

make sure when the question ask for your opinion, you should say, “after my study of textbook, page # or following site/s, I think, I believe”. In business I feel, I think does not have any place.

2. In the 1980s, the Supreme Court ruled that it is legal for protesters to burn the American flag.

This activity counts as free speech under the Constitution. If the Court hears a new flag-burning case in this decade, should it consider changing its ruling, or should it follow precedent? Is following past precedent something that seems sensible to you: always, usually, sometimes, rarely, or never?

or the need of the creature suffering from hunger or cold, in short, need.” What do you think? Does legal positivism or legal realism seem more sensible to you? 5. At the time of this writing, voters are particularly disgruntled. A good many people seem to be disgusted with government. For this question, we intentionally avoid distinguishing between Democrats and Republicans, and we intentionally do not name any particular President. Consider the following statements, and consider the degree to which you agree or disagree: • I believe that members of Congress usually try to do the right thing for America. • I believe that Presidents usually try to do the right thing for America. • I believe that Supreme Court justices usually try to do the right thing for America.

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FIFTH EDITION
ESSENTIALS
of BUSINESS LAW
Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States
Jeffrey F. Beatty
Boston University
Susan S. Samuelson
Boston UniversityPet
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Essentials of Business Law, Fifth Edition
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CONTENTS: OVERV IEW
Preface xix
UNIT 1
The Legal Environment 1
1 Introduction to Law 2
2 Ethics and Corporate Social Responsibility 23
3 Dispute Resolution 51
4 Common Law, Statutory Law, and
Administrative Law 83
5 Constitutional Law 109
6 Torts and Product Liability 134
7 Crime 164
8 International Law 190
UNIT 2
Contracts 213
9 Introduction to Contracts 214
10 Agreement 234
11 Consideration 256
12 Legality 276
13 Capacity and Consent 295
14 Written Contracts 316
15 Third Parties 337
16 Performance and Discharge 356
17 Remedies 377
18 Practical Contracts 400
UNIT 3
Commercial Transactions 423
19 Introduction to Sales 424
20 Ownership, Risk, and Warranties 450
21 Performance and Remedies 477
22 Negotiable Instruments 501
23 Secured Transactions 528
24 Bankruptcy 562
25 Agency Law 587
UNIT 4
Employment, Business
Organizations and Property 615
26 Employment and Labor Law 616
27 Employment Discrimination 644
28 Starting a Business: LLCs and
Other Options 673
29 Corporations 699
30 Government Regulation: Securities and
Antitrust 732
31 Consumer Protection 754
32 Cyberlaw 782
33 Intellectual Property 805
34 Real and Personal Property 832
Appendix A
The Constitution of the United States A1
Appendix B
Uniform Commercial Code (Selected Provisions) B1
Glossary G1
Table of Cases T1
Index I1
iii
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CONTENTS
Preface xix
UNIT 1
The Legal Environment 1
Chapter 1 Introduction to Law 2
1-1 The Role of Law in Society 3
1-1a Power 3
1-1b Importance 3
1-1c Fascination 3
1-2 Origins of Our Law 4
1-2a English Roots 4
Case Summary: The Oculist’s Case (1329) 5
1-2b Law in the United States 6
1-3 Sources of Contemporary Law 6
1-3a United States Constitution 7
1-3b Statutes 9
1-3c Common Law 9
1-3d Court Orders 10
1-3e Administrative Law 10
1-3f Treaties 10
1-4 Classifications 10
1-4a Criminal and Civil Law 10
1-4b Law and Morality 11
1-5 Jurisprudence 11
1-5a Legal Positivism 11
1-5b Natural Law 12
1-5c Legal Realism 12
1-6 Working with the Book’s Features 13
1-6a Analyzing a Case 13
Case Summary: Kuehn v. Pub Zone 13
1-6b Devil’s Advocate 15
1-6c Exam Strategy 16
1-6d You Be the Judge 16
You Be the Judge: Soldano v. O’Daniels 17
Chapter Conclusion 17
Exam Review 18
Multiple-Choice Questions 19
Essay Questions 20
Discussion Questions 21
Chapter 2 Ethics and Corporate Social
Responsibility 23
2-1 Introduction 24
2-2 The Role of Business in Society 26
2-3 Why Be Ethical? 27
2-3a Society as a Whole Benefits from
Ethical Behavior 27
2-3b People Feel Better When They
Behave Ethically 27
2-3c Unethical Behavior Can Be Very Costly 28
2-4 Theories of Ethics 28
2-4a Utilitarian Ethics 29
2-4b Deontological Ethics 29
2-4c Rawlsian Justice 30
2-4d Front Page Test 30
2-5 Ethics Traps 31
2-5a Money 31
2-5b Rationalization 32
2-5c Conformity 33
2-5d Following Orders 33
2-5e Euphemisms 34
2-5f Lost in a Crowd 34
2-5g Blind Spots 35
2-5h Avoiding Ethics Traps 35
2-6 Lying: A Special Case 36
2-7 Applying the Principles 37
2-7a Personal Ethics in the Workplace 37
2-7b The Organization’s Responsibility
to Society 38
2-7c The Organization’s Responsibility
to Its Employees 39
2-7d An Organization’s Responsibility
to Its Customers 40
2-7e Organization’s Responsibility
to Overseas Contract Workers 41
2-8 When the Going Gets Tough 42
2-8a Loyalty 42
2-8b Exit 43
2-8c Voice 43
2-9 Corporate Social Responsibility (CSR) 43
Chapter Conclusion 44
Exam Review 44
Multiple-Choice Questions 46
Essay Questions 47
Discussion Questions 48
Chapter 3 Dispute Resolution 51
3-1 Three Fundamental Areas of Law 52
3-1a Litigation versus Alternative Dispute
Resolution 52
v
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3-2 Court Systems 52
3-2a State Courts 52
Landmark Case: International Shoe Co. v.
State of Washington 55
3-2b Federal Courts 56
3-3 Litigation 60
3-3a Pleadings 60
Case Summary: Stinton v. Robin’s Wood, Inc. 65
Case Summary: Jones v. Clinton 67
3-4 Trial 69
3-4a Adversary System 69
3-4b Right to Jury Trial 69
3-4c Voir Dire 69
Case Summary: Pereda v. Parajon 70
3-4d Opening Statements 71
3-4e Burden of Proof 71
3-4f Plaintiff ’s Case 71
3-4g Rules of Evidence 72
3-4h Motion for Directed Verdict 72
3-4i Defendant’s Case 73
3-4j Closing Arguments 73
3-4k Jury Instructions 73
3-4l Verdict 73
3-4m Motions after the Verdict 74
3-5 Appeals 74
3-5a Appeals Court Options 74
3-6 Alternative Dispute Resolution 75
3-6a Negotiation 75
3-6b Mediation 76
3-6c Arbitration 76
Chapter Conclusion 77
Exam Review 78
Multiple-Choice Questions 80
Essay Questions 81
Discussion Questions 82
Chapter 4 Common Law, Statutory Law,
and Administrative Law 83
4-1 Common Law 84
4-1a Stare Decisis 84
4-1b Bystander Cases 84
Case Summary: Tarasoff v. Regents of the
University of California 85
4-2 Statutory Law 87
4-2a Bills 87
4-2b Discrimination: Congress and the Courts 88
4-2c Debate 89
4-2d Statutory Interpretation 91
Landmark Case: Griggs v. Duke Power Co. 92
4-2e Changing Times 93
4-2f Voters’ Role 93
4-2g Congressional Override 93
4-3 Administrative Law 95
4-3a Background 95
4-3b Classification of Agencies 96
4-4 Power of Agencies 96
4-4a Rulemaking 96
4-4b Investigation 98
Landmark Case: United States v. Biswell 99
4-4c Adjudication 99
4-5 Limits on Agency Power 100
4-5a Statutory Control 100
4-5b Political Control 100
4-5c Judicial Review 100
Case Summary: Federal Communications
Commission v. Fox Television Stations, Inc. 101
4-5d Informational Control and the Public 102
Chapter Conclusion 103
Exam Review 104
Multiple-Choice Questions 106
Essay Questions 107
Discussion Questions 108
Chapter 5 Constitutional Law 109
5-1 Government Power 110
5-1a One in a Million 110
5-2 Overview 110
5-2a Separation of Powers 111
5-2b Individual Rights 111
5-3 Power Granted 111
5-3a Congressional Power 111
5-3b Executive Power 115
5-3c Judicial Power 115
Case Summary: Kennedy v. Louisiana 116
5-4 Protected Rights 117
5-4a Incorporation 118
5-4b First Amendment: Free Speech 118
Case Summary: Texas v. Johnson 119
Case Summary: Citizens United v. Federal
Election Commission 120
Case Summary: Salib v. City of Mesa 121
5-4c Fifth Amendment: Due Process and
the Takings Clause 122
Case Summary: Kelo v. City of New London,
Connecticut 125
5-4d Fourteenth Amendment: Equal
Protection Clause 126
vi CONTENTS
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Chapter Conclusion 129
Exam Review 129
Multiple-Choice Questions 131
Essay Questions 132
Discussion Questions 133
Chapter 6 Torts and Product Liability 134
6-1 Intentional Torts 136
6-1a Defamation 136
6-1b False Imprisonment 139
6-1c Intentional Infliction of Emotional
Distress 139
Case Summary: Jane Doe and Nancy Roe v.
Lynn Mills 140
6-1d Additional Intentional Torts 140
6-2 Damages 140
6-2a Compensatory Damages 140
6-2b Punitive Damages 142
Landmark Case: State Farm v. Campbell 143
6-3 Business Torts 144
6-3a Tortious Interference with Business
Relations 144
6-3b Privacy and Publicity 145
6-4 Negligence 146
6-4a Duty of Due Care 146
Case Summary: Hernandez v. Arizona Board
of Regents 147
6-4b Breach of Duty 149
6-4c Causation 149
6-4d Damages 151
6-5 Defenses 152
6-5a Contributory and Comparative
Negligence 152
6-5b Assumption of the Risk 153
Case Summary: Truong v. Nguyen 154
6-6 Strict Liability 154
6-6a Ultrahazardous Activity 155
6-6b Product Liability 155
Chapter Conclusion 157
Exam Review 157
Multiple-Choice Questions 160
Essay Questions 161
Discussion Questions 162
Chapter 7 Crime 164
7-1 The Differences between a Civil and Criminal
Case 165
7-1a Prosecution 165
7-1b Burden of Proof 166
7-1c Right to a Jury 166
7-1d Felony/Misdemeanor 166
7-2 Criminal Procedure 166
7-2a Conduct Outlawed 166
7-2b State of Mind 167
7-2c Gathering Evidence: The Fourth
Amendment 167
You Be the Judge: Ohio v. Smith 169
7-2d The Case Begins 171
Landmark Case: Miranda v. Arizona 172
7-2e Right to a Lawyer 173
7-2f After Arrest 173
Case Summary: Ewing v. California 174
7-3 Crimes that Harm Business 176
7-3a Larceny 176
7-3b Fraud 176
Case Summary: Skilling v. United States 177
7-3c Arson 179
7-3d Embezzlement 179
7-4 Crimes Committed by Business 179
Case Summary: Commonwealth v. Angelo
Todesca Corp. 179
7-4a Selected Crimes Committed by
Business 180
7-4b Punishing a Corporation 183
Chapter Conclusion 184
Exam Review 184
Multiple-Choice Questions 186
Essay Questions 187
Discussion Questions 188
Chapter 8 International Law 190
8-1 Trade Regulation: The Big Picture 191
8-1a Export Controls 191
8-1b Import Controls 192
You Be the Judge: Totes-Isotoner Co. v.
United States 192
8-1c Treaties 193
Case Summary: United States—Import
Prohibition of Certain Shrimp and Shrimp
Products 194
8-2 International Sales Agreements 197
8-2a The Sales Contract 197
Case Summary: Centrifugal Casting
Machine Co., Inc. v. American Bank &
Trust Co. 200
8-3 International Trade Issues 201
8-3a Repatriation of Profits 201
CONTENTS vii
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8-3b Expropriation 201
8-3c Foreign Corrupt Practices Act 202
Case Summary: United States v. King 203
8-3d Extraterritoriality 205
You Be the Judge: Carnero v. Boston
Scientific Corporation 205
Chapter Conclusion 206
Exam Review 207
Multiple-Choice Questions 209
Essay Questions 210
Discussion Questions 211
UNIT 2
Contracts 213
Chapter 9 Introduction to Contracts 214
9-1 Contracts 215
9-1a Elements of a Contract 215
9-1b Other Important Issues 215
9-1c All Shapes and Sizes 216
9-1d Contracts Defined 216
9-1e Development of Contract Law 217
Case Summary: Davis v. Mason 217
9-2 Types of Contracts 218
9-2a Bilateral and Unilateral Contracts 218
9-2b Executory and Executed Contracts 219
9-2c Valid, Unenforceable, Voidable, and
Void Agreements 219
Case Summary: Mr. W Fireworks, Inc. v.
Ozuna 220
9-2d Express and Implied Contracts 220
You Be the Judge: DeMasse v. ITT
Corporation 221
9-2e Promissory Estoppel and Quasi-
Contracts 222
Case Summary: Norton v. Hoyt 223
9-3 Sources of Contract Law 225
9-3a Common Law 225
9-3b Uniform Commercial Code 225
Case Summary: Fallsview Glatt Kosher
Caterers, Inc. v. Rosenfeld 226
Chapter Conclusion 227
Exam Review 227
Multiple-Choice Questions 230
Essay Questions 231
Discussion Questions 233
Chapter 10 Agreement 234
10-1 Meeting of the Minds 235
10-2 Offer 236
10-2a Statements That Usually Do Not
Amount to Offers 236
Landmark Case: Carlill v. Carbolic Smoke
Ball Company 238
10-2b Problems with Definiteness 239
Case Summary: Baer v. Chase 240
10-2c The UCC and Open Terms 241
10-2d Termination of Offers 242
Case Summary: Nadel v. Tom Cat Bakery 242
10-3 Acceptance 244
10-3a Mirror Image Rule 244
10-3b UCC and the Battle of Forms 245
10-3c Clickwraps and Shrinkwraps 247
Case Summary: Specht v. Netscape
Communications Corporation 247
10-3d Communication of Acceptance 249
Case Summary: Soldau v. Organon, Inc. 250
Chapter Conclusion 250
Exam Review 250
Multiple-Choice Questions 253
Essay Questions 254
Discussion Questions 255
Chapter 11 Consideration 256
11-1 What Is Consideration? 257
11-1a What Is Value? 257
Landmark Case: Hamer v. Sidway 258
You Be the Judge: Kim v. Son 259
11-1b Adequacy of Consideration 259
11-1c Illusory Promises 260
11-2 Applications of Consideration 261
11-2a The UCC: Consideration in
Requirements and Output Contracts 261
11-2b Preexisting Duty 262
YouBe the Judge:CitizensTrustBankv.White 263
11-3 Settlement of Debts 265
11-3a Liquidated Debt 265
11-3b Unliquidated Debt: Accord and
Satisfaction 265
Case Summary: Henches v. Taylor 266
11-4 Consideration: Trends 267
11-4a Employment Agreements 267
Case Summary: Snider Bolt & Screw v.
Quality Screw & Nut 268
11-4b Promissory Estoppel and “Moral
Consideration” 268
viii CONTENTS
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deemed tha t any suppre s sed con ten t does no t ma te r i a l l y a ff ec t t he ove ra l l l e a rn ing expe r i ence . Cengage Lea rn ing r e se rves t he r i gh t t o r emove add i t i ona l con ten t a t any t ime i f subsequen t r i gh t s r e s t r i c t i ons r equ i r e i t .

Chapter Conclusion 269
Exam Review 269
Multiple-Choice Questions 272
Essay Questions 273
Discussion Questions 274
Chapter 12 Legality 276
12-1 Contracts That Violate a Statute 277
12-1a Wagers 277
12-1b Insurance 278
12-1c Licensing Statutes 278
Case Summary: Authentic Home
Improvements v. Mayo 279
12-1d Usury 279
Case Summary: American Express Travel
Related Services Company, Inc. v. Assih 280
12-2 Contracts That Violate Public Policy 281
12-2a Restraint of Trade: Noncompete
Agreements 281
Case Summary: King v. Head Start Family
Hair Salons, Inc. 281
12-2b The Legality of Noncompetition
Clauses (Noncompetes) 283
12-2c Exculpatory Clauses 284
You Be the Judge: Ransburg v. Richards 285
12-2d Unconscionable Contracts 287
Case Summary: Worldwide Insurance v.
Klopp 288
Chapter Conclusion 289
Exam Review 289
Multiple-Choice Questions 291
Essay Questions 292
Discussion Questions 294
Chapter 13 Capacity and Consent 295
13-1 Capacity 296
13-1a Minors 296
13-1b Mentally Impaired Persons 298
Landmark Case: Babcock v. Engel 299
13-2 Reality of Consent 300
13-2a Fraud 300
Case Summary: Hess v. Chase Manhattan
Bank, USA, N.A. 304
13-2b Mistake 305
Case Summary: Donovan v. RRL Corporation 306
13-2c Duress 307
You Be the Judge: In Re RLS Legal
Solutions, LLC 308
13-2d Undue Influence 309
Case Summary: Sepulveda v. Aviles 310
Chapter Conclusion 310
Exam Review 311
Multiple-Choice Questions 313
Essay Questions 314
Discussion Questions 315
Chapter 14 Written Contracts 316
Landmark Case: The Lessee of Richardson
v. Campbell 317
14-1 Common Law Statute of Frauds: Contracts
That Must Be in Writing 319
14-1a Agreements for an Interest in Land 319
14-1b Agreements That Cannot Be
Performed within One Year 321
You Be the Judge: Sawyer v. Mills 321
14-1c Promise to Pay the Debt of Another 322
14-1d Promise Made by an Executor of an
Estate 323
14-1e Promise Made in Consideration of
Marriage 323
14-2 The Common Law Statute of Frauds: What
the Writing Must Contain 323
14-2a Signature 324
14-2b Reasonable Certainty 324
14-2c Electronic Contracts and Signatures 326
14-3 The UCC’s Statute of Frauds 326
14-3a UCC §2-201(1)—The Basic Rule 326
14-3b UCC §2-201(2)—The Merchants’
Exception 327
Case Summary: Seton Co. v. Lear Corp. 328
14-3c UCC §2-201(3)—Special
Circumstances 328
14-4 Parol Evidence 329
Case Summary: Mayo v. North Carolina
State University 330
14-4a Exception: An Incomplete orAmbiguous
Contract 331
14-4b Fraud, Misrepresentation, or Duress 331
Chapter Conclusion 331
Exam Review 332
Multiple-Choice Questions 334
Essay Questions 335
Discussion Questions 336
CONTENTS ix
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Chapter 15 Third Parties 337
15-1 Third Party Beneficiary 338
15-1a Intended Beneficiaries 338
Case Summary: Schauer v. Mandarin Gems
of California, Inc. 339
15-1b Incidental Beneficiaries 340
Case Summary: Unite Here Local 30 v.
California Department of Parks and
Recreation 340
15-2 Assignment and Delegation 341
15-2a Assignment 341
Case Summary: Tenet HealthSystem
Surgical, L.L.C. v. Jefferson Parish
Hospital Service District No. 1 343
You Be the Judge: Wells Fargo Bank
Minnesota v. BrooksAmerica Mortgage
Corporation 346
15-2b Delegation of Duties 347
Case Summary: Rosenberg v. Son, Inc. 349
Chapter Conclusion 350
Exam Review 350
Multiple-Choice Questions 352
Essay Questions 353
Discussion Questions 355
Chapter 16 Performance and Discharge 356
16-1 Conditions 358
16-1a How Conditions Are Created 358
16-1b Types of Conditions 359
Case Summary: American Electronic
Components, Inc. v. Agere Systems, Inc. 359
You Be The Judge: Anderson v. Country
Life Insurance Co. 361
16-2 Performance 362
16-2a Strict Performance and Substantial
Performance 363
16-2b Personal Satisfaction Contracts 364
16-2c Good Faith 365
Case Summary: Brunswick Hills Racquet
Club Inc. v. Route 18 Shopping Center
Associates 365
16-2d Time of the Essence Clauses 367
16-3 Breach 367
16-3a Material Breach 367
Case Summary: O’Brien v. Ohio State
University 368
16-3b Anticipatory Breach 368
16-3c Statute of Limitations 369
16-4 Impossibility 369
16-4a True Impossibility 369
16-4b Commercial Impracticability and
Frustration of Purpose 370
Chapter Conclusion 371
Exam Review 371
Multiple-Choice Questions 373
Essay Questions 374
Discussion Questions 376
Chapter 17 Remedies 377
17-1 Breaching a Contract 378
17-1a Identifying the “Interest” to Be
Protected 378
17-2 Expectation Interest 379
Landmark Case: Hawkins v. McGee 379
17-2a Direct Damages 381
17-2b Consequential Damages 381
Case Summary: Hadley v. Baxendale 381
You Be the Judge: Bi-Economy Market, Inc.
v. Harleysville Ins. Co. of New York 382
17-2c Incidental Damages 383
17-2d The UCC and Damages 383
17-3 Reliance Interest 385
17-3a Promissory Estoppel 386
Case Summary: Toscano v. Greene Music 386
17-4 Restitution Interest 387
17-4a Restitution in Cases of a Voidable
Contract 388
Case Summary: Putnam Construction &
Realty Co. v. Byrd 388
17-4b Restitution in Cases of a
Quasi-Contract 389
17-5 Other Remedies 389
17-5a Specific Performance 389
17-5b Injunction 390
Case Summary: Milicic v. Basketball
Marketing Company, Inc. 391
17-5c Reformation 392
17-6 Special Issues 392
17-6a Mitigation of Damages 392
17-6b Nominal Damages 392
17-6c Liquidated Damages 392
Chapter Conclusion 394
Exam Review 394
Multiple-Choice Questions 396
Essay Questions 397
Discussion Questions 399
x CONTENTS
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Chapter 18 Practical Contracts 400
18-1 The Lawyer 401
18-1a Lawyers and Clients 402
18-1b Hiring a Lawyer 402
18-2 The Contract 403
18-2a Who Drafts It? 403
18-2b How to Read a Contract 403
18-2c Mistakes 403
You Be the Judge: Quake Construction, Inc.
v. American Airlines, Inc. 404
Case Summary: Cipriano v. Patrons Mutual
Insurance Company of Connecticut 406
You Be the Judge: Heritage Technologies v.
Phibro-Tech 408
18-2d The Structure of a Contract 409
Case Summary: Lemond Cycling, Inc. v.
PTI Holding, Inc. 413
Chapter Conclusion 418
Exam Review 419
Multiple-Choice Questions 421
Essay Questions 421
Discussion Questions 422
UNIT 3
Commercial Transactions 423
Chapter 19 Introduction to Sales 424
19-1 Development of Commercial Law 425
19-1a Harold and Maude, Revisited 427
19-1b This Unit and This Chapter 427
19-2 UCC Basics 428
19-2a Code’s Purpose 428
19-2b Scope of Article 2 428
19-2c Mixed Contracts 429
19-2d Merchants 429
19-2e Good Faith and Unconscionability 429
19-3 Contract Formation 430
19-3a Formation Basics: §2-204 430
Case Summary: Jannusch v. Naffziger 431
19-3b Statute of Frauds 431
Case Summary: Delta Star, Inc. v. Michael’s
Carpet World 433
19-3c Added Terms: §2-207 433
Case Summary: Superior Boiler Works, Inc.
v. R. J. Sanders, Inc. 436
19-3d Open Terms: §§2-305 and 2-306 437
Case Summary: Mathis v. Exxon
Corporation 438
You Be the Judge: Lohman v. Wagner 440
19-3e Modification 441
Chapter Conclusion 444
Exam Review 444
Multiple-Choice Questions 447
Essay Questions 448
Discussion Questions 449
Chapter 20 Ownership, Risk,
and Warranties 450
20-1 Legal Interest 451
20-2 Identification, Title, and Insurable Interest 452
20-2a Existence and Identification 452
20-2b Passing of Title 453
20-2c Insurable Interest 454
Case Summary: Valley Forge Insurance Co.
v. Great American Insurance Co. 455
20-3 Imperfect Title 455
20-3a Bona Fide Purchaser 455
Case Summary: Bakalar v. Vavra 457
20-3b Entrustment 457
20-4 Risk of Loss 458
20-4a Shipping Terms 459
20-4b When the Parties Fail to Allocate the
Risk 459
Case Summary: Harmon v. Dunn 463
20-5 Warranties 463
20-6 Express Warranties 464
20-6a Affirmation of Fact or Promise 464
20-6b Description of Goods 464
20-6c Sample or Model 465
20-6d Basis of Bargain 465
20-7 Implied Warranties 465
20-7a Implied Warranty of Merchantability 465
CaseSummary:Goodmanv.WencoFoods, Inc. 466
20-7b Implied Warranty of Fitness for a
Particular Purpose 467
20-7c Warranty of Title 467
20-8 Disclaimers and Defenses 468
20-8a Disclaimers 468
20-8b Remedy Limitations 469
20-8c Privity 470
Case Summary: Reed v. City of Chicago 471
20-8d Buyer’s Misuse 472
CONTENTS xi
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Chapter Conclusion 472
Exam Review 472
Multiple-Choice Questions 473
Essay Questions 474
Discussion Questions 476
Chapter 21 Performance and Remedies 477
21-1 Obligation on All Parties: Good Faith 478
21-2 Seller’s Rights and Obligations 478
21-2a Perfect Tender Rule 479
21-2b Restrictions on the Perfect Tender
Rule 479
Case Summary: Zion Temple First
Pentecostal Church of Cincinnati, Ohio,
Inc. v. Brighter Day Bookstore & Gifts
& Murphy Cap & Gown Co. 481
You Be the Judge: United Aluminum
Corporation v. Linde, Inc. 483
21-3 Buyer’s Rights and Obligations 485
21-3a Inspection and Acceptance 485
Case Summary: Lile v. Kiesel 486
21-4 Seller’s Remedies 487
21-4a Stop Delivery 487
21-4b Identify Goods to the Contract 487
21-4c Resale 487
21-4d Damages for Non-Acceptance 488
21-4e Action for the Price 489
21-5 Buyer’s Remedies 489
21-5a Incidental Damages and
Consequential Damages 490
Case Summary: Smith v. Penbridge
Associates, Inc. 490
21-5b Specific Performance 491
21-5c Cover 491
Case Summary: Hessler v. Crystal Lake
Chrysler-Plymouth, Inc. 492
21-5d Non-Delivery 493
21-5e Acceptance of Non-Conforming Goods 493
21-5f Liquidated Damages 493
Chapter Conclusion 494
Exam Review 494
Multiple-Choice Questions 498
Essay Questions 499
Discussion Questions 500
Chapter 22 Negotiable Instruments 501
22-1 Commercial Paper 502
22-2 Types of Negotiable Instruments 502
22-3 The Fundamental “Rule” of Commercial
Paper 503
22-3a Negotiable 503
You Be the Judge: Blasco v. Money
Services Center 506
22-3b Negotiated 506
22-3c Holder in Due Course 507
Case Summary: Buckeye Check Cashing,
Inc. v. Camp 508
22-3d Defenses against a Holder in Due
Course 509
22-3e Consumer Exception 510
Case Summary: Antuna v. Nescor, Inc. 510
22-4 Liability for Negotiable Instruments 511
22-4a Primary versus Secondary Liability 511
22-5 Signature Liability 511
22-5a Maker 511
22-5b Drawer 511
22-5c Drawee 512
22-5d Indorser 513
22-5e Accommodation Party 513
22-6 Warranty Liability 514
22-6a Basic Rules of Warranty Liability 514
22-6b Transfer Warranties 515
You Be the Judge: Quimby v. Bank of
America 516
22-6c Comparison of Signature Liability
and Transfer Warranties 517
22-6d Presentment Warranties 517
22-7 Other Liability Rules 518
22-7a Conversion Liability 518
22-7b Impostor Rule 519
22-7c Fictitious Payee Rule 519
22-7d Employee Indorsement Rule 519
22-7e Negligence 520
Chapter Conclusion 521
Exam Review 521
Multiple-Choice Questions 525
Essay Questions 526
Discussion Questions 527
Chapter 23 Secured Transactions 528
23-1 Article 9: Terms and Scope 529
23-1a Article 9 Vocabulary 529
23-1b Scope of Article 9 530
23-2 Attachment of a Security Interest 532
23-2a Agreement 533
23-2b Control and Possession 533
xii CONTENTS
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Case Summary: In Re CFLC, Inc. 534
23-2c Value 535
23-2d Debtor Rights in the Collateral 535
23-2e Attachment to Future Property 535
23-3 Perfection 536
23-3a Nothing Less than Perfection 536
23-3b Perfection by Filing 536
Case Summary: Corona Fruits & Veggies,
Inc. v. Frozsun Foods, Inc. 538
23-3c Perfection by Possession or Control 540
Case Summary: Layne v. Bank One 541
23-3d Perfection of Consumer Goods 542
23-3e Perfection of Movable Collateral
and Fixtures 544
23-4 Protection of Buyers 545
23-4a Buyers in Ordinary Course of Business 546
You Be the Judge: Conseco Finance
Servicing Corp. v. Lee 547
23-4b Buyers of Consumer Goods 547
23-4c Buyers of Chattel Paper, Instruments,
and Documents 548
23-4d Liens 549
23-5 Priorities Among Creditors 550
23-5a Filing versus Control or Possession 551
23-5b Priority Involving a Purchase Money
Security Interest 552
Case Summary: In Re Roser 553
23-6 Default and Termination 553
23-6a Default 553
23-6b Termination 556
Chapter Conclusion 556
Exam Review 556
Multiple-Choice Questions 559
Essay Questions 560
Discussion Questions 561
Chapter 24 Bankruptcy 562
24-1 Overview of the Bankruptcy Code 563
24-1a Rehabilitation 563
24-1b Liquidation 564
24-1c Chapter Description 564
24-1d Goals 564
24-2 Chapter 7 Liquidation 564
24-2a Filing a Petition 565
24-2b Trustee 566
24-2c Creditors 566
24-2d Automatic Stay 567
Case Summary: Jackson v. Holiday Furniture 567
24-2e Bankruptcy Estate 568
24-2f Payment of Claims 570
24-2g Discharge 572
Case Summary: In Re Stern 573
Case Summary: In Re Grisham 575
24-3 Chapter 11 Reorganization 576
24-3a Debtor in Possession 576
24-3b Creditors’ Committee 576
24-3c Plan of Reorganization 577
24-3d Confirmation of the Plan 577
Case Summary: In Re Fox 577
24-3e Discharge 578
24-3f Small-Business Bankruptcy 579
24-4 Chapter 13 Consumer Reorganizations 579
You Be the Judge: Marrama v. Citizens
Bank of Massachusetts 579
24-4a Beginning a Chapter 13 Case 580
24-4b Plan of Payment 580
24-4c Discharge 581
Chapter Conclusion 581
Exam Review 582
Multiple-Choice Questions 583
Essay Questions 584
Discussion Questions 585
Chapter 25 Agency Law 587
25-1 Creating an Agency Relationship 588
25-1a Consent 588
25-1b Control 589
25-1c Fiduciary Relationship 589
25-1d Elements Not Required for an
Agency Relationship 589
25-2 Duties of Agents to Principals 590
25-2a Duty of Loyalty 590
Case Summary: Otsuka v. Polo Ralph
Lauren Corporation 590
Case Summary: Abkco Music, Inc. v.
Harrisongs Music, Ltd. 591
25-2b Other Duties of an Agent 593
25-2c Principal’s Remedies When the
Agent Breaches a Duty 594
25-3 Duties of Principals to Agents 595
25-3a Duty to Cooperate 596
25-4 Terminating an Agency Relationship 596
25-4a Termination by Agent or Principal 596
25-4b Principal or Agent Can No Longer
Perform Required Duties 597
25-4c Change in Circumstances 598
25-4d Effect of Termination 598
25-5 Liability 599
CONTENTS xiii
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25-6 Principal’s Liability for Contracts 599
25-6a Authority 599
25-6b Ratification 600
25-6c Subagents 601
25-7 Agent’s Liability for Contracts 601
25-7a Fully Disclosed Principal 601
25-7b Unidentified Principal 602
25-7c Undisclosed Principal 602
25-7d Unauthorized Agent 603
25-8 Principal’s Liability for Torts 604
25-8a Employee 604
25-8b Scope of Employment 605
You Be the Judge: Zankel v. United States
of America 606
25-8c Intentional Torts 607
Case Summary: Doe v. Liberatore 607
25-8d Physical or Nonphysical Harm 608
25-9 Agent’s Liability for Torts 609
Chapter Conclusion 609
Exam Review 609
Multiple-Choice Questions 612
Essay Questions 613
Discussion Questions 614
UNIT 4
Employment, Business
Organizations and Property 615
Chapter 26 Employment and Labor Law 616
26-1 Introduction 617
26-2 Employment Security 618
26-2a Family and Medical Leave Act 618
Case Summary: Peterson v. Exide
Technologies 618
26-2b Health Insurance 619
26-2c Common Law Protections 619
Case Summary: Kozloski v. American Tissue
Services Foundation 621
26-2d Whistleblowing 624
26-3 Privacy in the Workplace 626
26-3a Lifestyle Laws 626
You Be the Judge: Rodrigues v. Scotts
Lawnservice 627
26-4 Workplace Safety 630
26-5 Financial Protection 630
26-5a Fair Labor Standards Act: Minimum
Wage, Overtime, and Child Labor 631
26-5b Workers’ Compensation 631
26-5c Social Security 631
26-5d Pension Benefits 632
26-6 Labor Law and Collective Bargaining 632
26-6a Key Pro-Union Statutes 632
26-6b Labor Unions Today 633
26-6c Organizing a Union 633
26-6d Collective Bargaining 635
Landmark Case: NLRB v. Truitt
Manufacturing Co. 636
26-6e Concerted Action 636
Chapter Conclusion 638
Exam Review 638
Multiple-Choice Questions 641
Essay Questions 642
Discussion Questions 643
Chapter 27 Employment Discrimination 644
27-1 Introduction 645
27-2 The United States Constitution 646
27-3 Civil Rights Act of 1866 646
27-4 Title VII of the Civil Rights Act of 1964 646
27-4a Prohibited Activities 646
You Be the Judge: Jespersen v. Harrah’s 647
Landmark Case: Griggs v. Duke Power Co. 648
Case Summary: Teresa Harris v. Forklift
Systems, Inc. 650
27-4b Religion 652
27-4c Sex 652
27-4d Family Responsibility Discrimination 653
27-4e Sexual Orientation 653
27-4f Gender Identity 653
27-4g Defenses to Charges of Discrimination 654
27-5 Equal Pay Act of 1963 656
27-6 Pregnancy Discrimination Act 656
27-7 Age Discrimination in Employment Act 656
27-7a Disparate Treatment 657
Case Summary: Reid v. Google, Inc. 657
27-7b Disparate Impact 658
27-7c Hostile Work Environment 658
27-7d Bona Fide Occupational Qualification 659
27-8 Discrimination on the Basis of Disability 659
27-8a The Rehabilitation Act of 1973 659
27-8b Americans with Disabilities Act 660
Case Summary: Allen v. SouthCrest Hospital 660
27-9 Genetic Information Nondiscrimination Act 664
27-10 Enforcement 664
27-10a Constitutional Claims 664
xiv CONTENTS
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27-10b The Civil Rights Act of 1866 664
27-10c The Rehabilitation Act of 1973 664
27-10d Other Statutory Claims 664
Chapter Conclusion 666
Exam Review 666
Multiple-Choice Questions 669
Essay Questions 671
Discussion Questions 671
Chapter 28 Starting a Business: LLCs
and Other Options 673
28-1 Sole Proprietorships 674
28-2 Corporations 675
28-2a Corporations in General 675
28-2b S Corporations 677
28-2c Close Corporations 678
28-3 Limited Liability Companies 679
You Be the Judge: Ridgaway v. Silk 680
Case Summary: Wyoming.com, LLC v.
Lieberman 681
Case Summary: BLD Products, Ltd. v.
Technical Plastics of Oregon, LLC 682
Case Summary: Tzolis v. Wolff 683
28-4 Socially Conscious Organizations 685
28-5 General Partnerships 685
Case Summary: Marsh v. Gentry 687
28-6 Limited Liability Partnerships 688
28-7 Limited Partnerships and Limited Liability
Limited Partnerships 689
28-8 Professional Corporations 690
28-9 Joint Ventures 691
28-10 Franchises 691
Case Summary: National Franchisee
Association v. Burger King Corporation 693
Chapter Conclusion 693
Exam Review 694
Multiple-Choice Questions 695
Essay Questions 696
Discussion Questions 697
Chapter 29 Corporations 699
29-1 Promoter’s Liability 700
29-2 Incorporation Process 700
29-2a Where to Incorporate? 700
29-2b The Charter 701
29-3 After Incorporation 704
29-3a Directors and Officers 704
29-3b Bylaws 705
29-3c Issuing Debt 705
29-4 Death of the Corporation 705
29-4a Piercing the Corporate Veil 706
Case Summary: Brooks v. Becker 706
29-4b Termination 707
29-5 The Role of Corporate Management 707
29-6 The Business Judgment Rule 708
29-6a Duty of Loyalty 709
29-6b Corporate Opportunity 709
Case Summary: Anderson v. Bellino 710
29-6c Duty of Care 712
29-7 The Role of Shareholders 713
29-7a Rights of Shareholders 714
Case Summary: Brehm v. Eisner 722
You Be the Judge: eBay Domestic Holdings,
Inc. v. Newmark 723
29-8 Enforcing Shareholder Rights 724
29-8a Derivative Lawsuits 724
29-8b Direct Lawsuits 725
Chapter Conclusion 725
Exam Review 725
Multiple-Choice Questions 728
Essay Questions 729
Discussion Questions 730
Chapter 30 Government Regulation:
Securities and Antitrust 732
30-1 Securities Laws 733
30-1a What Is a Security? 733
30-1b Securities Act of 1933 733
30-1c Securities Exchange Act of 1934 735
Case Summary: Matrixx Initiatives, Inc. v.
Siracusano 736
30-1d Short-Swing Trading—Section 16 737
30-1e Insider Trading 737
Case Summary: Securities and Exchange
Commission v. Steffes 739
30-1f Blue Sky Laws 740
30-2 Antitrust Law 740
30-2a The Sherman Act 741
Landmark Case: United States v. Trenton
Potteries Company 741
Case Summary: Leegin Creative Leather
Products, Inc. v. PSKS, Inc. 742
30-2b The Clayton Act 745
Landmark Case: United States v. Waste
Management, Inc. 745
30-2c The Robinson-Patman Act 747
CONTENTS xv
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Chapter Conclusion 748
Exam Review 748
Multiple-Choice Questions 751
Essay Questions 752
Discussion Questions 752
Chapter 31 Consumer Protection 754
31-1 Introduction 755
31-1a Federal Trade Commission 755
31-1b Consumer Financial Protection Bureau 756
31-2 Sales 756
31-2a Deceptive Acts or Practices 756
Case Summary: Federal Trade Commission
v. Direct Marketing Concepts, Inc. 756
31-2b Unfair Practices 757
31-2c Additional Sales Rules 758
31-3 Consumer Credit 759
31-3a Truth in Lending Act—General
Provisions 760
31-3b Home Loans 761
31-3c Credit Cards 763
Case Summary: Gray v. American
Express Co. 766
31-3d Debit Cards 766
31-3e Credit Reports 767
31-3f Debt Collection 769
You Be the Judge: Brown v. Card Service
Center 770
31-3g Equal Credit Opportunity Act 771
Case Summary: Treadway v. Gateway
Chevrolet Oldsmobile Inc. 771
31-3h Consumer Leasing Act 772
31-4 Magnuson-Moss Warranty Act 773
31-5 Consumer Product Safety 774
Chapter Conclusion 774
Exam Review 774
Multiple-Choice Questions 778
Essay Questions 779
Discussion Questions 781
Chapter 32 Cyberlaw 782
32-1 Privacy 784
32-1a Tracking Tools 784
32-1b Regulation of Online Privacy 785
You Be the Judge: Juzwiak v. John/Jane Doe 786
Case Summary: United States of America v.
Angevine 787
Case Summary: United States of America v.
Warshak 788
You Be the Judge: Scott v. Beth Israel
Medical Center Inc. 791
32-2 Spam 792
32-3 Internet Service Providers and Web Hosts:
Communications Decency Act of 1996 793
Case Summary: Carafano v. Metrosplash
.com, Inc. 794
32-4 Crime on the Internet 795
32-4a Hacking 795
32-4b Fraud 797
Chapter Conclusion 799
Exam Review 800
Multiple-Choice Questions 802
Essay Questions 803
Discussion Questions 804
Chapter 33 Intellectual Property 805
33-1 Introduction 806
33-2 Patents 806
33-2a Types of Patents 806
33-2b Requirements for a Patent 808
33-2c Patent Application and Issuance 809
33-3 Copyrights 812
Case Summary: Lapine v. Seinfeld 813
33-3a Copyright Term 813
33-3b Infringement 813
33-3c First Sale Doctrine 814
33-3d Fair Use 814
33-3e Digital Music and Movies 815
Case Summary: Metro-Goldwyn-Mayer
Studios, Inc. v. Grokster, Ltd. 816
33-3f International Copyright Treaties 818
33-4 Trademarks 818
33-4a Types of Marks 819
33-4b Ownership and Registration 819
33-4c Valid Trademarks 819
33-4d Infringement 821
You Be the Judge: Network Automation,
Inc. v. Advanced Systems Concepts, Inc. 822
33-4e Federal Trademark Dilution Act of 1995 823
33-4f Domain Names 823
33-4g International Trademark Treaties 824
33-5 Trade Secrets 825
Case Summary: Pollack v. Skinsmart
Dermatology and Aesthetic Center P.C. 826
xvi CONTENTS
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Chapter Conclusion 827
Exam Review 827
Multiple-Choice Questions 828
Essay Questions 829
Discussion Questions 831
Chapter 34 Real and Personal Property 832
34-1 Nature of Real Property 833
Case Summary: Freeman v. Barrs 833
34-2 Estates in Real Property 834
34-2a Concurrent Estates 834
Case Summary: Jackson v. Estate
of Green 835
34-3 Nonpossessory Interests 837
34-3a Easements 837
34-3b Profit 837
34-3c License 837
34-3d Mortgage 838
34-4 Land Use Regulation 838
34-4a Nuisance Law 838
34-4b Zoning 839
34-4c Eminent Domain 839
34-5 Landlord-Tenant Law 840
34-5a Three Legal Areas Combined 840
34-5b Lease 840
34-6 Types of Tenancy 840
34-6a Tenancy for Years 841
34-6b Periodic Tenancy 841
34-6c Tenancy at Will 841
34-6d Tenancy at Sufferance 841
34-7 Landlord’s Duties 841
34-7a Duty to Deliver Possession 841
34-7b Quiet Enjoyment 842
34-7c Duty to Maintain Premises 842
Case Summary: Mishkin v. Young 844
34-8 Tenant’s Duties 845
34-8a Duty to Pay Rent 845
34-8b Duty to Use Premises for Proper
Purpose 846
34-8c Duty Not to Damage Premises 846
34-8d Duty Not to Disturb Other Tenants 846
34-9 Injuries 847
34-9a Tenant’s Liability 847
34-9b Landlord’s Liability 847
34-10 Personal Property 848
34-11 Gifts 848
34-11a Intention to Transfer Ownership 848
34-11b Delivery 849
34-11c Inter Vivos Gifts and Gifts Causa
Mortis 849
34-11d Acceptance 850
You Be the Judge: Albinger v. Harris 850
34-12 Bailment 852
34-12a Control 852
34-12b Rights of the Bailee 852
34-12c Duties of the Bailee 853
You Be the Judge: Johnson v. Weedman 854
34-12d Rights and Duties of the Bailor 854
Chapter Conclusion 854
Exam Review 855
Multiple-Choice Questions 857
Essay Questions 858
Discussion Questions 860
Appendix A
The Constitution of the United States A1
Appendix B
Uniform Commercial Code (Selected Provisions) B1
Glossary G1
Table of Cases T1
Index I1
CONTENTS xvii
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PREFACE
Looking for more examples for class? Do you want the latest develop-
ments? Visit our blog at bizlawupdate.com or our Facebook page at
Beatty Business Law. To be notified when we post updates, follow us
on Twitter @bizlawupdate.
NOTE FROM THE AUTHORS
New to This Edition
A NEW CHAPTER: PRACTICAL CONTRACTS
In this textbook, as well as other business law texts, contracts chapters focus on the theory of
contract law. And that theory is important. But our students tell us that theory, by itself, is
not enough. They need to know how these abstract rules operate in practice. They want to
understand the structure and content of a standard agreement. They have questions such as:
• Do I need a written agreement?
• What do these legal terms really mean?
• Are any important provisions missing?
• What happens if a term is unclear?
• Do I need to hire a lawyer? How can I use a lawyer most effectively?
We answer all these questions in Chapter 18, “Practical Contracts,” which is new to this
edition. As an illustration throughout the chapter, we use a real-life contract between a
movie studio and an actor.
A NEW CHAPTER: EMPLOYMENT DISCRIMINATION
We have heard from faculty and students alike that employment law plays an increasingly
important role in the life of a businessperson. At the same time, fewer and fewer workers
belong to labor unions. Therefore, we have rewritten the labor law and employment law
chapters from the previous edition. Instead of one chapter on labor law and one on employ-
ment law, we now have a new Chapter 26, “Employment and Labor Law,” which covers
both common law employment issues and labor law. In addition, Chapter 27, “Employment
Discrimination,” focuses solely on employment discrimination and includes, among other
things, an expanded discussion of disparate impact cases, which have become increasingly
common and important.
NEW MATERIAL: ETHICS CHAPTER
The Ethics chapter has been completely revised and is full of up-to-date examples, all
either from the news or true stories provided by executives. The section on the Theories of
Ethics has been enhanced and now includes, among others, John Rawls’ theory of justice.
This chapter also includes a discussion of the latest research on the ethics traps that prevent
us from doing what we know to be right. Students are asked to develop their own list of Life
xix
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Principles that they can use to make ethical decisions and avoid ethics traps. The chapter also
discusses the options that employees face when confronted with unethical behavior in
the workplace. And, finally, the chapter concludes with a discussion of Corporate Social
Responsibility—should companies practice it and, if so, how should they evaluate success?
LANDMARK CASES
As a general rule, we want our cases to be as current as possible, reporting on the world as it
is now. However, sometimes students can benefit from reading vintage cases that are still
good law and provide a deep understanding of how and why the law has developed as it has.
Thus, for example, we have added a discussion about the famous Supreme Court case
Miranda v. Arizona. Reading this case provides students with a much better understanding
of why the Supreme Court created Miranda rights, and this context helps students follow
the recent Supreme Court rulings on Miranda. Other landmark cases include Hawkins v.
McGee (the case of the hairy hand), and Griggs v. Duke Power Co.
REORGANIZED AND REVISED MATERIAL
In response to requests from faculty, product liability is now covered in Chapter 6, “Torts
and Product Liability.” It seems that most people like to teach these two subjects together.
The discussion of warranties is now found in the chapter on ownership and risk.
The new CPA exam no longer includes questions about banks and their customers, and
much of that material (such as how long it takes checks to clear) is not very relevant to our
students. Therefore we have deleted the chapter on Banks and Their Customers, and
combined the remaining material on Negotiable Instruments into one chapter, which now
covers how to create a negotiable instrument and liability.
The chapter on Securities Regulation has been expanded to include coverage of
antitrust law, under the title, “Government Regulation.” As the Justice Department
increases its oversight of mergers and with price-fixing violations increasingly common, it
is more important than ever for students to understand the basics of antitrust law.
In response to faculty requests, we have added a chapter on Consumer Protection. This
material is critical for all of us—everyone from the experienced executive to the young adult
with increasing financial responsibilities.
END OF CHAPTER MATERIAL
To facilitate class discussion and student learning, we have overhauled the study questions
at the end of the chapters. They are now divided into three parts:
1. Multiple-choice questions. Because many instructors use this format in their tests, it
seemed appropriate to provide practice questions. The answers to these multiple-
choice questions are available to students online at www.cengagebrain.com.
2. Essay questions. Students can use these as study questions, and professors can also
assign them as written homework problems.
3. Discussion questions. Instructors can use these questions to enhance class discussion.
If assigned in advance, students will have a chance to think about the answers before
class. This approach is similar to business cases, which often provide discussion
questions in advance.
OTHER NEW MATERIAL
We have, of course, added substantial new material, with a particular focus on the Internet
and social media. Chapter 26, “Employment and Labor Law,” includes a section on
social media. Chapter 29, “Corporations,” uses Facebook as an example of how to
organize a corporation. There are also new cases involving eBay and craigslist. In addition,
xx PREFACE
Copyr igh t 2013 Cengage Lea rn ing . A l l R igh t s Rese rved . May no t be cop i ed , s canned , o r dup l i ca t ed , i n who le o r i n pa r t . Due t o e l ec t ron i c r i gh t s , some th i rd pa r ty con t en t may be supp re s sed f rom the eBook and /o r eChap te r ( s ) . Ed i to r i a l r ev i ew has
deemed tha t any supp re s sed con t en t does no t ma te r i a l l y a ff ec t t he ove ra l l l e a rn ing expe r i ence . Cengage Lea rn ing r e se rves t he r i gh t t o r emove add i t i ona l con t en t a t any t ime i f subsequen t r i gh t s r e s t r i c t i ons r equ i r e i t .

Chapter 28, “Starting a Business: LLCs and Other Options,” includes a new section about
socially conscious organizations.
STAYING CURRENT: OUR BLOG, FACEBOOK, AND TWITTER
To find out about new developments in business law, visit our blog at Bizlawupdate.com or
our Facebook page at Beatty Business Law. If you follow us on Twitter @bizlawupdate, you
will receive a notification automatically whenever we post to the blog.
The Beatty/Samuelson Difference
When we began work on the first edition of this textbook, our publisher warned us that
our undertaking was risky because there were already so many law texts. Despite these
warnings, we were convinced that there was a market for an Essentials book that was
different from all the others. Our goal was to capture the passion and excitement—the
sheer enjoyment—of the law. Business law is notoriously complex, and as authors we are
obsessed with accuracy. Yet this intriguing subject also abounds with human conflict and
hard-earned wisdom, forces that can make a law book sparkle.
Now, as this fifth edition goes to press, we look back over the intervening years and are
touched by the many unsolicited comments from students, such as these posted on Amazon:
• “Glad I purchased this. It really helps put the law into perspective and allows me as a
leader to make intelligent decisions. Thanks.”
• “I enjoyed learning business law and was happy my college wanted this book.
THUMBS UP!”
We think of the students who have emailed us to say, “In terms of clarity, comprehen-
siveness, and vividness of style, I think it’s probably the best textbook I’ve ever used in any
subject,” and “I had no idea business law could be so interesting.” Or the professor who
said, “With your book, we have great class discussions.” Comments such as these never
cease to thrill us and to make us grateful that we persisted in writing an Essentials text like
no other—a book that is precise and authoritative, yet a pleasure to read.
Comprehensive Staying comprehensive means staying current. This fifth edition
contains over 25 new cases. Almost all were reported within the last two or three years.
We never include a new court opinion merely because it is recent, but the law evolves
continually, and our willingness to toss out old cases and add important new ones ensures
that this book—and its readers—remain on the frontier of legal developments.
Look, for example, at the important field of corporate governance. All texts cover par
value, and so do we. Yet a future executive is far likelier to face conflicts over Sarbanes-Oxley
(SOX), executive compensation, and shareholder proposals. We present a clear path through
this thicket of new issues. In Chapter 29, for example, read the section about the election and
removal of directors. Typically, students (even those who are high-level executives) have a
basic misconception about the process of removing a director from office. They think that it is
easy. Once they understand the complexity of this process, their whole view of corporate
governance—and compensation—changes. We want tomorrow’s business leaders to anticipate
the challenges that await them and then use their knowledge to avert problems.
Strong Narrative The law is full of great stories, and we use them. Your students and
ours should come to class excited. Look at Chapter 3, “Dispute Resolution.” No tedious list
of next steps in litigation, this chapter teaches the subject by tracking a double-indemnity
lawsuit. An executive is dead. Did he drown accidentally, obligating the insurance company
to pay? Or did the businessman commit suicide, voiding the policy? The student follows the
action from the discovery of the body, through each step of the lawsuit, to the final appeal.
PREFACE xxi
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Students read stories and remember them. Strong narratives provide a rich context for
the remarkable quantity of legal material presented. When students care about the material
they are reading, they persevere. We have been delighted to find that they also arrive in
class eager to question, discuss, and learn more about issues.
Precise The great joy of using English accurately is the power it gives us to attack and
dissect difficult issues, rendering them comprehensible to any lay reader. This text takes on
the most complex legal topics of the day, yet it is appropriate for all college and graduate-level
students. Accessible prose goes hand in hand with legal precision. We take great pride in
walking our readers through the most serpentine mazes this tough subject can offer.
As we explore this extraordinary discipline, we lure readers along with quirky anecdotes
and colorful diagrams. (Notice that the chart on page 713 clarifies the complex rules of the duty
of care in the business judgment rule.) However, before the trip is over, we insist that students:
• Gauge policy and political considerations,
• Grapple with legal and social history,
• Spot the nexus between disparate doctrines, and
• Confront tough moral choices.
Authoritative We insist, as you do, on a law book that is indisputably accurate. A
professor must teach with assurance, confident that every paragraph is the result of
exhaustive research and meticulous presentation. Dozens of tough-minded people spent
thousands of hours reviewing this book, and we are delighted with the stamp of approval we
have received from trial and appellate judges, working attorneys, scholars, and teachers.
We reject the cloudy definitions and fuzzy explanations that can invade judicial
opinions and legal scholarship. To highlight the most important rules, we use bold print,
and then follow with vivacious examples written in clear, forceful English. (See, for
example, the discussion of factual cause on page 149.) We cheerfully venture into con-
tentious areas, relying on very recent appellate decisions. Can a creditor pierce the veil of an
LLC? What are the rights of an LLC member in the absence of an operating agreement?
(See pages 679–684.) Where there is doubt about the current (or future) status of a doctrine,
we say so. In areas of particularly heated debate, we footnote our work: we want you to have
absolute trust in this book.
A Book for Students We have written this book as if we were speaking directly to our
students. We provide black letter law, but we also explain concepts in terms that hook
students. Over the years, we have learned how much more successfully we can teach when
our students are intrigued. No matter what kind of a show we put on in class, they are only
learning when they want to learn.
Every chapter begins with a story, either fictional or real, to illustrate the issues in the
chapter and provide context. Chapter 32, “Cyberlaw,” begins with the true story of a college
student who discovers nude pictures of himself online. These photos had been taken in the
locker room without his knowledge. What privacy rights do any of us have? Does the
Internet jeopardize them? Students want to know—right away.
Many of our students were not yet born when Bill Clinton was elected president. They
come to college with varying levels of preparation; many now arrive from other countries.
We have found that to teach business law most effectively, we must provide its context.
Chapter 26, on employment law, provides the historical setting for the employment-at-will
doctrine. Chapter 33, on intellectual property, explains the difference between intellectual
and other types of property.
At the same time, we enjoy offering “nuts-and-bolts” information that grabs students.
For example, in Chapter 31, “Consumer Protection,” we offer advice about how students
can obtain a free credit report (page 768).
xxii PREFACE
Copyr igh t 2013 Cengage Lea rn ing . A l l R igh t s Rese rved . May no t be cop i ed , s canned , o r dup l i ca t ed , i n who le o r i n pa r t . Due t o e l ec t ron i c r i gh t s , some th i rd pa r ty con t en t may be supp re s sed f rom the eBook and /o r eChap te r ( s ) . Ed i to r i a l r ev i ew has
deemed tha t any supp re s sed con t en t does no t ma te r i a l l y a ff ec t t he ove ra l l l e a rn ing expe r i ence . Cengage Lea rn ing r e se rves t he r i gh t t o r emove add i t i ona l con t en t a t any t ime i f subsequen t r i gh t s r e s t r i c t i ons r equ i r e i t .

Students respond enthusiastically to this approach. One professor asked a student to
compare our book with the one that the class was then using. This was the student’s
reaction: “I really enjoy reading the [Beatty & Samuelson] textbook and I have decided
that I will give you this memo ASAP, but I am keeping the book until Wednesday so that I
may continue reading. Thanks! :-).”
Along with other professors, we have used this text in courses for undergraduates,
MBAs, and Executive MBAs, with the students ranging in age from 18 to 55. The book
works, as some unsolicited comments indicate:
• An undergraduate wrote, “This is the best textbook I have had in college, on any
subject.”
• A business law professor stated that the “clarity of presentation is superlative. I have
never seen the complexity of contract law made this readable.”
• An MBA student commented, “I think the textbook is great. The book is relevant,
easy to understand, and interesting.”
• A state supreme court justice wrote that the book is “a valuable blend of rich
scholarship and easy readability. Students and professors should rejoice with this
publication.”
• A Fortune 500 vice president, enrolled in an Executive MBA program, commented,
“I really liked the chapters. They were crisp, organized and current. The information
was easy to understand and enjoyable.”
• An undergraduate wrote, “The textbook is awesome. A lot of the time I read more
than what is assigned—I just don’t want to stop.”
Humor Throughout the text, we use humor—judiciously—to lighten and enlighten. Not
surprisingly, students have applauded—but is it appropriate? How dare we employ levity in
this venerable discipline? We offer humor because we take the law seriously. We revere the
law for its ancient traditions; its dazzling intricacy; its relentless, though imperfect, attempt
to give order and decency to our world. Because we are confident of our respect for the law,
we are not afraid to employ some levity. Leaden prose masquerading as legal scholarship
does no honor to the field.
Humor also helps retention. Research shows that the funnier or more bizarre the
example, the longer students will remember it. Students are more likely to remember a
contract problem described in a fanciful setting, and from that setting recall the underlying
principle. By contrast, one widget is hard to distinguish from another.
Features
We chose the features for our book with great care. Each one supports an essential
pedagogical goal. Here are some of those goals and the matching feature.
EXAM STRATEGY
GOAL: To help students learn more effectively and to prepare for exams. In preparing this
fifth edition, we asked ourselves: What do students want? The short answer is—a good
grade in the course. How many times a semester does a student ask you, “What can I do to
study for the exam?” We are happy to help them study and earn a good grade because that
means they are learning.
About six times per chapter, we stop the action and give students a two-minute quiz.
In the body of the text, again in the end-of-chapter review, and also in the Instructor’s
Manual, we present a typical exam question. Here lies the innovation: We guide the
PREFACE xxiii
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

student in analyzing the issue. We teach the reader—over and over—how to approach a
question: To start with the overarching principle, examine the fine point raised in the
question, apply the analysis that courts use, and deduce the right answer. This skill is
second nature to lawyers, but not to students. Without practice, too many students panic,
jumping at a convenient answer and leaving aside the tools that they have spent the
course acquiring. Let’s change that. Students tell us that they love the Exam Strategy
feature.
YOU BE THE JUDGE
GOAL: Get students to think independently. When reading case opinions, students tend
to accept the court’s “answer.” Judges, of course, try to reach decisions that appear
indisputable, when in reality they may be controversial—or wrong. From time to time
we want students to think through the problem and reach their own answer. Almost
every chapter contains a You Be the Judge feature, providing the facts of the case and
conflicting appellate arguments. The court’s decision, however, appears only in the
Instructor’s Manual. Because students do not know the result, class discussions are
more complex and lively.
ETHICS
GOAL: Make ethics real.We ask ethical questions about cases, legal issues, and commercial
practices. Is it fair for one party to void a contract by arguing, months after the fact, that
there was no consideration? What is a manager’s ethical obligation when asked to provide a
reference for a former employee? What is wrong with bribery? We believe that asking the
questions and encouraging discussion reminds students that ethics is an essential element of
justice and of a satisfying life.
CASES
GOAL: Bring Case Law Alive. Each case begins with a summary of the facts followed
by a statement of both the issue and the decision. Next comes a summary of the court’s
opinion. We have written this summary ourselves to make the judges’ reasoning
accessible to all readers while retaining the court’s focus and the decision’s impact.
We cite cases using a modified bluebook form. In the principal cases in each chapter,
we provide the state or federal citation, the regional citation, and the LEXIS or
Westlaw citation. We also give students a brief description of the court. Because many
of our cases are so recent, some will have only a regional reporter and a LEXIS or
Westlaw citation.
EXAM REVIEW
GOAL: Help students to remember and practice! At the end of every chapter, we provide a
list of review points and several additional Exam Strategy exercises in a Question/Strategy/
Result format. We also challenge the students with 15 or more problems—Multiple-Choice,
Essay Questions, and Discussion Questions. The questions include the following:
• You Be the Judge Writing Problem. The students are given appellate arguments on both
sides of the question and must prepare a written opinion.
• Ethics. This question highlights the ethical issues of a dispute and calls upon the
student to formulate a specific, reasoned response.
• CPA Questions. Where relevant, practice tests include questions from previous CPA
exams administered by the American Institute of Certified Public Accountants.
Answers to all the Multiple-Choice questions are available to students online through
www.cengagebrain.com.
xxiv PREFACE
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deemed tha t any supp re s sed con t en t does no t ma te r i a l l y a ff ec t t he ove ra l l l e a rn ing expe r i ence . Cengage Lea rn ing r e se rves t he r i gh t t o r emove add i t i ona l con t en t a t any t ime i f subsequen t r i gh t s r e s t r i c t i ons r equ i r e i t .

TEACHING MATERIALS
For more information about any of these ancillaries, contact your Cengage Learning/
SouthWestern Legal Studies Sales Representative for more details, or visit the Beatty &
Samuelson Essentials, fifth edition web page, accessed through www.cengagebrain.com.
Instructor’s Manual Available through cengagebrain.com, this manual includes
answers to the You Be the Judge cases and also to the questions at the end of each
chapter. In addition, the Instructors’ Manual provides additional cases to use as the basis
of class discussion as well as other pedagogical features.
PowerPoint Lecture Review Slides PowerPoint slides are available for instructors
to use with their lectures, and can be accessed through cengagebrain.com.
Test Bank The test bank offers hundreds of essay, short-answer, and multiple-choice
problems. Editable files of the test bank are available at cengagebrain.com, and the test
bank is also available through the Cognero Testing Software.
Cognero Testing Software—Computerized Testing Software This online
testing system contains all of the questions in the test bank. Instructors can add or edit
questions, instructions, and answers; and select questions by previewing them on the
screen, selecting them randomly, or selecting them by number. Instructors can also create
and administer quizzes online.
CengageNOW This robust, online course management system gives you more control
in less time and delivers better student outcomes—NOW. CengageNOW for Essentials 5e
includes six homework types that align with the six levels of Bloom’s taxonomy:
Knowledge: Chapter Review; Comprehension: Business Law Scenarios; Application:
Legal Reasoning; Analysis: IRAC; Synthesis: Exam Strategy; and Evaluation: Business
Wisdom. With all these elements used together, CengageNOW will ensure that students
develop the higher-level thinking skills they need to reach an advanced understanding of
the material.
Business Law CourseMate Cengage Learning’s Business Law CourseMate brings
course concepts to life with interactive learning, study, and exam preparation tools—
including an e-book—that supports the printed textbook. Designed to address a variety of
learning styles, students will have access to flashcards, Learning Objectives, and the Key
Terms for quick reviews. A set of auto-gradable, interactive quizzes will allow students to
instantly gauge their comprehension of the material. For instructors, all quiz scores and
student activity are mapped within Engagement Tracker, a set of intuitive student
performance analytical tools that help identify at-risk students. An interactive blog helps
connect book concepts to real-world situations happening now.
Business Law Digital Video Library This dynamic online video library features
over 90 video clips that spark class discussion and clarify core legal principles. The library is
organized into six series:
• Legal Conflicts in Business includes specific modern business and e-commerce
scenarios.
• Ask the Instructor contains straightforward explanations of concepts for student review.
• Drama of the Law features classic business scenarios that spark classroom
participation.
PREFACE xxv
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

• Real World Legal takes students out of the classroom and into real-life situations,
encouraging them to consider the legal aspects of decision making in the business
world.
• Business Ethics in Action challenges students to examine ethical dilemmas in the world
of business.
Access to the Business Law Digital Video Library is available as an optional package with
each new student text at no additional charge. Students with used books can purchase
access to the video clips online. For more information about the Business Law Digital Video
Library, visit www.cengagebrain.com.
A Handbook of Basic Law Terms, Blacks Law Dictionary Series This
paperback dictionary, prepared by the editor of the popular Black’s Law Dictionary, can
be packaged for a small additional cost with any new South-Western Legal Studies in
Business text.
Student Guide to the SOX This brief overview for business students explains SOX,
what is required of whom, and how it might affect students in their business lives. Available
as an optional package with the text.
Interaction with the Author This is my standard: Every professor who adopts this
book must have a superior experience. I am available to help in any way I can. Adopters of
this text often call me or email me to ask questions, obtain a syllabus, offer suggestions,
share pedagogical concerns, or inquire about ancillaries. One of the pleasures of working on
this project has been this link to so many colleagues around the country. I value those
connections, am eager to respond, and would be happy to hear from you.
Susan S. Samuelson
Phone: (617) 353-2033
Email: ssamuels@bu.edu
ACKNOWLEDGMENTS
We appreciate the thoughtful insights of the reviewers for this fifth edition:
Randall Berens
Ohio University-Lancaster
Machiavelli Chao
University of California, Irvine
Raven Davenport
Houston Community College System
Terry L. Dimmick
Lakeshore Technical College
Craig Dokken
Hamline University
Philip Ettman
Westfield State University
Sheryl Fitzpatrick
North Iowa Area Community College
Janet L. Grange
Chicago State University
John Gray
Faulkner University
Jack Green
MiraCosta College
Anne-Marie Hakstian
Salem State University
Nancy Johnson
Mt. San Jacinto Community College
Sandra Leigh King
Sullivan University
xxvi PREFACE
Copyr igh t 2013 Cengage Lea rn ing . A l l R igh t s Rese rved . May no t be cop i ed , s canned , o r dup l i ca t ed , i n who le o r i n pa r t . Due t o e l ec t ron i c r i gh t s , some th i rd pa r ty con t en t may be supp re s sed f rom the eBook and /o r eChap te r ( s ) . Ed i to r i a l r ev i ew has
deemed tha t any supp re s sed con t en t does no t ma te r i a l l y a ff ec t t he ove ra l l l e a rn ing expe r i ence . Cengage Lea rn ing r e se rves t he r i gh t t o r emove add i t i ona l con t en t a t any t ime i f subsequen t r i gh t s r e s t r i c t i ons r equ i r e i t .

Ken Knox
Eastern Gateway Community
College
Joni Koegel
Cazenovia College
Greg Lauer
North Iowa Area Community College
Donald Letourneau
Pacific University
Magdalena Lorenz
State University of New York College of
Oneonta
Bill Mills
East Texas Baptist University
Jack Neveaux
Saint Mary’s University of Minnesota
Brad Reid
Lipscomb University
Alan Rosenbloom
Baruch College
Tom Severance
MiraCosta College
Frank Wetterau
Delaware Technical Community College
Kim Wong
Central New Mexico Community College
Bruce Zucker
California State University, Northridge
And we are continually grateful to the following reviewers who gave such helpful comments
on the first four editions of this book:
Manzoor Ahmad
Compton Educational Center, El Camino
College
Steven J. Arsenault
College of Charleston
Lois Beier
Kent State University
Martha Broderick
University of Maine
Amy Chataginer
Mississippi Gulf Coast Community
College
Burke Christensen
Eastern Kentucky University
Linda Christiansen
Indiana University Southeast
Michael Costello
University of Missouri, St. Louis
G. Howard Doty
Nashville State Technical Community
College
Teri Elkins
University of Houston
Lizbeth G. Ellis
New Mexico State University
Paul Fiorelli
Xavier University
Suzanne M. Gradisher
University of Akron
Gary Greene
Manatee Community College
Wendy Hind
Doane College
Elizabeth Grimm-Howell
University of Missouri—St. Louis
Richard Guarino
California State University, Sacramento
Stephen Hearn
Louisiana Tech University
Timothy Jackson
School of Business, California Baptist
University
William C. Kostner
Doane College
Ronald B. Kowalczyk
Elgin Community College
Colleen Arnott Less
Johnson & Wales University
Maurice J. McCann
Southern Illinois University Carbondale
PREFACE xxvii
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Russ Meade
Gardner-Webb University
Michael Monhollon
Hardin-Simmons University
Carol Nielsen
Bemidji State University
Margaret A. Parker
Owens Community College
Barbara Redman
Gainesville State College
Bruce L. Rockwood
Bloomsburg University
Rebecca Rutz
Mississippi Gulf Coast Community
College—Jackson County Campus
Rachel Spooner
Boston University School
of Management
Cheryl Staley
Lake Land College
Paulette L. Stenzel
Michigan State University
Kenneth Ray Taurman, Jr.
Indiana University Southeast
Daphyne Saunders Thomas
James Madison University
Glen M. Vogel
Hofstra University
Deborah Walsh
Middlesex Community College
ABOUT THE AUTHORS
Jeffrey F. Beatty was an associate professor of business law at the Boston University School
of Management. After receiving his B.A. from Sarah Lawrence and his J.D. from Boston
University, he practiced with the Greater Boston Legal Services representing indigent
clients. At Boston University, he won the Metcalf Cup and Prize, the university’s highest
teaching award. Professor Beatty also wrote plays and television scripts that were performed
in Boston, London, and Amsterdam.
Susan S. Samuelson is a professor of business law at Boston University’s School of
Management. After earning her undergraduate and law degrees at Harvard University,
Professor Samuelson practiced with the firm of Choate, Hall, and Stewart. She has written
many articles on legal issues for scholarly and popular journals, including the American
Business Law Journal, Ohio State Law Journal, Boston University Law Review, Harvard Journal
on Legislation, National Law Journal, Sloan Management Review, Better Homes and Gardens, and
Boston Magazine. At Boston University, she won the Broderick Prize for excellence in
teaching. For 12 years, Professor Samuelson was the faculty director of the Boston Uni-
versity Executive MBA program.
xxviii PREFACE
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deemed tha t any supp re s sed con t en t does no t ma te r i a l l y a ff ec t t he ove ra l l l e a rn ing expe r i ence . Cengage Lea rn ing r e se rves t he r i gh t t o r emove add i t i ona l con t en t a t any t ime i f subsequen t r i gh t s r e s t r i c t i ons r equ i r e i t .

UNIT1
The Legal
Environment
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Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

CHAPTER1
INTRODUCTION
TO LAW
The Pagans were a motorcycle gang with a repu-
tation for violence. Two of its rougher members,
Rhino and Backdraft, entered a tavern called the
Pub Zone, shoving their way past the bouncer.
The pair wore gang insignia, in violation of the
bar’s rules. For a while, all was quiet, as the two
sipped drinks at the bar. Then they followed an
innocent patron toward the men’s room, and
things happened fast.
“Wait a moment,” you may be thinking. “Are we
reading a chapter on business law or one about biker
crimes in a roadside tavern?” Both.
Law is powerful, essential, and fascinating. We hope
this book will persuade you of all three ideas. Law can
also be surprising. Later in the chapter we will return to
the Pub Zone (with armed guards) and follow Rhino and
Backdraft to the back of the pub. Yes, the pair engaged
in street crime, which is hardly a focus of this text.
However, their criminal acts will enable us to explore
one of the law’s basic principles, negligence. Should a
pub owner pay money damages to the victim of gang
violence? The owner herself did nothing aggressive.
Should she have prevented the harm? Does her failure
to stop the assault make her liable?
We place great demands on our courts, asking them to make our large, complex, and
sometimes violent society into a safer, fairer, more orderly place. The Pub Zone case is a
good example of how judges reason their way through the convoluted issues involved. What
began as a gang incident ends up as a matter of commercial liability. We will traipse after
Rhino and Backdraft because they have a lesson to teach anyone who enters the world of
business.
For a while, all was quiet,
as the two sipped drinks
at the bar. Then they
followed an innocent
patron toward the men’s
room…
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Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

1-1 THE ROLE OF LAW IN SOCIETY
1-1a Power
The strong reach of the law touches nearly everything we do, especially at work. Consider a
mid-level manager at Sublime Corp., which manufactures and distributes video games.
During the course of a day’s work, she might negotiate a deal with a game developer
(contract law). Before signing any deals, she might research whether similar games already exist,
which might diminish her ability to market the proposed new game (intellectual property law).
One of her subordinates might complain about being harassed by a coworker (employment law).
Another worker may complain about being required to work long hours (administrative law).
And she may consider investing her own money in her company’s stock, but she may wonder
whether she will get into trouble if she invests based on inside information (securities law).
It is not only as a corporate manager that you will confront the law. As a voter, investor,
juror, entrepreneur, and community member, you will influence and be affected by the law.
Whenever you take a stance about a legal issue, whether in the corporate office, in the
voting booth, or as part of local community groups, you help to create the fabric of our
nation. Your views are vital. This book will offer you knowledge and ideas from which to
form and continually reassess your legal opinions and values.
1-1b Importance
Law is also essential. Every society of which we have any historical record has had some
system of laws. For example, consider the Visigoths, a nomadic European people who
overran much of present-day France and Spain during the fifth and sixth centuries C.E.
Their code admirably required judges to be “quick of perception, clear in judgment, and
lenient in the infliction of penalties.” It detailed dozens of crimes.
Our legal system is largely based upon the English model, but many societies contributed
ideas. The Iroquois Native Americans, for example, played a role in the creation of our own
government. Five major nations made up the Iroquois group: the Mohawk, Cayuga, Oneida,
Onondaga, and Seneca. Each nation governed its own domestic issues. But each nation also
elected “sachems” to a League of the Iroquois. The league had authority over any matters that
were common to all, such as relations with outsiders. Thus, by the fifteenth century, the Iroquois
had solved the problem of federalism: how to have two levels of government, each with specified
powers. Their system impressed Benjamin Franklin and others and influenced the drafting of
our Constitution, with its powers divided between state and federal governments.1
1-1c Fascination
In 1835, the young French aristocrat Alexis de Tocqueville traveled through the United
States, observing the newly democratic people and the qualities that made them unique.
One of the things that struck de Tocqueville most forcefully was the American tendency to
file suit: “Scarcely any political question arises in the United States that is not resolved,
sooner or later, into a judicial question.”2 De Tocqueville got it right: For better or worse,
we do expect courts to solve many problems.
Not only do Americans litigate—they watch each other do it. Every television season
offers at least one new courtroom drama to a national audience breathless for more
cross-examination. Almost all of the states permit live television coverage of real trials.
One of the most heavily viewed events in the history of courtroom television was the 1995
1Jack Weatherford, Indian Givers (New York: Fawcett Columbine, 1988), pp. 133–150.
2Alexis de Tocqueville, Democracy in America (1835), Vol. 1, Ch. 16.
CHAPTER 1 Introduction to Law 3
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murder trial of former football star O.J. Simpson: 150 million viewers tuned in. In most
nations, coverage of judicial proceedings is not allowed.3
The law is a big part of our lives, and it is wise to know something about it. Within a few
weeks, you will probably find yourself following legal events in the news with keener
interest and deeper understanding. In this chapter, we develop the background for our
study. We look at where law comes from: its history and its present-day institutions. In the
section on jurisprudence, we examine different theories about what “law” really means. And
finally we see how courts—and students—analyze a case.
1-2 ORIGINS OF OUR LAW
It would be nice if we could look up “the law” in one book, memorize it, and then apply it.
But the law is not that simple, and cannot be that simple, because it reflects the complexity
of contemporary life. In truth, there is no such thing as “the law.” Principles and rules of law
actually come from many different sources. Why is this so? In part because we inherited a
complex structure of laws from England.
Additionally, ours is a nation born in revolution and created, in large part, to protect the
rights of its people from the government. The Founding Fathers created a national government
but insisted that the individual states maintain control in many areas. As a result, each state has
its own government with exclusive power over many important areas of our lives. To top it off,
the Founders guaranteed many rights to the people alone, ordering national and state govern-
ments to keep clear. This has worked, but it has caused a multilayered system, with 50 state
governments and one federal government all creating and enforcing law.
1-2a English Roots
England in the tenth century was a rustic agricultural community with a tiny population and
very little law or order. Vikings invaded repeatedly, terrorizing the Anglo-Saxon peoples.
Criminals were hard to catch in the heavily forested, sparsely settled nation. The king used
a primitive legal system to maintain a tenuous control over his people.
England was divided into shires, and daily administration was carried out by a “shire
reeve,” later called a sheriff. The shire reeve collected taxes and did what he could to keep
peace, apprehending criminals and acting as mediator between feuding families. Two or
three times a year, a shire court met; lower courts met more frequently. Today, this method
of resolving disputes lives on as mediation, which we will discuss in Chapter 3.
Because there were so few officers to keep the peace, Anglo-Saxon society created an
interesting method of ensuring public order. Every freeman belonged to a group of 10 freemen
known as a “tithing,” headed by a “tithingman.” If anyone injured a person outside his tithing
or interfered with the king’s property, all 10 men of the tithing could be forced to pay. Today,
we still use this idea of collective responsibility in business partnerships. All partners are
personally responsible for the debts of the partnership. They could potentially lose their homes
and all assets because of the irresponsible conduct of one partner. That liability has helped
create new forms of business organization, including limited liability companies.
When cases did come before an Anglo-Saxon court, the parties would often be represented
by a clergyman, by a nobleman, or by themselves. There were few professional lawyers. Each
party produced “oath helpers,” usually 12, who would swear that one version of events was
correct. The Anglo-Saxon oath helpers were forerunners of our modern jury of 12 persons.
3Regardless of whether we allow cameras, it is an undeniable benefit of the electronic age that we can
obtain information quickly. From time to time, we will mention websites of interest. Some of these are
for nonprofit groups, while others are commercial sites. We do not endorse or advocate on behalf of
any group or company; we simply wish to alert you to what is available.
4 U N I T 1 The Legal Environment
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

In 1066, the Normans conquered England. William the Conqueror made a claim never
before made in England: that he owned all of the land. The king then granted sections of his
lands to his favorite noblemen, as his tenants in chief, creating the system of feudalism. These
tenants in chief then granted parts of their land to tenants in demesne, who actually occupied a
particular estate. Each tenant in demesne owed fidelity to his lord (hence, “landlord”). So
what? Just this: land became the most valuable commodity in all of England, and our law still
reflects that. One thousand years later, American law still regards land as special. The Statute
of Frauds, which we study in the section on contracts, demands that contracts for the sale or
lease of property be in writing. And landlord-tenant law, vital to students andmany others, still
reflects its ancient roots. Some of a landlord’s rights are based on the 1,000-year-old tradition
that land is uniquely valuable.
In 1250, Henry de Bracton (d. 1268) wrote a legal treatise that still influences us. De Legibus et
Consuetudinibus Angliae (On the Laws and Customs of England), written in Latin, summarized many of
the legal rulings in cases since the Norman Conquest. De Bracton was teaching judges to rule based
on previous cases. He was helping to establish the idea of precedent. The doctrine of precedent,
which developed gradually over centuries, requires that judges decide current cases based on
previous rulings. This vital principle is the heart of American common law. Precedent ensures
predictability. Suppose a 17-year-old student promises to lease an apartment from a landlord, but
then changes her mind. The landlord sues to enforce the lease. The student claims that she cannot
be held to the agreement because she is a minor. The judge will look for precedent, that is, older
cases dealing with the same issue, and hewill findmany holding that a contract generallymay not be
enforced against a minor. That precedent is binding on this case, and the student wins. The
accumulation of precedent, based on case after case, makes up the common law.
In the end, today’s society is dramatically different from that of medieval English
society. But interestingly, legal disputes from hundreds of years ago are often quite recog-
nizable today. Some things have changed but others never do.
Here is an actual case from more than six centuries ago, in the court’s own language.
The plaintiff claims that he asked the defendant to heal his eye with “herbs and other
medicines.” He says the defendant did it so badly that he blinded the plaintiff in that eye.
THE OCULIST’S CASE (1329)
LI MS. Hale 137 (1), fo. 150, Nottingham4
C A S E S U M M A R Y
Attorney Launde [for defendant]: Sir, you plainly see
how [the plaintiff claims] that he had submitted himself to
[the defendant’s] medicines and his care; and after that he
can assign no trespass in his person, inasmuch as he sub-
mitted himself to his care: but this action, if he has any,
sounds naturally in breach of covenant. We demand [that
the case be dismissed].
Excerpts from Judge Denum’s Decision: I saw aNew-
castle man arraigned before my fellow justice and me for the
death of a man. I asked the reason for the indictment, and it
was said that he had slain a man under his care, who
died within four days afterwards. And because I saw
that he was a [doctor] and that he had not done the
thing feloniously but [accidentally] I ordered him to be
discharged. And suppose a blacksmith, who is a man of
skill, injures your horse with a nail, whereby you lose
your horse: you shall never have recovery against him.
No more shall you here.
Afterwards the plaintiff did not wish to pursue his
case any more.
Common law
Judge-made law.
4J. Baker and S. Milsom, Sources of English Legal History (London: Butterworth & Co., 1986).
Precedent
The tendency to decide current
cases based on previous
rulings.
CHAPTER 1 Introduction to Law 5
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

This case from 1329 is an ancient medical malpractice action. Attorney Launde does not
deny that his client blinded the plaintiff. He claims that the plaintiff has brought the wrong
kind of lawsuit. Launde argues that the plaintiff should have brought a case of “covenant”;
that is, a lawsuit about a contract.
Judge Denum decides the case on a different principle. He gives judgment to
the defendant because the plaintiff voluntarily sought medical care. He implies that
the defendant would lose only if he had attacked the plaintiff. As we will see when
we study negligence law, this case might have a different outcome today. Note also
the informality of the judge’s ruling. He rather casually mentions that he came across
a related case once before and that he would stand by that outcome. The idea of
precedent is just beginning to take hold.
1-2b Law in the United States
The colonists brought with them a basic knowledge of English law, some of which
they were content to adopt as their own. Other parts, such as religious restrictions,
were abhorrent to them. Many settlers had made the dangerous trip to America
precisely to escape persecution, and they were not interested in recreating their
difficulties in a new land. Finally, some laws were simply irrelevant or unworkable
in a world that was socially and geographically so different. American law ever since
has been a blend of the ancient principles of English common law and a zeal and
determination for change.
During the nineteenth century, the United States changed from a weak, rural
nation into one of vast size and potential power. Cities grew, factories appeared,
and sweeping movements of social migration changed the population. Changing
conditions raised new legal questions. Did workers have a right to form industrial
unions? To what extent should a manufacturer be liable if its product injured
someone? Could a state government invalidate an employment contract that
required 16-hour workdays? Should one company be permitted to dominate an
entire industry?
In the twentieth century, the rate of social and technological change increased,
creating new legal puzzles. Were some products, such as automobiles, so inherently
dangerous that the seller should be responsible for injuries even if no mistakes were
made in manufacturing? Who should clean up toxic waste if the company that had
caused the pollution no longer existed? If a consumer signed a contract with a
billion-dollar corporation, should the agreement be enforced even if the consumer
never understood it? New and startling questions arise with great regularity. Before
we can begin to examine the answers, we need to understand the sources of con-
temporary law.
1-3 SOURCES OF CONTEMPORARY LAW
Throughout the text, we will examine countless legal ideas. But binding rules come from
many different places. This section describes the significant categories of laws in the United
States.
6 U N I T 1 The Legal Environment
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

1-3a United States Constitution
America’s greatest legal achievement was the writing of the United States Constitution in 1787.
It is the supreme law of the land.5 Any law that conflicts with it is void. This federal
Constitution does three basic things. First, it establishes the national government of the United
States, with its three branches. Second, it creates a system of checks and balances among the
branches. And third, the Constitution guarantees many basic rights to the American people.
BRANCHES OF GOVERNMENT
The Founding Fathers sought a division of government power. They did not want all power
centralized in a king or in anyone else. And so, the Constitution divides legal authority into
three pieces: legislative, executive, and judicial power.
Legislative power gives the ability to create new laws. In Article I, the Constitution gives
this power to the Congress, which is comprised of two chambers—a Senate and a House of
Representatives. Voters in all 50 states elect representatives who go to Washington, D.C., to
serve in the Congress and debate new legal ideas.
The House of Representatives has 435 voting members. A state’s voting power is based
on its population. Large states (Texas, California, and Florida) send dozens of representa-
tives to the House. Some small states (Wyoming, North Dakota, and Delaware) send only
one. The Senate has 100 voting members—two from each state.
Executive power is the authority to enforce laws. Article II of the Constitution establishes
the President as commander in chief of the armed forces and the head of the executive
branch of the federal government.
Judicial power gives the right to interpret laws and determine their validity. Article III
places the Supreme Court at the head of the judicial branch of the federal government.
Interpretive power is often underrated, but it is often every bit as important as the ability to
create laws in the first place. For instance, the Supreme Court ruled that privacy provisions
of the Constitution protect a woman’s right to abortion, although neither the word “privacy”
nor “abortion” appears in the text of the Constitution.6
At times, courts void laws altogether. For example, in 1995, the Supreme Court ruled
that the Gun-Free School Zones Act of 1990 was unconstitutional because Congress did not
have the authority to pass such a law.7
CHECKS AND BALANCES
Sidney Crosby might score 300 goals per season if checking were not allowed in the
National Hockey League. But because opponents are allowed to hit Crosby and the rest
of his teammates on the Penguins, he is held to a much more reasonable 50 goals per year.
Political checks work in much the same way. They allow one branch of the government
to trip up another.
The authors of the Constitution were not content merely to divide government power
three ways. They also wanted to give each part of the government some power over the
other two branches. Many people complain about “gridlock” in Washington, but the
government is slow and sluggish by design. The Founding Fathers wanted to create a
system that, without broad agreement, would tend towards inaction.
The President can veto Congressional legislation. Congress can impeach the President.
The Supreme Court can void laws passed by Congress. The President appoints judges to
5The Constitution took effect in 1788, when 9 of 13 colonies ratified it. Two more colonies ratified it
that year, and the last of the 13 did so in 1789, after the government was already in operation. The
complete text of the Constitution appears in Appendix A.
6Roe v. Wade, 410 U.S. 113 (1973).
7United States v. Alfonso Lopez, Jr., 514 U.S. 549 (1995).
CHAPTER 1 Introduction to Law 7
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Sources of Law
Legislative
Branch
Executive
Branch
Judicial
Branch
State
Legislature
• passes statutes
on state law
• creates state
agencies
Governor
• proposes
statutes
• signs or vetoes
statutes
• oversees state
agencies
State
Courts
• create state
common law
• interpret
statutes
• review
constitutionality
of statutes and
other acts
50 State Governments
State Constitution
• establishes the state government
• guarantees the rights of state residents
One Federal Government
United States Constitution
• establishes limited federal government
• protects states’ power
• guarantees liberty of citizens
Administrative Agencies
oversee day-to-day application of law in dozens of
commercial and other areas
Legislative
Branch
Executive
Branch
Judicial
Branch
Congress
• passes statutes
• ratifies treaties
• creates
administrative
agencies
President
• proposes
statutes
• signs or vetoes
statutes
• oversees
administrative
agencies
Federal
Courts
• interpret
statutes
• create
(limited) federal
common law
• review the
constitutionality
of statutes and
other legal acts
Administrative Agencies
oversee day-to-day application of law in dozens of
commercial and other areas
Federal Form of Government. Principles and rules of law come from many sources. The government in Washington
creates and enforces law throughout the nation. But 50 state governments exercise great power in local affairs. And
citizens enjoy constitutional protection from both state and federal government. The Founding Fathers wanted this balance
of power and rights, but the overlapping authority creates legal complexity.
©
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ag
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8 U N I T 1 The Legal Environment
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

the federal courts, including the Supreme Court, but these nominees do not serve unless
approved by the Senate. Congress (with help from the 50 states) can override the Supreme
Court by amending the Constitution. The President and the Congress influence the
Supreme Court by controlling who is placed on the court in the first place.
Many of these checks and balances will be examined in more detail later in this book,
starting in Chapter 4.
FUNDAMENTAL RIGHTS
The Constitution also grants many of our most basic liberties. For the most part, they are found
in the amendments to the Constitution. The First Amendment guarantees the rights of free
speech, free press, and the free exercise of religion. The Fourth, Fifth, and Sixth Amendments
protect the rights of any person accused of a crime. Other amendments ensure that the
government treats all people equally and that it pays for any property it takes from a citizen.
By creating a limited government of three branches and guaranteeing basic liberties to
all citizens, the Constitution became one of the most important documents ever written.
1-3b Statutes
The second important source of law is statutory law. The Constitution gave to the United
States Congress the power to pass laws on various subjects. These laws are called statutes,
and they can cover absolutely any topic, so long as they do not violate the Constitution.
Almost all statutes are created by the same method. An idea for a new law—on taxes,
health care, texting while driving, or any other topic, big or small—is first proposed in the
Congress. This idea is called a bill. The House and Senate then independently vote on the
bill. To pass Congress, the bill must win a simple majority vote in each of these chambers.
If Congress passes a bill, it goes to the White House for the President’s approval. If
the President signs it, a new statute is created. It is no longer a mere idea; it is the law of the
land. If the President refuses to approve, or vetoes a bill, it does not become a statute unless
Congress overrides the veto. To do that, both the House and the Senate must approve the
bill by a two-thirds majority. If this happens, it becomes a statute without the President’s
signature.
1-3c Common Law
Binding legal ideas often come from the courts. Judges generally follow precedent. When
courts decide a case, they tend to apply the legal rules that other courts have used in
similar cases.
The principle that precedent is binding on later cases is called stare decisis, which means
“let the decision stand.” Stare decisis makes the law predictable, and this in turn enables
businesses and private citizens to plan intelligently.
It is important to note that precedent is binding only on lower courts. For example, if
the Supreme Court decided a case in one way in 1965, it is under no obligation to follow
precedent if the same issue arises in 2015.
Sometimes, this ability to change is quite beneficial. In 1896, the Supreme Court
decided (unbelievably) that segregation—separating people by race in schools, hotels,
public transportation, and other public services—was legal under certain conditions.8 In
1954, on the exact same issue, the court changed its mind.9
In other circumstances, it is more difficult to see the value in breaking with an
established rule.
8Plessy v. Ferguson, 163 U.S. 537 (1896).
9Brown v. Board of Education of Topeka, 347 U.S. 483 (1954).
Statute
A law created by a legislative
body.
CHAPTER 1 Introduction to Law 9
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1-3d Court Orders
Judges have the authority to issue court orders that place binding obligations on specific
people or companies. An injunction, for example, is a court order to stop doing something. A
judge might order a stalker to stay more than 500 yards away from an ex-lover. Lindsay
Lohan might be ordered to stop drinking and enter rehab. Courts have the authority to
imprison or fine those who violate their orders.
1-3e Administrative Law
In a society as large and diverse as ours, the executive and legislative branches of govern-
ment cannot oversee all aspects of commerce. Congress passes statutes about air safety, but
United States senators do not stand around air traffic towers, serving coffee to keep every-
one awake. The executive branch establishes rules concerning how foreign nationals enter
the United States, but Presidents are reluctant to sit on the dock of the bay, watching the
ships come in. Administrative agencies do this day-to-day work.
Most government agencies are created by Congress.
Familiar examples are the Environmental Protection
Agency (EPA), the Securities and Exchange Commis-
sion (SEC), and the Internal Revenue Service (IRS),
whose feelings are hurt if it does not hear from you
every April 15. Agencies have the power to create laws
called regulations.
1-3f Treaties
The Constitution authorizes the President to make treaties
with foreign nations. These agreements must then be
ratified by the United States Senate by a two-thirds vote.
When they are ratified, they are as binding upon all citi-
zens as any federal statute. In 1994, the Senate ratified the
North American Free Trade Agreement (NAFTA) with Mexico and Canada. NAFTA was
controversial then and remains so today—but it is the law of the land.
1-4 CLASSIFICATIONS
We have seen where law comes from. Now we need to classify the various types of laws.
First, we will distinguish between criminal and civil law. Then, we will take a look at the
intersection between law and morality.
1-4a Criminal and Civil Law
It is a crime to embezzle money from a bank, to steal a car, to sell cocaine. Criminal law
concerns behavior so threatening that society outlaws it altogether. Most criminal laws are
statutes, passed by Congress or a state legislature. The government itself prosecutes the
wrongdoer, regardless of what the bank President or car owner wants. A district attorney,
paid by the government, brings the case to court. The injured party, for example the owner
of the stolen car, is not in charge of the case, although she may appear as a witness. The
government will seek to punish the defendant with a prison sentence, a fine, or both.
If there is a fine, the money goes to the state, not to the injured party.
Civil law is different, and most of this book is about civil law. The civil law regulates the
rights and duties between parties. Tracy agrees in writing to lease you a 30,000-square-foot
store in her shopping mall. She now has a legal duty to make the space available. But then
United States senators
do not stand around
air traffic towers,
serving coffee to keep
everyone awake.
Criminal law
Criminal law prohibits certain
behavior.
Civil law
Civil law regulates the rights
and duties between parties.
10 U N I T 1 The Legal Environment
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another tenant offers her more money, and she refuses to let you move in. Tracy has
violated her duty, but she has not committed a crime. The government will not prosecute
the case. It is up to you to file a civil lawsuit. Your case will be based on the common law
of contract. You will also seek equitable relief, namely, an injunction ordering Tracy not to
lease to anyone else. You should win the suit, and you will get your injunction and some
money damages. But Tracy will not go to jail.
Some conduct involves both civil and criminal law. Suppose Tracy is so upset over
losing the court case that she becomes drunk and causes a serious car accident. She has
committed the crime of driving while intoxicated, and the state will prosecute. Tracy may
be fined or imprisoned. She has also committed negligence, and the injured party will file a
lawsuit against her, seeking money. We will again see civil and criminal law joined together
in the Pub Zone case, later in the chapter.
1-4b Law and Morality
Law is different from morality, yet the two are obviously linked. There are many instances
when the law duplicates what all of us would regard as a moral position. It is negligent to
drive too fast in a school zone, and few would dispute the moral value of seeking to limit
harm to students. And the same holds with contract law: If the owner of land agrees in
writing to sell property to a buyer at a stated price, both the buyer and the seller must
go through with the deal, and the legal outcome matches our moral expectations.
On the other hand, we have had laws that we now clearly regard as immoral. At the turn
of the century, a factory owner could typically fire a worker for any reason at all—including,
for example, his religious or political views. It is immoral to fire a worker because she is
Jewish—and today the law prohibits it.
Finally, there are legal issues where the morality is less clear. You are walking down a
country lane and notice a three-year-old child playing with matches near a barn filled with
hay. Are you obligated to intervene? No, says the law, though many think that is preposter-
ous. (See Chapter 4, on common law, for more about this topic.) A company buys property
and then discovers, buried under the ground, toxic waste that will cost $300,000 to clean up.
The original owner has gone bankrupt. Should the new owner be forced to pay for the
cleanup? If the new owner fails to pay for the job, who will?
Chapter 2 will further examine the bond between law and morality.
1-5 JURISPRUDENCE
We have had a glimpse of legal history and a summary of the present-day sources of American
law. But what is law? That question is the basis of a field known as jurisprudence. What is the
real nature of law? Can there be such a thing as an “illegal” law?
1-5a Legal Positivism
This philosophy can be simply stated: Law is what the sovereign says it is. The sovereign is
the recognized political power whom citizens obey, so in the United States, both state and
federal governments are sovereign. A legal positivist holds that whatever the sovereign
declares to be the law is the law, whether it is right or wrong.
The primary criticism of legal positivism is that it seems to leave no room for questions
of morality. A law permitting a factory owner to fire a worker because she is Catholic
is surely different from a law prohibiting arson. Do citizens in a democracy have a duty to
consider such differences? Consider the following example.
Most states allow citizens to pass laws directly at the ballot box, a process called voter
referendum. California voters often do this, and during the 1990s, they passed one of the
Sovereign
The recognized political power,
whom citizens obey.
Jurisprudence
The philosophy of law.
CHAPTER 1 Introduction to Law 11
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state’s most controversial laws. Proposition 187 was designed to curb illegal immigration into
the state by eliminating social spending for undocumented aliens. Citizens debated the
measure fiercely but passed it by a large margin. One section of the new law forbade public
schools from educating illegal immigrants. The law obligated a principal to inquire into the
immigration status of all children enrolled in the school and to report undocumented
students to immigration authorities. Several San Diego school principals rejected the new
rules, stating that they would neither inquire into immigration status nor report undocu-
mented aliens. Their statements produced a heated response. Some San Diego residents
castigated the school officials as lawbreakers, claiming that:
• A school officer who knowingly disobeyed a law was setting a terrible example for
students, who would assume they were free to do the same;
• The principals were advocating permanent residence and a free education for
anyone able to evade our immigration laws; and
• The officials were scorning grass-roots democracy by disregarding a law passed
by popular referendum.
Others applauded the principals’ position, asserting that:
• The referendum’s rules would transform school officials from educators into border
police, forcing them to cross-examine young children and their parents;
• The new law was foolish because it punished innocent children for violations
committed by their parents; and
• Our nation has long respected civil disobedience based on humanitarian ideals,
and these officials were providing moral leadership to the whole community.
Ultimately, no one had to decide whether to obey Proposition 187. A federal court ruled
that only Congress had the power to regulate immigration and that California’s attempt was
unconstitutional and void. The debate over immigration reform—and ethics—did not end,
however. It continues to be a thorny issue.
1-5b Natural Law
St. Thomas Aquinas (1225–1274) answered the legal positivists even before they had spoken.
In his Summa Theologica, he argued that an unjust law is no law at all and need not be obeyed. It
is not enough that a sovereign makes a command. The law must have a moral basis.
Where do we find the moral basis that would justify a law? Aquinas says that “good is that
which all things seek after.” Therefore, the fundamental rule of all laws is that “good is to be
done and promoted, and evil is to be avoided.”This sounds appealing, but also vague. Exactly
which laws promote good and which do not? Is it better to have a huge corporation dominate a
market or many smaller companies competing? Did the huge company get that way by being
better than its competitors? If Wal-Mart moves into a rural area, establishes a mammoth store,
and sells inexpensive products, is that “good”? Yes, if you are a consumer who cares only about
prices. No, if you are the owner of aMain Street store driven into bankruptcy.Maybe, if you are
a resident who values small-town life but wants lower prices.
1-5c Legal Realism
Legal realists take a very different tack. They claim it does not matter what is written as law.
What counts is who enforces that law and by what process. All of us are biased by issues
such as income, education, family background, race, religion, and many other factors. These
personal characteristics, they say, determine which contracts will be enforced and which
ignored, why some criminals receive harsh sentences while others get off lightly, and so on.
12 U N I T 1 The Legal Environment
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Judge Jones hears a multimillion dollar lawsuit involving an airplane crash. Was the
airline negligent? The law is the same everywhere, but legal realists say that Jones’s
background will determine the outcome. If she spent 20 years representing insurance
companies, she will tend to favor the airline. If her law practice consisted of helping the
“little guy,” she will favor the plaintiff.
Other legal realists argue, more aggressively, that those in power use the machinery of the
law to perpetuate their control. The outcome of a given case will be determined by the needs of
those withmoney and political clout. A court puts “window dressing” on a decision, they say, so
that society thinks there are principles behind the law. A problem with legal realism, however,
is its denial that any lawmaker can overcome personal bias. Yet clearly some do act unselfishly.
SUMMARY OF JURISPRUDENCE
Legal Positivism Law is what the sovereign says.
Natural Law An unjust law is no law at all.
Legal Realism Who enforces the law counts more than what is in writing.
No one school of jurisprudence is likely to seem perfect. We urge you to keep the
different theories in mind as you read cases in the book.
1-6 WORKING WITH THE BOOK’S
FEATURES
In this section, we introduce a few of the book’s features and discuss how you can use them
effectively. We will start with cases.
1-6a Analyzing a Case
A law case is the decision a court has made in a civil lawsuit or criminal prosecution. Cases
are the heart of the law and an important part of this book. Reading them effectively takes
practice. This chapter’s opening scenario is based on a real case. Who can be held liable for
the assault? Let’s see.
KUEHN V. PUB ZONE
364 N.J. Super. 301, 835 A.2d 692
Superior Court of New Jersey, Appellate Division, 2003
C A S E S U M M A R Y
Facts: Maria Kerkoulas owned the Pub Zone bar. She
knew that several motorcycle gangs frequented the
tavern. From her own experience tending bar, and con-
versations with city police, she knew that some of the
gangs, including the Pagans, were dangerous and prone
to attack customers for no reason. Kerkoulas posted a sign
prohibiting any motorcycle gangs from entering the bar
while wearing “colors,” that is, insignia of their gangs. She
believed that gangs without their colors were less prone to
violence, and experience proved her right.
©
C
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Le
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CHAPTER 1 Introduction to Law 13
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

ANALYSIS
Let’s take it from the top. The case is called Kuehn v. Pub Zone. Karl Kuehn is the
plaintiff, the person who is suing. The Pub Zone is being sued, and is called the
defendant. In this example, the plaintiff’s name happens to appear first, but that is
not always true. When a defendant loses a trial and files an appeal, some courts reverse
the names of the parties.
The next line gives the legal citation, which indicates where to find the case in a law
library. We explain in the footnote how to locate a case if you plan to do research.10
The Facts section provides a background to the lawsuit, written by the authors of this
text. The court’s own explanation of the facts is often many pages long, and may involve
complex matters irrelevant to the subject covered in this book, so we relate only what
is necessary. This section will usually include some mention of what happened at the
Rhino, Backdraft, and several other Pagans, all wear-
ing colors, pushed their way past the tavern’s bouncer and
approached the bar. Although Kerkoulas saw their colors,
she allowed them to stay for one drink. They later moved
towards the back of the pub, and Kerkoulas believed
they were departing. In fact, they followed a customer
named Karl Kuehn to the men’s room where, without any
provocation, they savagely beat him. Kuehn was knocked
unconscious and suffered brain hemorrhaging, disc hernia-
tion, and numerous fractures of facial bones. He was
forced to undergo various surgeries, including eye
reconstruction.
Although the government prosecuted Rhino and Back-
draft for their vicious assault, our case does not concern that
prosecution. Kuehn sued the Pub Zone, and that is the case
we will read. The jury awarded him $300,000 in damages.
However, the trial court judge overruled the jury’s verdict.
He granted a judgment for the Pub Zone, meaning that the
tavern owed nothing. The judge ruled that the pub’s owner
could not have foreseen the attack on Kuehn, and had no
duty to protect him from an outlawmotorcycle gang. Kuehn
appealed, and the appeals court’s decision follows.
Issue: Did the Pub Zone have a duty to protect Kuehn from
the Pagans’ attack?
Decision: Yes, the Pub Zone had a duty to protect Kuehn.
The decision is reversed, and the jury’s verdict is reinstated.
Reasoning: Whether a duty exists depends on the fore-
seeability of the harm, its potential severity, and the
defendant’s ability to prevent the injury. A court should
also evaluate society’s interest in the dispute.
A business owner generally has no duty to protect a
customer from acts of a third party unless experience
suggests that there is danger. However, if the owner could
in fact foresee injury, she is obligated to take reasonable
safety precautions.
Kerkoulas knew that the Pagans engaged in random
violence. She realized that when gang members entered
the pub, they endangered her customers. That is why she
prohibited bikers from wearing their colors—a reasonable
rule. Regrettably, the pub failed to enforce the rule.
Pagans were allowed to enter wearing their colors, and
the pub did not call the police. The pub’s behavior was
unreasonable and it is liable to Kuehn.
Plaintiff
The party who is suing.
Defendant
The party being sued.
10If you want to do legal research, you need to know where to find particular legal decisions. A case
citation guides you to the correct volume(s). The full citation of our case is Kuehn v. Pub Zone, 364 N. J.
Super. 301, 835 A. 2d 692. The string of numbers identifies two different books in which you can find
the full text of this decision. The first citation is to “N. J. Super,” which means the official court
reporter of the state of New Jersey. New Jersey, like most states, reports its law cases in a series of
numbered volumes. This case appears in volume 364 of the New Jersey Superior Court reporters. If
you go to a law library and find that book, you can then turn to page 301 and—voilà!—you have the
case. The decision is also reported in another set of volumes, called the regional reporters. This series
of law reports is grouped by geographic region. New Jersey is included in the Atlantic region, so our
case appears in reporters dedicated to that region. The “A” stands for Atlantic. After a series of
reporters reaches volume 999, a second set begins. Our case appears in volume 835 of the second set of
the Atlantic reporters (“A. 2d”), at page 692. In addition, cases are now available online, and your
professor or librarian can show you how to find them electronically.
14 U N I T 1 The Legal Environment
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trial court. Lawsuits always begin in a trial court. The losing party often appeals to a court of
appeals, and it is usually an appeals court decision that we are reading. The trial judge ruled
in favor of Pub Zone, but later, in the decision we are reading, Kuehn wins.
The Issue section is very important. It tells you what the court had to decide—and also
why you are reading the case. In giving its decision, a court may digress. If you keep in mind
the issue and relate the court’s discussion to it, you will not get lost.
The Decision is the court’s answer to the issue posed. A court’s decision is often referred
to as its holding. The court rules that the Pub Zone did have a duty to Kuehn. The appellate
court reverses the trial court’s decision, meaning that it declares the trial judge’s ruling wrong
and void. The appellate judges also reinstate the jury verdict. The appellate court could
have remanded the case if the judges had wished, meaning to send it back down to the lower
court for a new trial. If the appeals court had agreed with the trial court’s decision, the
judges would have affirmed the lower court’s ruling, meaning to uphold it.
The Reasoning section explains why the court reached its decision. The actual written
decision may be three paragraphs or 75 pages. Some judges offer us lucid prose, while others
seem intent on torturing the reader. Judges frequently digress and often discuss matters that
are irrelevant to the issue on which this text is focusing. For those reasons, we have taken
the court’s explanation and recast it in our own words. If you are curious about the full
opinion, you can always look it up.
Let us examine the reasoning. The court begins with a set of guidelines concerning a
business owner’s duty. Whether a defendant has such a duty depends on the foreseeability
and severity of the harm, whether the business person could have prevented it, and society’s
interest. The court emphasizes that a bar owner is not an ensurer of its patrons’ safety. Not
every assault in a pub results in the defendant’s liability. The judges are emphasizing that
courts do not reach decisions arbitrarily. They attempt to make thoughtful choices, consistent
with earlier rulings, which make good sense for the general public.
Having laid out the ground rules, the court describes the key facts, from this case, that it
will use to decide whether the Pub Zone had a duty to Kuehn. The judges note that the bar’s
owner knew that gang members were dangerous. The rule against wearing colors made sense.
When Pagans entered wearing their insignia, the pub had a duty to protect its patrons. The
pub’s owner was still not obligated to guarantee the safety of its patrons, but she had to do a
reasonable job of reacting to the foreseeable danger. All Kerkoulas reasonably had to do was
enforce the pub’s no-colors rule and telephone the police if gang members refused to obey it.
When she failed to take those steps, she violated her duty to Kuehn and became liable. The
court reversed the trial judge’s decision and reinstated the jury’s verdict.
1-6b Devil’s Advocate
Each chapter has several cases. After some of them, a “Devil’s Advocate” feature offers you
a contrasting view of the legal issue. This is not part of the case but is instead a suggestion of
another perspective on the problem discussed. The authors take no position for or against
the court’s decision, but merely want you to consider an alternate view, and decide which
analysis of the law makes more sense to you—that of the court or the Devil’s Advocate. Is
the following view persuasive?
Devil’s Advocate A court should not force small businesses to guarantee
their customers’ safety. Two or three violent men,
whether motorcycle gang members or frustrated professors, could enter a grocery store
or clothing retailer at anytime and mindlessly attack innocent visitors. Random attacks
are just that—random, unforeseeable. No merchant should be required to anticipate
them. Send the criminals to jail, but do not place the burden on honest businesspeople.
CHAPTER 1 Introduction to Law 15
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1-6c Exam Strategy
This feature gives you practice analyzing cases the way lawyers do—and the way you must
on tests. Law exams are different from most others because you must determine the issue
from the facts provided. Too frequently, students faced with a law exam forget that the
questions relate to the issues in the text and those discussed in class. Understandably,
students new to law may focus on the wrong information in the problem or rely on material
learned elsewhere. Exam Strategies teach you to figure out exactly what issue is at stake,
and then analyze it in a logical, consistent manner. Here is an example, relating to the
element of “duty,” which the court discussed in the Pub Zone case.
EXAM Strategy
The Big Red Traveling (BRT) Carnival is in town. Tony arrives at 8:00 p.m., parks in
the lot—and is robbed at gunpoint by a man who beats him and escapes with his
money. There are several police officers on the carnival grounds, but no officer is in
the parking lot at the time of the robbery. Tony sues, claiming that brighter lighting
and more police in the lot would have prevented the robbery. There has never before
been any violent crime—robbery, beating, or otherwise—at any BRT carnival. BRT
claims it had no duty to protect Tony from this harm. Who is likely to win?
Strategy: Begin by isolating the legal issue. What are the parties disputing? They are
debating whether BRT had a duty to protect Tony from an armed robbery,
committed by a stranger. Now ask yourself: How do courts decide whether a business
has a duty to prevent this kind of harm? The Pub Zone case provides our answer.
A business owner is not an ensurer of the visitor’s safety. The owner generally has no
duty to protect a customer from the criminal act of a third party, unless the owner
knows the harm is occurring or could foresee it is about to happen. (In the Pub Zone
case, the business owner knew of the gang’s violent history, and could have foreseen
the assault.) Now apply that rule to the facts of this case.
Result: There has never been a violent attack of any kind at a BRT carnival. BRT
cannot foresee this robbery, and has no duty to protect against it. The carnival wins.
1-6d You Be the Judge
Many cases involve difficult decisions for juries and judges. Often both parties have
legitimate, opposing arguments. Most chapters in this book will have a feature called
“You Be the Judge,” in which we present the facts of a case but not the court’s holding.
We offer you two opposing arguments based on the kinds of claims the lawyers made in
court. We leave it up to you to debate and decide which position is stronger or to add your
own arguments to those given.
The following case is another negligence lawsuit, with issues that overlap those of the Pub
Zone case. This time the court confronts a fight that resulted in a death. The victim’s distraught
family sued the owner of a bar, claiming that one of his employees was partly responsible for the
death. Once again, the defendant asked the court to dismiss the case, claiming that he owed no
duty to protect the victim—the same argument made by the Pub Zone.
But there is a difference here—this time the defendant owned the bar across the street,
not the one where the fight took place. Could he be held legally responsible for the death?
You be the judge.
16 U N I T 1 The Legal Environment
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Chapter Conclusion
We depend upon the law to give us a stable nation and economy, a fair society, a safe place
to live and work. These worthy goals have occupied ancient kings and twenty-first-century
lawmakers alike. But while law is a vital tool for crafting the society we want, there are no
easy answers about how to create it. In a democracy, we all participate in the crafting. Legal
rules control us, yet we create them. A working knowledge of the law can help build a
successful career—and a solid democracy.
You Be the Judge
Facts: In the days before
cell phones, a fight broke
out at Happy Jack’s Saloon.
A good Samaritan ran across
the street to the Circle Inn,
whereheaskedthebartender
to let him use the telephone
to call the police. The bartender refused.
Back at Happy Jack’s Saloon, the fight escalated, and a
man shot and killed Soldano’s father. Soldano sued the
owner of the Circle Inn for negligence. He argued the
bartender violated a legal duty when he refused to hand over
the inn’s telephone, and that, as the employer of the bar-
tender, O’Daniels was partially liable for his father’s death.
The lower court dismissed the case, citing the princi-
ple that generally, a person does not have a legal respon-
sibility to help another unless he created the dangerous
situation in the first place. Soldano appealed.
You Be the Judge: Did the bartender have a duty to allow
the use of the Circle Inn’s telephone?
Argument for the Defendant: Your honors, my client
did not act wrongfully. He did nothing to create the
danger. The fight was not even on his property. We
sympathize with the plaintiff, but it is the shooter,
and perhaps the bar where the fight took place, who are
responsible for his father’s death. Our client was not
involved. Liability can be stretched only so far.
The court would place a great burden on the citi-
zens of California by going against precedent. The
Circle Inn is Mr. O’Daniel’s private property. If the
court imposes potential liability on him in this case,
would citizens be forced to open the doors of their
homes whenever a stranger claims an emergency?
Criminals would delight
in their newfound ability
to gain access to busi-
nesses and residences
by simply demanding to
use a phone to “call the
police.”
The law has developed sensibly. People are left to
decide for themselves whether to help in a dangerous
situation. They are not legally required to place them-
selves in harm’s way.
Argument for the Plaintiff: Your honors, the Circle
Inn’s bartender had both a moral and a legal duty to allow
the use of his establishment’s telephone. The Circle Inn
may be privately owned, but it is a business open to the
public. Anyone in the world is invited to stop by and order
a drink or a meal. The good Samaritan had every right to
be there.
We do not argue that the bartender had an obligation
to break up the fight or endanger himself in any way. We
simply argue he had a responsibility to stand aside and
allow a free call on his restaurant’s telephone. Any “bur-
den” on him or on the Circle Inn was incredibly slight.
The potential benefits were enormous. The trial court
made a mistake in concluding that a person never has a
duty to help another. Such an interpretation makes for
poor public policy.
There is no need to radically change the . Residences
can be excluded from this ruling. People need not be
required to allow strangers into their homes. This court
can simply determine that businesses have a legal duty to
allow the placement of emergency calls during normal
business hours.
SOLDANO V. O’DANIELS
141 Cal. App. 3d 443
Court of Appeal of California,
5th Appellate District,1983
CHAPTER 1 Introduction to Law 17
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EXAM REVIEW
1. THE FEDERAL SYSTEM Our federal system of government means that law
comes from a national government in Washington, D.C., and from 50 state
governments. (pp. 7–9)
2. LEGAL HISTORY The history of law foreshadows many current legal issues,
including mediation, partnership liability, the jury system, the role of witnesses,
the special value placed on land, and the idea of precedent. (pp. 4–5)
3. PRIMARY SOURCES OF LAW The primary sources of contemporary law are:
• United States Constitution and state constitutions;
• Statutes, which are drafted by legislatures;
• Common law, which is the body of cases decided by judges, as they follow earlier
cases, known as precedent;
• Court orders, which place obligations on specific people or companies;
• Administrative law, the rules and decisions made by federal and state
administrative agencies; and
• Treaties, agreements between the United States and foreign nations.
(pp. 6–10).
Question: The stock market crash of 1929 and the Great Depression that
followed were caused in part because so many investors blindly put their money
into stocks they knew nothing about. During the 1920s, it was often impossible for
an investor to find out what a corporation was planning to do with its money, who
was running the corporation, and many other vital things. Congress responded by
passing the Securities Act of 1933, which required a corporation to divulge more
information about itself before it could seek money for a new stock issue. What
kind of law did Congress create?
Strategy: What is the question seeking? The question asks you which type of law
Congress created when it passed the 1933 Securities Act. What are the primary
kinds of law? Administrative law consists of rules passed by agencies. Congress is
not a federal agency. Common law is the body of cases decided by judges.
Congress is not a judge. Statutes are laws passed by legislatures. Congress is a
legislature. (See the “Result” at the end of this section.)
4. CRIMINAL LAW Criminal law concerns behavior so threatening to society that it
is outlawed altogether. Civil law deals with duties and disputes between parties, not
with outlawed behavior. (pp. 10–11)
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18 U N I T 1 The Legal Environment
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Question: Bill and Diane are hiking in the woods. Diane walks down a hill to
fetch fresh water. Bill meets a stranger, who introduces herself as Katrina. Bill sells
a kilo of cocaine to Katrina, who then flashes a badge and mentions how much she
enjoys her job at the Drug Enforcement Agency. Diane, heading back to camp
with the water, meets Freddy, a motorist whose car has overheated. Freddy is late
for a meeting where he expects to make a $30 million profit; he’s desperate for
water for his car. He promises to pay Diane $500 tomorrow if she will give him the
pail of water, which she does. The next day, Bill is in jail and Freddy refuses to
pay for Diane’s water. Explain the criminal law/civil law distinction and what it
means to Bill and Diane. Who will do what to whom, with what results?
Strategy: You are asked to distinguish between criminal and civil law. What is
the difference? The criminal law concerns behavior that threatens society and
is therefore outlawed. The government prosecutes the defendant. Civil law deals
with the rights and duties between parties. One party files a suit against the other.
Apply those different standards to these facts. (See the “Result” at the end of
this section.)
5. JURISPRUDENCE Jurisprudence is concerned with the basic nature of law.
Three theories of jurisprudence are
1. Legal positivism: The law is what the sovereign says it is.
2. Natural law: An unjust law is no law at all.
3. Legal realism: Who enforces the law is more important than what the law says.
(pp. 11–13)
3. Result: The Securities Act of 1933 is a statute.
4. Result: The government will prosecute Bill for dealing in drugs. If convicted, he will go
to prison. The government will take no interest in Diane’s dispute. However, if she chooses,
she may sue Freddy for $500, the amount he promised her for the water. In that civil lawsuit,
a court will decide whether Freddy must pay what he promised; however, even if Freddy
loses, he will not go to jail.
MULTIPLE-CHOICE QUESTIONS
1. The United States Constitution is among the finest legal accomplishments in the
history of the world. Which of the following influenced Benjamin Franklin, Thomas
Jefferson, and the rest of the Founding Fathers?
(a) English common law principles
(b) the Iroquois’s system of federalism
(c) Both (a) and (b)
(d) None of the above
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CHAPTER 1 Introduction to Law 19
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2. Which of the following parts of the modern legal system are “borrowed” from
medieval England?
(a) Jury trials
(b) Special rules for selling land
(c) Following precedent
(d) All of the above
3. Union organizers at a hospital wanted to distribute leaflets to potential union
members, but hospital rules prohibited leafleting in areas of patient care, hallways,
cafeterias, and any areas open to the public. The National Labor Relations Board,
a government agency, ruled that these restrictions violated the law and ordered the
hospital to permit the activities in the cafeteria and coffee shop. What kind of law
was it creating?
(a) A statute
(b) Common law
(c) A constitutional amendment
(d) Administrative regulation
4. If the Congress creates a new statute with the President’s support, it must pass the
idea by a___majority vote in the House and the Senate. If the President vetoes a
proposed statute and the Congress wishes to pass it without his support, the idea must
pass by a___majority vote in the House and Senate.
(a) simple; simple
(b) simple; two-thirds
(c) simple; three-fourths
(d) two-thirds; three-fourths
5. What part of the Constitution addresses the most basic liberties?
(a) Article I
(b) Article II
(c) Article III
(d) Amendments
ESSAY QUESTIONS
1. Burglar Bob breaks into Vince Victim’s house. Bob steals a flat-screen television
and laptop and does a significant amount of damage to the property before he
leaves. Fortunately, Vince has a state-of-the-art security system. It captures
excellent images of Bob, who is soon caught by police. Assume that two legal
actions follow, one civil and one criminal. Who will be responsible for bringing
the civil case? What will be the outcome if the jury believes that Bob burgled
Vince’s house? Who will be responsible for bringing the criminal case? What
will be the outcome if the jury believes that Bob burgled Vince’s house?
20 U N I T 1 The Legal Environment
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2. As “The Oculist’s Case” indicates, the medical profession has faced a large number of
lawsuits for centuries. In Texas, a law provides that, so long as a doctor was not
reckless and did not intentionally harm a patient, recovery for “pain and suffering”
is limited to $750,000. In many other states, no such limit exists. If a patient will suffer
a lifetime of pain after a botched operation, for example, he might recover millions
in compensation. Which rule seems more sensible to you—the “Texas” rule or the
alternative?
3. YOU BE THE JUDGE WRITING PROBLEM Should trials be televised?
Here are a few arguments on both sides of the issue. You be the judge. Arguments
against live television coverage: We have tried this experiment and it has failed. Trials
fall into two categories: those that create great public interest and those that do not.
No one watches dull trials, so we do not need to broadcast them. The few that are
interesting have all become circuses. Judges and lawyers have shown that they cannot
resist the temptation to play to the camera. Trials are supposed to be about justice,
not entertainment. If a citizen seriously wants to follow a case, she can do it by reading
the daily newspaper. Arguments for live television coverage: It is true that some
televised trials have been unseemly affairs, but that is the fault of the presiding
judges, not the media. Indeed, one of the virtues of television coverage is that
millions of people now understand that we have a lot of incompetent people running
our courtrooms. The proper response is to train judges to run a tight trial by
prohibiting grandstanding by lawyers. Access to accurate information is the foundation
on which a democracy is built, and we must not eliminate a source of valuable data
just because some judges are ill-trained or otherwise incompetent.
4. Leslie Bergh and his two brothers, Milton and Raymond, formed a partnership to
help build a fancy saloon and dance hall in Evanston, Wyoming. Later, Leslie met
with his friend and drinking buddy, John Mills, and tricked Mills into investing in the
saloon. Leslie did not tell Mills that no one else was investing cash or that the
entire enterprise was already bankrupt. Mills mortgaged his home, invested $150,000
in the saloon—and lost every penny of it. Mills sued all three partners for fraud.
Milton and Raymond defended on the grounds that they did not commit the fraud;
only Leslie did. The defendants lost. Was that fair? By holding them liable, what
general idea did the court rely on? What Anglo-Saxon legal custom did the ruling
resemble?
5. Kuehn v. Pub Zone and Soldano v. O’Daniels both involve attacks in a bar. Should they
have the same result? If so, in which way—in favor of the injured plaintiffs or owner-
defendants? If not, why should they have different outcomes? What are the key facts
that lead you to believe as you do?
DISCUSSION QUESTIONS
1. Do you believe that there are toomany lawsuits in the
United States? If so, do you place more blame for the
problem on lawyers or on individuals who go to court?
Is there anything that would help the problem, or will
we always have large numbers of lawsuits?
2. In the 1980s, the Supreme Court ruled that it is
legal for protesters to burn the American flag.
This activity counts as free speech under
the Constitution. If the Court hears a
new flag-burning case in this decade, should
it consider changing its ruling, or should it
follow precedent? Is following past precedent
something that seems sensible to you:
always, usually, sometimes, rarely, or never?
CHAPTER 1 Introduction to Law 21
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3. When should a business be held legally responsible
for customer safety? Consider the following
statements, and consider the degree to which you
agree or disagree:
• A business should keep customers safe from its
own employees.
• A business should keep customers safe from other
customers.
• A business should keep customers safe from
themselves. (Example: an intoxicated customer
who can no longer walk straight.)
• A business should keep people outside its own
establishment safe if it is reasonable to do so.
4. In his most famous novel, The Red and the Black, the
French author Stendhal (1783–1842) wrote:
“There is no such thing as ‘natural law’: this
expression is nothing but old nonsense. Prior to
laws, what is natural is only the strength of the lion,
or the need of the creature suffering from hunger
or cold, in short, need.” What do you think? Does
legal positivism or legal realism seem more
sensible to you?
5. At the time of this writing, voters are particularly
disgruntled. A good many people seem to be
disgusted with government. For this question, we
intentionally avoid distinguishing between
Democrats and Republicans, and we intentionally
do not name any particular President. Consider the
following statements, and consider the degree to
which you agree or disagree:
• I believe that members of Congress usually try to
do the right thing for America.
• I believe that Presidents usually try to do the right
thing for America.
• I believe that Supreme Court justices usually try to
do the right thing for America.
22 U N I T 1 The Legal Environment
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CHAPTER2
ETHICS AND
CORPORATE
SOCIAL
RESPONSIBILITY
Eating is one of life’s most fundamental needs and
greatest pleasures. Yet all around the world many
people go to bed hungry. Food companies have
played an important role in reducing hunger by producing vast quantities of food cheaply.
Somuch food, so cheaply that, in America, one in three adults and one in five children are obese.
Some critics argue that food companies bear responsibility for this overeating because theymake
their products too alluring. Many processed food products are calorie bombs of fat (which is
linked to heart disease), sugar (leading to diabetes), and salt (causing high blood pressure). What
obligation do food producers and restaurants have to their customers? After all, no one is forcing
anyone to eat. Do any of the following examples cross the line into unethical behavior?
1. Increasing Addiction. Food with high levels of fat, sugar, and salt not only taste better,
they are also more addictive to consumers. Food processors hire neuroscientists who
perform MRIs on consumers to gauge the precise
level of fat, sugar, and salt that will create the most
powerful cravings, the so-called bliss point. To take
one example, in some Prego tomato sauces, sugar is
the second most important ingredient after
tomatoes. Did you know you were getting a large
dose of sugar with your pasta?
2. Increasing Quantity. Food companies also work hard
to create new categories of products that increase the
number of times a day that people eat and the amount
of calories in each session. For example, they have
created a new category of food that is meant to be more than a snack but less than a meal,
such as Hot Pockets. But some versions of this product have more than 700 calories, which
Food with high levels of
fat, sugar and salt not
only taste better, they are
also more addictive to
consumers.
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Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
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would be a lot for lunch, never mind for just a snack. And candy companies
carefully package their products to encourage consumers to nibble all day.
For example, when Hershey’s learned that the wrappers on a Reese’s
Peanut Butter Cup act as a deterrent to nonstop eating, the company
created Reese’s minis, which are unwrapped candies in a resealable bag.
Feel free to chow down!
Food executives argue that they are just providing what consumers want.
3. Increasing Calories. Uno Chicago Grill serves a macaroni and cheese
dish that, by itself, provides more than two-thirds of the calories that a
moderately active man should eat in one day, and almost three times
the amount of saturated fat. But this dish is at least food. Dunkin
Donuts offers a Frozen Caramel Coffee Coolatta with more than one-
third the calories that a male should have in a day and 50 percent more
saturated fat. Of course, these items are even worse choices for women
and children. Should restaurants serve items such as these? If they do,
what disclosure should they make?
4. Targeting Children. Kraft Food developed Lunchables, packaged food
designed for children to take to school. The first version contained
bologna, cheese, crackers, and candy—all of which delivered unhealthy
levels of fat, sugar, and salt. The company lured children by advertising
on Saturday morning cartoons.
5. Targeting the Poor. Traditionally, Coca Cola focused its marketing
efforts on low-income areas in the United States. It then took this effort
overseas, selling Coke in the slums of Brazil. One of its strategies is to
provide small bottles that cost only 20 cents. Said Jeffrey Dunn, the
former president and chief operating officer for Coca Cola in North and
South America, “These people need a lot of things, but they don’t
need a Coke. I almost threw up.”1 When Dunn tried to develop more
healthful strategies for Coke, he was fired.
2-1 INTRODUCTION
This text, for the most part, covers legal ideas. The law dictates how a person must behave.
This chapter examines ethics, or how people should behave. Any choice that affects people
or animals is an ethics decision. This chapter will explore ethical dilemmas that commonly
arise in workplaces, and present tools for making decisions when the law does not require or
prohibit any particular choice.
Ethics decision
Any choice that affects people
or animals.
Ethics
How people should behave.
1Michael Moss, “The Extraordinary Science of Addictive Junk Food,” New York Times, February 20,
2013.
24 U N I T 1 The Legal Environment
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If a person is intent on lying, cheating, and stealing his way through a career, then he is
unlikely to be dissuaded by anything in this or any other course. But for the large majority of
people who want to do the right thing, it is useful to study new ways of approaching difficult
problems.
Laws represent society’s view of basic ethical rules. And most people agree that certain
activities such as murder, assault, and fraud are wrong. However, laws may permit behavior
that some feel is wrong, and it may criminalize acts that some feel are right. For example,
assisted suicide is legal in a few states. Some people believe that it is wrong under all
circumstances, while others think that it is the right thing to do for someone suffering horribly
from a terminal illness. Likewise, many people feel that it is ethical to record videos of farm
animals being mistreated, although some states now prohibit secret videotaping on farms.
In this chapter, the usual legal cases are replaced by Ethics Cases with discussion
questions. The goal of these scenarios is to generate classroom debates on right and wrong.
It is important for everyone to hear a variety of different points of view. In your career, you
will work with and manage diverse groups of people, so it is good to have insight into how
different people perceive ethical issues.
We also hope that hearing these various points of view will help you develop your own
Life Principles. These principles are the rules by which you live your life. As we will see,
research shows that people who think about the right rules for living are less likely to do
wrong. Developing your own Life Principles, based on your values, may be the most
important outcome of reading this chapter and studying ethics.
How do you go about preparing a list of Life Principles? Think first of important
categories. A list of Life Principles should include your rules on:
• Lying
• Stealing
• Cheating
• Applying the same or different standards at home and at work
• Your responsibility as a bystander when you see other people doing wrong
Specific is better than general. Many people say, for example, that they will maintain a
healthy work life balance, but such a vow is not as effective as promising to set aside certain
specific times each week for family activities. Many religions honor the Sabbath for this
reason. Another common Life Principle is: “I will always put my family first.” But what does
that mean? That you are willing to engage in unethical behavior at work to make sure that
you keep your job? Increase your income by cheating everyone you can? Or live your life so
that you serve as a good example?
Some Life Principles focus not so much on right versus wrong but rather serve as a
general guide for living a happier, more engaged life: I will keep promises, forgive those
who harm me, say I’m sorry, appreciate my blessings every day, understand the other
person’s point of view, try to say “yes” when asked for a favor.
Remember that, no matter what you say, every ethics decision you make illustrates your
actual Life Principles. For example, one MBA student told the story of how his boss had
ordered him to cheat on his expense report. The company did not require any receipts for
meals that cost less than $25. He and his fellow salespeople ate at fast food restaurants
where it was almost impossible to spend $25. Everyone else was reporting a lot of $24 meals
while he was submitting bills for $12. His boss told him he was making everyone else look
bad and he needed to increase the amounts he claimed. What is your Life Principle in this
case? Understand that if you cheat in this situation, your Life Principle is effectively: I am
willing to cheat if it involves small sums or I am willing to cheat if I am unlikely to get
caught. An alternative would be: I won’t cheat even if my boss tells me to—I’ll look for
another job instead.
CHAPTER 2 Ethics and Corporate Social Responsibility 25
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It is important to think through your Life Principles now, so that you will be prepared
when facing ethical dilemmas in the future.
In this chapter, we will present eight topics:
1. The Role of Business in Society
2. Why Be Ethical?
3. Theories of Ethics
4. Ethics Traps
5. Lying
6. Applying the Principles
7. When the Going Gets Tough (responding to unethical behavior)
8. Corporate Social Responsibility
2-2 THE ROLE OF BUSINESS IN SOCIETY
Nobel Prize-winning economist Milton Friedman is famous for arguing that a corporate
manager’s primary responsibility is to the owners of the organization, that is, to shareholders.
Unless the owners explicitly provide otherwise, managers should make the company as
profitable as possible while also complying with the law.2
Others have argued that corporations should instead consider all company stakeholders,
not just the shareholders. Stakeholders include employees, customers, and the communities
and countries in which a company operates. This choice can create an obligation to such
broad categories as “society” or “the environment.” For example, after the shooting in
Newtown, Connecticut, in which 20 first-graders and 6 educators were murdered, General
Electric Co. stopped lending money to shops that sell guns. GE headquarters are near
Newtown. Many of its employees lived in the area, and some had children in the Sandy
Hook Elementary School where the shooting took place. In this case, GE was putting its
employees ahead of its investors.
Every executive will treat employees well if she believes that doing so leads to
increased profits. All executives are in favor of giving money to charity if the donation
improves the company’s image and thereby increases profits enough to pay for itself. But
such win-win cases are not ethical dilemmas. In a true dilemma, a company considers an
action that would not increase shareholder returns in any certain or measureable way but
would benefit other stakeholders. Neither side is obviously right in the sense that everyone
agrees or that the law requires one particular outcome.
As we will see in this chapter, managers face many choices in which the most profitable
option is not the most ethical choice. For example, Michael Mudd, a former executive vice
president of global corporate affairs for Kraft Foods, had this to say about his fellow
executives:
In so many other ways, these are good people. But, little by little, they strayed from the honorable
business of feeding people appropriately to the deplorable mission of “increasing shareholder value”
by enticing people to consume more and more high-margin, low-nutrition branded products.3
2He also mentions that managers should comply with “ethical custom” but never explains what that
means. Milton Friedman, New York Times Magazine, September 13, 1970.
3Michael Moss, “How to Force Ethics on the Food Industry,” New York Times, March 16, 2013.
26 U N I T 1 The Legal Environment
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Of course, when profitability increases and, with it, a company’s stock price, managers
also benefit because their compensation is often tied to corporate results, either explicitly
or through ownership of stock and options. Thus, managers who say that they are just acting
in the best interest of shareholders are also conveniently benefiting themselves. That
connection creates an incentive to ignore stakeholders.
Conversely, doing the right thing will sometimes lead to a loss of profits or even one’s
job. For example, Hugh Aaron worked for a company that sold plastic materials.4 One of
the firm’s major clients hired a new purchasing agent who refused to buy any product
unless he was provided with expensive gifts, paid vacations, and sex. When Aaron refused
to comply with these requests, the man bought from someone else. And that was that—
the two companies never did business again. Aaron did not regret his choice—he believed
that his employees’ self-respect was as important as profits. But if your only concern is
maximizing your company’s profitability in the short run, you will find yourself in a
position of making unethical choices.
2-3 WHY BE ETHICAL?
An ethical decision may not be the most profitable, but it does generate a range of benefits
for employees, companies, and society.
2-3a Society as a Whole Benefits from Ethical
Behavior
John Akers, the former chairman of IBM, argues that without ethical behavior, a society
cannot be economically competitive. He puts it this way:
Ethics and competitiveness are inseparable. We compete as a society. No society anywhere will
compete very long or successfully with people stabbing each other in the back; with people trying
to steal from each other; with everything requiring notarized confirmation because you can’t trust
the other fellow; with every little squabble ending in litigation; and with government writing
reams of regulatory legislation, tying business hand and foot to keep it honest. That is a recipe not
only for headaches in running a company, but for a nation to become wasteful, inefficient, and
noncompetitive. There is no escaping this fact: the greater the measure of mutual trust and
confidence in the ethics of a society, the greater its economic strength.5
In short, ethical behavior builds trust, which is important in all of our relationships. It is
the ingredient that allows us to live and work together happily.
2-3b People Feel Better When They Behave Ethically
Every businessperson has many opportunities to be dishonest. But each of us must ask
ourselves: What kind of person do we want to be? In what kind of world do we want to live?
You might think about how you would like people who know you to describe you to others.
Managers want to feel good about themselves and the decisions they have made; they
want to sleep well at night. Their decisions—to lay off employees, install safety devices in
4Virtually all of the examples in this chapter are true events involving real people. Only first names are
used if the person prefers privacy. Full names are used when the individual has consented or the
events are a matter of public record.
5David Grier, “Confronting Ethical Dilemmas,” unpublished manuscript of remarks at the Royal Bank
of Canada, September 19, 1989.
CHAPTER 2 Ethics and Corporate Social Responsibility 27
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cars, burn a cleaner fuel—affect people’s lives. And their unethical decisions are painful to
remember.
To take an example, an executive, whom we will call “Hank,” told a story that still haunts
him. His boss had refused to pay his tuition for an MBA program so Hank went over his head
and asked Sam, an executive several levels higher. Sam interceded immediately and person-
ally approved the tuition reimbursement. He then took Hank under his wing, checking with
him regularly to find out how the program and his work were going. Naturally, Hank felt
grateful and indebted. Then one day, some other higher ups told him that they were planning
a coup against Sam. They were trying to get him fired in a complete blindside. They offered
Hank a big promotion in return for his help. All went according to plan and Sam was fired.
When Sam found out about Hank’s betrayal, he called to tell the younger man exactly what
he thought of his character. Hank said that he will carry that phone call and his guilt forever.
And because he was so untrustworthy, he finds it hard to trust others.
2-3c Unethical Behavior Can Be Very Costly
Unethical behavior is a risky business strategy—it can harm not only the bad actors but
entire industries and even countries. For example, when VIPshop recently offered its shares
publicly in the United States, they plummeted in price. This was the first Chinese company
to go public in the United States in nine months, since a series of accounting frauds in other
Chinese companies had caused billions of dollars in losses. Although VIPshop had done
nothing wrong, investors were skeptical of all Chinese companies.
Although unethical decisions may increase short-term profits, they can create a lot of long-
term harm. Johnson & Johnson (J&J) manufactured a new artificial hip that had more metal
parts than the old version. In theory, the hip would last longer and thereby let the patient avoid
difficult replacement surgery. But the theory turned out to be wrong. The two parts ground
together, releasing microscopic bits of metal that not only failed quickly but also irreparably
damaged the patient’s bone and tissue. Even when Johnson & Johnson (J&J) had data from an
English surgeon revealing these problems, it denied and stonewalled while continuing to sell
the product. J&J now faces over 10,000 lawsuits. The company has not only taken a $3 billion
charge in its financial statements to cover legal and medical costs, it finds its reputation sullied.
What is the cost of a lost reputation?Research indicates that consumers are willing to paymore
for a product that they believe to be ethically produced. Andmuch less if they believe it was made
using shoddy ethical practices.6 Unethical behavior can also cause other, subtler damage. In one
survey, a majority of those questioned said that they had witnessed unethical behavior in their
workplace and that this behavior had reduced productivity, job stability, and profits. Unethical
behavior in an organization creates a cynical, resentful, and unproductive workforce.
Although there is no guarantee that ethical behavior pays in the short or long run, there is
evidence that the ethical company is more likely to win financially. Ethical companies tend
to have a better reputation, more creative employees, and higher returns than those that
engage in wrongdoing.7
But ifwe decide thatwewant to behave ethically, howdoweknowwhat ethical behavior is?
2-4 THEORIES OF ETHICS
When making ethical decisions, people sometimes focus on the reason for the decision—
they want to do what is right. Thus, if they think it is wrong to lie, then they will tell the
truth no matter what the consequence. Other times, people think about the outcome
6Remi Trudel and June Cotte, “Does it Pay to Be Good,” Sloan Management Review, January 8, 2009.
7For sources, see “Ethics: A Basic Framework,” Harvard Business School case 9-307-059.
28 U N I T 1 The Legal Environment
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of their actions. They will do whatever it takes to achieve the right result, no matter what.
This choice—between doing right and getting the right result—has been the subject of
much philosophical debate.
2-4a Utilitarian Ethics
In 1863, Englishman John Stuart Mill wrote Utilitarianism. To Mill, a correct decision was
one that would maximize overall happiness and minimize overall pain, thereby producing
the greatest net benefit. As he put it, his goal was to produce the greatest good for the
greatest number of people. Risk management and cost-benefit analyses are examples of
utilitarian business practices.
Suppose that an automobile manufacturer could add a device to its cars that would
reduce air pollution. As a result, the incidence of strokes and lung cancer would decline
dramatically, saving society hundreds of millions of dollars over the life of the cars. But by
charging a higher price to cover the cost of the device, the company would sell fewer cars
and shareholders would earn lower returns. A utilitarian would argue that, despite the
decline in profits, the company should install the device.
Consider this example that a student told us:
During college, I used drugs—some cocaine, but mostly prescription painkillers. Things got pretty
bad. At one point, I would wait outside emergency rooms hoping to buy drugs from people who
were leaving. But that was three years ago. I went into rehab and have been clean ever since.
I don’t even drink. I’ve applied for a job, but the application asks if I have ever used drugs illegally.
I am afraid that if I tell the truth, I will never get a job. What should I say on the application?
A utilitarian would ask: What harm will be caused if she tells the truth? She will be less
likely to get that job, or maybe any job—a large and immediate harm. What if she lies? She
might argue that no harm would result because she is now clean, and her past drug addiction
will not have an adverse impact on her new employer.
There are many critics of utilitarian thought. Some argue that it is very difficult to measure
utility accurately, at least in the way that one would measure distance or the passage of time.
The car company does not really know how many lives will be saved or how much its profits
might decline if the device is installed. It is also difficult to predict benefit and harm accurately.
The recovered drug addict may relapse, or her employer may find out about her lie.
A focus on outcome can justify some really terrible behavior. Among other things, it can
be used to legitimize torture. After the 9/11 terrorist attacks, Americans debated the
acceptability of torture. Is it ethical to torture a terrorist with the hope of obtaining the
details of an upcoming attack?
Or suppose that wealthy old Ebenezer has several chronic illnesses that cause him great
suffering and prevent him from doing any of the activities that once gave meaning to his
life. Also, he is such a nasty piece of work that everyone who knows him hates him. If he
were to die, all his heirs would benefit tremendously from the money that they inherited
from him, including a disabled grandchild who then could afford medical care that would
improve his life dramatically. Would it be ethical to kill Ebenezer?
2-4b Deontological Ethics
The word deontological comes from the Greek word for obligation. Proponents of
deontological ethics believe that utilitarians have it all wrong and that the results of a decision
are not as important as the reason for which it is made. To a deontological thinker, the ends
do not justify the means. Rather, it is important to do the right thing, no matter the result.
The best-known proponent of the deontological model was the eighteenth-century
German philosopher Immanuel Kant. He believed in what he called the categorical
imperative. He argued that you should not do something unless you would be willing to
have everyone else do it, too. Applying this idea, he concluded that one should always tell
Deontological
From the Greek word for
obligation. The duty to do the
right thing, regardless of the
result.
Kant’s categorical
imperative
An act is only ethical if it would
be acceptable for everyone to
do the same thing.
CHAPTER 2 Ethics and Corporate Social Responsibility 29
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the truth because if everyone lied, the world would become an awful place. Thus, Kant would
say that the drug user should tell the truth on job applications, even if that meant she could
not find work. The truth should be told, no matter the outcome.
Kant also believed that human beings possess a unique dignity and that no decision that
treats people as commodities could be considered just, even if the decision tended to
maximize overall happiness, or profit, or any other quantifiable measure. Thus, Kant would
argue against killing Ebenezer, no matter how unpleasant the man was.
Although many people disagree with some of Kant’s specific ideas, most people do
acknowledge that a utilitarian approach is incomplete, and that winning in the end does not
automatically make a decision right.
2-4c Rawlsian Justice
How did you manage to get into college or graduate school? Presumably due to some
combination of talent, hard work, and support from family and friends. Imagine that you had
been born into different circumstances—say, a country where the literacy rate is only 25
percent and almost all of the population lives in desperate poverty. Would you be reading
this book now? Most likely not. People are born with wildly different talents into very
different circumstances, all of which dramatically affect their outcomes.
John Rawls (1921–2002) was an American philosopher who referred to these circum-
stances into which we are born as life prospects. In his view, hard work certainly matters,
but so does luck. Rawls argued that we should think about what rules for society we would
propose if we faced a “veil of ignorance.” In other words, suppose that there is going to be a
lottery tomorrow that would determine all our attributes. We could be a winner, ending up a
hugely talented, healthy person in a loving family, or we could be the most miserable person
on the face of the earth.
What type of society would we establish now, if we did not know whether we would
be one of life’s winners or losers? First, we would design some form of a democratic
system that provided equal liberty to all and important rights such as freedom of speech
and religion. Second, we would apply the difference principle. Under this principle we
would not plan a system in which everyone received an equal income because society is
better off if people have an incentive to work hard. But we would reward the type of work
that provides the most benefit to the community as a whole. We might decide, for
example, to pay doctors more than baseball players. But maybe not all doctors—perhaps
just the ones who research cancer cures or provide care for the poor, not cosmetic surgeons
operating on the affluent. Rawls argues that everyone should have the opportunity to earn
great wealth so long as the tax system provides enough revenue to provide decent health,
education, and welfare for all. In thinking about ethical decisions, it is worth remembering
that many of us have been winners in life’s lottery and that the unlucky are deserving of
our compassion.
2-4d Front Page Test
There you are, trying to decide what to do in a difficult situation. How would you feel if your
actions were going to be reported on the Huffington Post, your Facebook page, the front page
of a national newspaper or would be tweeted to all of your followers? Would that help you
decide what to do? Would such exposure have caused Hank to tell Sam about the planned
coup? Make the Johnson & Johnson executives manage their hip implant differently?
The Front Page test is not completely foolproof—there are times you might want to do
something private for legitimate reasons. You might, for example, think that having an
abortion is completely ethical, but still not want everyone to know. Or, if you live in a state
that prohibits the videotaping of mistreated farm animals, you would not want everyone to
know that you had done so, even if you thought it the right thing to do.
Difference principle
Rawls’ suggestion that society
should reward behavior that
provides the most benefit to the
community as a whole.
Life prospects
The opportunities one has at
birth, based on one’s natural
attributes and initial place in
society.
“Veil of ignorance”
The rules for society that we
would propose if we did not
know how lucky we would be in
life’s lottery.
30 U N I T 1 The Legal Environment
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^ Ethics Case: Lincoln at War ^
In 1865, toward the end of the American civil war, President Abraham Lincoln had to
choose between two rival goals: an immediate end to a devastating, bloody war or a change
to the Constitution that would make slavery illegal. If he ended the war immediately, the
Southern states would return to the Union and then be eligible to vote on the anti-slavery
amendment. They would have enough votes to defeat it. He ultimately decided to delay
peace with the South, a decision that cost thousands of lives.
To obtain the votes he needed, Lincoln did whatever it took. He figured out how to
win over each individual Congressman, appealing to one man’s sense of idealism, another’s
greed. He made threats and promises, handed out jobs and cash. And, in the end, he
succeeded in ending the barbarous practice of slavery.8
QUESTIONS
• What would Mill, Kant, and Rawls have said about Lincoln’s actions?
• What would have been the result if Lincoln had applied the Front Page test?
• Lincoln risked people’s lives for his principles and made decisions that affected
millions. Can you think of a similar scenario in a business context?
2-5 ETHICS TRAPS
Very few people wake up one morning and think, “Today I’ll do something unethical.”
Then why do so many unethical things happen? Sometimes our brains trick us into
believing wrong is right. It is important to understand the ethics traps that create great
temptation to do what we know to be wrong or fail to do what we know to be right.
2-5a Money
Money is a powerful lure because most people believe that they would be happier if only
they had more. But that is not necessarily true. Good health, companionship, and enjoyable
leisure activities all contribute more to happiness than money does. And, regardless of
income, 85 percent of Americans feel happy on a day-to-day basis anyway.
Money can, of course, provide some protection against the inevitable bumps in the road
of life. Being hungry is no fun. If you lose your winter coat, you will be happier if you can
replace it. It is easier to maintain friendships if you can afford to go out together occasion-
ally. So money can contribute to happiness, but research indicates that this impact disap-
pears when household income exceeds $75,000. Above that level, income seems to have
no impact on day-to-day happiness. Indeed, there is some evidence that higher income
levels actually reduce the ability to appreciate small pleasures. Interestingly, too, people
who come into a windfall are happier if they spend it on others or save it rather than blowing
it in a spree.9
Money is also a way of keeping score. If my company pays me more, that must mean
I am a better employee. So although an increase in income above $75,000 does not affect
8The Steven Spielberg movie Lincoln illustrates this process.
9Elizabeth Dunn and Michael Norton, “Don’t Indulge, Be Happy,” New York Times, July 8, 2012; and
Daniel Kahneman and Angus Deaton, “High Income Improves Evaluation of Life but not Emotional
Well-Being,” Proceedings of the National Academy of Sciences of the United States of America, August 4, 2010.
CHAPTER 2 Ethics and Corporate Social Responsibility 31
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day-to-day happiness, higher pay can make people feel more satisfied with their lives. They
consider themselves more successful and feel that their life is going better.
In short, the relationship between money and happiness is complicated. Above a certain
level, more money does not make for more day-to-day happiness. Higher pay can increase
general satisfaction with life but when people work so hard or so dishonestly that their
health, friendships, and leisure activities suffer, it has the reverse effect.
2-5b Rationalization
A recent study found that more creative people tend to be less ethical. The reason? They
are better at rationalizing their bad behavior. Virtually any foul deed can be rationalized.
Some common rationalizations:
• If I don’t do it, someone else will.
• I deserve this because…
• They had it coming.
• I am not harming a person—it is just a big company.
• This is someone else’s responsibility.
For example, Dan Ariely has found in his ground-breaking research that almost every-
one is willing to cheat, just a little. That is because we want to maximize results (and
enhance our belief in how smart we are) but we also want to think of ourselves as being
honest. If we cheat—just a little—then we can tell ourselves that it does not really count.
Ariely did an experiment in which people were asked to solve math problems and he paid
them for each correct answer. When participants knew that he was going to check their
results, they averaged four correct answers. But when they were allowed to self-report the
number they got correct, suddenly people averaged six correct answers.10 You can imagine
how they might have rationalized that behavior—“I was close on this one. I normally would
have gotten that one right. Today was an off day for me.” Surprisingly, when the partici-
pants were paid a lot for each correct answer ($10 as opposed to $0.50), they cheated less.
Presumably, they would have felt worse about themselves if they stole a lot of money rather
than a little.
To take a real example, the gift shop at the Kennedy Center for the Performing Arts in
Washington, D.C., was mostly run by elderly volunteers. The shop had revenues of $400,000 a
year, but someone was stealing $150,000 of that. It turned out there was not one thief. Instead,
dozens of volunteers were each stealing a little bit, which added up. These people felt good
about themselves for being volunteers so they thought that stealing a little was fine.11
Rationalization allows us to expect less of ourselves than we do other people. When we
do something wrong, we are creative at explaining why it did not really count. For example,
participants in a study were put in the position of deciding whether they or someone else
got an easy assignment. When asked in the abstract what would be a fair method for
assigning tasks, everyone said that the computer should make the assignments randomly.
But when another group of people was actually given the authority to decide, three quarters
ignored the computer option and just assigned themselves the easy jobs. And then they
rated themselves high on a fairness scale.12 In making a decision that affects you, it is
important to remember that you are unlikely to be objective.
10Dan Ariely, “Why We Lie,” Wall Street Journal, May 26, 2012.
11David Brooks, “The Moral Diet,” New York Times, June 7, 2012.
12John Tierney, “Deep Down, We Can’t Fool Even Ourselves,” New York Times, July 1, 2008.
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2-5c Conformity
Warren Buffett has been quoted as saying, “The five most dangerous words in business may
be: ‘Everybody else is doing it.’ ” Humans are social animals who are often willing to follow
the leader, even to a place where they do not really want to go. If all the salespeople in a
company cheat on their expense accounts, a new hire is much more likely to view this
behavior as acceptable.
^ Ethics Case: Diamonds in the Rough ^
When Orlanda graduated from college, she got a job as a software engineer in Silicon Valley.
After two years working in technical support, one of her customers offered her a job at his
company. It turned out that her new firm was in shambles but, after months of killer hours, she
managed to get the company on a better path. One of her biggest accomplishments was to help
a major supplier solve its technical problems so that its product would work reliably. On her
birthday, her contact at the supplier (who was a friend of her boss) gave her a diamond watch.
Her company had no policy on accepting gifts, so she kept it. Afterwards, she realized that she
was spending evenmore time working on this supplier’s issues. But, she said to herself, this was
good for her company, too. Also, no one at her company had high ethical standards anyway.
Some months later, the same supplier offered to buy her a diamond necklace if she
would make his company a preferred supplier. He said the necklace would look just like the
one he had given her boss.
QUESTIONS
1. What ethics traps is Orlanda facing?
2. Is there anything wrong with accepting these gifts?
2-5d Following Orders
When someone in authority issues orders, even to do some-
thing clearly wrong, it is very tempting to comply. Fear of
punishment, the belief in authority figures, and the ability to
rationalize all play a role. In a true story (with the facts dis-
guised), Amanda worked at a private school that was struggling
to pay its bills. As a result, it kept the lights turned off in the
hallways. On a particularly cloudy day, a visitor tripped and fell
in one of these darkened passages. When he sued, the princi-
pal told Amanda to lie on the witness stand and say that the
lights had been on. The school’s lawyer reinforced this advice.
Amanda did as she was told. When asked why, she said,
“I figured it must be the right thing to do if the lawyer said
so. Also, if I hadn’t lied, the principal would have fired me,
and I might not have been able to get another job in teaching.”
It seems likely that you will be faced many times with the dilemma of a boss who orders
you to do something wrong. Executives have told us that they have been ordered to:
• Misrepresent data in a presentation to the board (so the boss could take on a project
that was not as profitable as it should have been)
• Avoid hiring certain ethnic groups or pregnant women
• “Smooth” numbers, that is, report sales that had not, actually, taken place yet
• Support the boss’ position, even if it was clearly wrong
“File sharing” sounds
friendly and helpful—it
has a very different ring
than “stealing intellectual
property,” which is what
it really is.
CHAPTER 2 Ethics and Corporate Social Responsibility 33
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Be aware, too, that setting goals for your subordinates carries risks. Especially if the
goals are too narrowly focused. A law firm partner once said, “If we tell associates they have
to bill 2,000 hours a year, they will bill 2,000 hours. Whether they will work 2,000 hours is
another matter.” Research supports this view. Participants in an experiment were more
likely to cheat if they had been assigned specific goals, whether or not they were actually
being paid for meeting the targets.13
As you might expect, employees who work for firms with a culture of blind obedience
are twice as likely to report having seen unethical behavior as are workers at companies with
a more collaborative environment.14
2-5e Euphemisms
To “smooth earnings” sounds a lot better than to “cook the books” or “commit fraud.” And
“file sharing” sounds friendly and helpful—it has a very different ring from “stealing
intellectual property,” which is what it really is. In making ethical decisions, it is important
to use accurate terminology. Anything else is just a variation on rationalization.
2-5f Lost in a Crowd
After being struck by a car, a two-year-old child lies at the side of the road as people walk
and ride by. No one stops to help, and the child dies. On a busy street, a man picks up a
seven-year-old girl and carries her away while she screams, “You’re not my dad—someone
help me!” No one responds. The first incident was real; the second one was a test staged
by a news station. It took hours and many repetitions before anyone tried to prevent
the abduction.
When in a group, people are less likely to take responsibility, because they assume
(hope?) that someone else will. They tend to check the reactions of others, and if everyone
else seems calm, they assume that all is right. Bystanders are much more likely to react if
they are alone and have to form an independent judgment.
Thus, in a business, if everyone is cheating on their expense accounts, smoothing
earnings, or sexually harassing the staff, it is tempting to go with the flow rather than
protest the wrongdoing. In the example about food companies that began this chapter,
one former executive says that producers shrug off responsibility for obesity in America
by pointing to all the “other” causes: a car culture; too much screen time; less outdoor
play; fewer women at home to cook. And, Americans spend half of their food money
outside the home anyway.
^ Ethics Case: Train Spotting ^
Wesley Autrey was standing on a train platform with his two young daughters and a man he
did not know. Suddenly, this man had a seizure, causing him to fall on the tracks. Autrey
could hear a train approaching so he knew he had only seconds to act. Leaping on to
the track, he pulled the man between the rails and lay on top of him to protect him from
the train. The train engineer tried to stop, but five cars passed over the two men. Both were
unharmed.
Some years later in New York City, a homeless man pushed Ki-Suck Han onto subway
tracks, in view of many people. No one reacted, except a photographer who took photos as
Han was killed by a train.
13Alina Tugend, “Experts’ Advice to the Goal-Oriented: Don’t Overdo It,” New York Times, October 5,
2012.
14
“The view from the top and bottom,” The Economist, September 24, 2011.
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QUESTIONS
• Why was Autrey more likely to act than the crowds watching Han?
• What are your ethical obligations to respond when someone needs help? Or you
observe wrongdoing?
• Imagine that, at your work, you know that someone is:
� Lying on an expense account
� Wrongly booking sales that have not yet occurred
� Sexually harassing staff members
What is your ethical obligation? What would you do, under what circumstances?
2-5g Blind Spots
As Bob Dylan memorably sang, “How many times can a man turn his head and
pretend that he just doesn’t see?” The answer is: a whole lot. For example, Bernard
Madoff will long be remembered for running one of the biggest frauds ever through
his brokerage house. One of the mysteries yet unresolved is: Who else knew what was
going on? His brother, Peter, was second in command at his brother’s firm. He
admitted that he had committed many crimes, including income tax evasion and filing
false documents with regulators. But he has always insisted that he had no idea his
brother was committing fraud.
And then there is the case of Barry Bonds, one of the greatest baseball players ever.
Although he quickly gained tremendous weight and muscle mass that was consistent with
the illegal use of steroids, neither his team nor baseball executives took any action against
him until the federal government began an investigation. (To see the change in Bonds’
physique, google “steroids, Barry Bonds.”)
Or a partner in a law firm was consistently billing 2,000+ hours a year. Yet he seemed to
have time to attend his children’s school functions in the middle of the day and was rarely in
the office early or late. Firm executives were shocked to discover that he had been over-
billing clients.15
2-5h Avoiding Ethics Traps
As we see from these ethics traps, circumstances affect our decision making. You are, for
example, more likely to act if alone rather than in a crowd.
Being in a hurry also makes a difference. A group of students at Princeton Theological
Seminary (i.e., people in training to be ministers) were told to go to a location across campus to
give a talk. On their walk over, they encountered a man lying in distress in a doorway. Only
one-tenth of those participants who had been told they were late for their talk stopped to help
the ill man while almost two-thirds of those who thought they had plenty of time did stop.16
The topic of the talk also mattered. Those who were speaking on the Parable of the
Good Samaritan (in which a man offers aid to an injured person from a different clan) were
twice as likely to provide help than those who were giving a talk on careers for seminarians.
15For more on this topic, see Max Bazerman and Ann Tenbrunsel, Blind Spots: Why We Fail to Do
What’s Right and What to Do about It (Princeton, NJ: Princeton University Press).
16John M. Darley and Daniel C. Batson, “From Jerusalem to Jericho”: A study of situational and
dispositional variables in helping behavior,” Journal of Personality and Social Psychology 27, no.1 (July
1973): 100–108.
CHAPTER 2 Ethics and Corporate Social Responsibility 35
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Two thoughts about how to avoid ethics traps:
1. Do not trust your first instinct. Being in a hurry, or in a crowd, being able to
rationalize easily, using euphemisms, doing what every else does, receiving an order,
being dazzled by money; these can all lead you to make a quick and wrong decision.
Test your initial reaction by asking whether you have fallen into any of these traps.
2. Remember your Life Principles. In his research, Ariely found that participants were
less likely to cheat if they were reminded of their school honor code or the Ten
Commandments (the fundamental rules of both the Christian and Jewish religions).
This result was true even if the participants were atheists.
2-6 LYING: A SPECIAL CASE
We are taught from an early age to tell the truth. Yet research shows that we tell
between one and two lies a day.17 Is honesty the best policy? The consequences of
lying can be severe: students are suspended, employees are fired, and witnesses are
convicted of perjury. Sometimes the problems are subtler but still significant: a loss of
trust or of opportunities.
When is lying acceptable? If poker players bluff their way through lousy hands, we
consider them skilled because that is an accepted part of the game. What about white
lies to make others feel better: I love your lasagna. You’re not going bald. No, that
sweater doesn’t make you look fat. When Victoria McGrath suffered a terrible wound to
her leg in the Boston Marathon bombing, Tyler Dodd comforted her at the scene by
telling her that he had recovered from a shrapnel wound in Afghanistan. His story was
not true—he had never been in combat or Afghanistan. McGrath was grateful to him for
his lie because it gave her strength and hope. Was he right or wrong? What are your
rules on lying?
Kant felt that any lie violated his principle of the categorical imperative. Because the
world would be intolerable if everyone lied all the time, no one should lie ever. He gave the
example of the murderer who knocks on your door and asks, “Where’s Lukas?” You know
Lukas is cowering just inside, but you might be tempted to lie and send the murderer off in
the opposite direction. Kant preferred that you tell what is now called a Kantian Evasion or
a palter. That is, you would make a truthful statement that is nonetheless misleading. So,
you might say, truthfully, “I saw Lukas in the park just an hour ago.” And off the murderer
would go.
Is a Kantian Evasion really more ethical than a lie? For example, when a candidate for
the presidency, Bill Clinton was asked if he had ever smoked marijuana. He answered that
he “never broke the laws of my state or of the United States.” Later, it was revealed that he
had used marijuana while a student in England. So, although technically correct, his
statement was misleading. Was that really better than lying about marijuana use?
What are your Life Principles on this issue? There may indeed be good reasons to lie
but what are they? Would it be right to say that you would only lie to benefit other people?
Lukas hiding from the murderer? Children who believe in Santa Claus? It is useful to
analyze this issue now rather than to rationalize later.
What about in business? Does the presence of competition make a difference? When do
the ends justify the means?
Kantian evasion or palter
A truthful statement that is
nonetheless misleading.
17Bella M. DePaulo, Deborah A. Kashy, Susan E. Kirkendol, and Melissa M. Wyer, “Lying in
Everyday Life,” Journal of Personality and Social Psychology 70, no. 5, (1996): 979–995.
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^ Ethics Case: Truth (?) in Borrowing ^
Rob is in the business of buying dental practices. He finds solo practitioners, buys their
assets, signs them to a long-term contract and then improves their management and billing
processes so effectively that both he and the dentists are better off.
Rob has just found a great opportunity with a lot of potential profit. There is only one
problem. The bank will not give him a loan to buy the practice without checking the
dentist’s financial record. Her credit rating is fine, but it turns out that she filed for bank-
ruptcy twenty years ago. That event no longer appears on her credit rating, but the bank
asked about bankruptcies on the form it required her to sign. She is perfectly willing to lie.
Rob refused to turn in the form with a lie. But when the bank learned about the bankruptcy,
it denied his loan even though her bankruptcy in no way affects his ability to pay the loan.
And the incident is ancient history—the dentist’s current finances are strong. Four other
banks also refused to make the loan.
Rob is feeling pretty frustrated. He figures the return on this deal would be 20 percent.
Everyone would benefit—the dentist would earn more, her patients would have better
technology, he could afford a house in a better school district, and the bank would make a
profit. There is one more bank he could try.
QUESTIONS
1. Should Rob file loan documents with the bank, knowing the dentist has lied?
2. Who would be harmed by this lie?
3. What if Rob pays back the loan without incident, as he knew he would? Was what he
did wrong? Do the ends justify the means?
4. What is your Life Principle about telling lies? When is making a misrepresentation
acceptable? To protect someone’s life or physical safety? To protect a job?
To protect another person’s feelings? To gain an advantage? When others are
doing the same?
5. Do you have the same rule when lying to protect yourself, as opposed to others?
2-7 APPLYING THE PRINCIPLES
Having thought about ethical principles and traps, let’s now practice applying them to
situations that are similar to those that you are likely to face in your life. Be aware that
some of these ethical dilemmas illustrate the tradeoff between shareholders and stake-
holders. Note also that sometimes the right decision will be obvious, but difficult to do
because of the risk or expense. Other times, the right answer is unclear, because someone
will be harmed no matter what choice you make. In both of these situations, it is important
to recognize explicitly the forces that push or pull you when making a decision. Unless you
are aware of these forces, you cannot make a truly informed decision.
2-7a Personal Ethics in the Workplace
Should you behave in the workplace the way you do at home, or do you have a separate set
of ethics for each part of your life? What if your employees behave badly outside of work—
should that affect their employment? Consider the following case.
CHAPTER 2 Ethics and Corporate Social Responsibility 37
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^ Ethics Case: No Sheen on Sheen ^
Charlie Sheen, who starred in the hit CBS television show Two and a Half Men, admitted to
using large quantities of cocaine. He was hospitalized with drug overdoses and had been
charged with both misdemeanor and felony drug offenses, which led to probation several
times. When asked about entering rehab, he said that only losers go to recovery programs
and he could cure himself with his mind. He openly spent tens of thousands of dollars on
prostitutes. His second wife filed a restraining order against him, alleging that he had
pushed her down the stairs and threatened to kill her. He was also charged with a felony
for threatening his third wife. She claimed that he held a knife to her throat and said, “You
better be in fear. If you tell anybody, I’ll kill you.” Then there was the widely reported
incident in the Plaza Hotel in New York City in which the police escorted him to the
hospital after he trashed his room and threatened the prostitute whom he had hired—all
while his ex-wife and children slept in a room across the hall. Five months later, the police
removed his twin sons from his house after their mother obtained a restraining order. On a
radio show, Sheen made anti-Semitic comments about his boss, called him a clown and a
charlatan, and said that he “violently hated him.” This boss was the most successful
producer of comedy shows in the business.
QUESTIONS
1. If CBS fired Sheen from his television show, the network would lose tens of millions
of dollars. At what point, if any, should CBS have fired him? If not for this, then for
what?
2. Would you fire a warehouse worker who behaved this way? How much revenue does
an employee have to bring in to be able to buy his way out of bad behavior?
3. What would you say to someone who argues that the goal at work is to make as much
money as possible, but at home it is to be a kind and honorable human being?
4. What would Kant and Mill say is the right thing to do in this case? What result under
the Front Page Test?
5. What ethics traps did Sheen’s bosses face in this situation?
6. What is your Life Principle? What behavior are you willing to tolerate in the interest of
profitability?
2-7b The Organization’s Responsibility to Society
Many products can potentially cause harm to customers or employees. Does it matter if the
customers and employees willingly accept exposure to these products? What constitutes
informed agreement? What is the company’s responsibility to those who are unwittingly
harmed by its products?
^ Ethics Case: Breathing the Fumes ^
Every other year, the National Institutes of Health publish the “Report on Carcinogens,”
which lists products that cause cancer. Among those in the most recent report was formal-
dehyde, found in furniture, cosmetics, building products, carpets, and fabric softeners.
Unless we take heroic efforts to avoid this chemical, we are all exposed to it when inside.
Indeed, almost all homes have formaldehyde levels that exceed government safety rules. In
an effort to shoot the messenger, the American Chemistry Council, which is an industry
38 U N I T 1 The Legal Environment
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trade group, lobbied Congress to cut off funding for the “Report on Carcinogens”—not
improve it, but defund it.
QUESTIONS
1. If you were one of the many companies using products that contain formaldehyde,
what would you do? What would you be willing to pay to provide a safer product?
2. If you were an executive at Exxon, Dow, or DuPont, all members of the American
Chemistry Council, what would you do?
3. What would Mill and Kant recommend?
4. What ethics traps would you face in making a decision?
5. What Life Principle would you apply?
2-7c The Organization’s Responsibility to Its
Employees
Organizations cannot be successful without good workers. In many circumstances, the
shareholder and stakeholder models agree that employees should be treated well. Dis-
gruntled workers are likely to be unmotivated and unproductive. But sometimes looking
out for employees may not lead to higher profits. In these cases, does an organization have a
duty to take care of its workers? The shareholder model says no; the stakeholder model
takes the opposite view.
Corporate leaders are often faced with difficult decisions when the issue of layoffs
arises. Choices can be particularly difficult to navigate when outsourcing is an option.
Outsourcing refers to cutting jobs at home and relocating operations to another country. That
is the issue in the following scenario.
^ Ethics Case: The Storm After the Storm ^
Yanni is the CEO of Cloud Farm, a company that provides online data centers for Internet
companies. Because these data centers are enormous, they are located in rural areas where
they are often the main employer. A series of tornados has just destroyed a data center near
Farmfield, Arkansas, a town with a population of roughly 5,000 people. Farmfield is a three-
hour drive from the nearest city, Little Rock.
Here is the good news: The insurance payout will cover the full cost of rebuilding.
Indeed, the payout will be so generous that Cloud Farm could build a bigger and better
facility than the one destroyed. The bad news? Data centers are much more expensive to
build and operate in the United States than in Africa, Asia, or Latin America. Yanni could
take the money from the insurance company and build three data centers overseas. He has
asked Adam and Zoe to present the pros and cons of relocating.
Adam says, “If we rebuild overseas, our employees will never find equivalent jobs. We
pay $20 an hour, and the other jobs in town are mostly minimum-wage. And remember how
some of the guys worked right through Christmas to set up for that new client. They have
been loyal to us—we owe them something in return. Going overseas is not just bad for
Farmfield or Arkansas, it’s bad for the country. We can’t continue to ship jobs overseas.”
Zoe responds, “That is the government’s problem, not ours. We’ll pay to retrain the
workers, which, frankly, is a generous offer. Our investors get a return of 4 percent;
the industry average is closer to 8 percent. If we act like a charity to support Farmfield,
we could all lose our jobs. It is our obligation to do what’s best for our shareholders— which,
in this case, happens to be what’s right for us, too.”
CHAPTER 2 Ethics and Corporate Social Responsibility 39
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QUESTIONS
1. Do you agree with Zoe’s argument that it is the government’s responsibility to create
and protect American jobs, and that it is a CEO’s job to increase shareholder wealth?
2. Imagine that you personally own $10,000 worth of shares in Cloud Farm. Would you
be upset with a decision to rebuild the data center in the United States?
3. If you were in Yanni’s position, would you rebuild the plant in Arkansas or relocate
overseas?
4. If Cloud Farm decides to rebuild in Arkansas, should it pay the workers while the
center is being rebuilt? If yes, should it apply to all the workers, or just the high-level
ones who might leave if they were not paid?
5. What ethics traps does Yanni face in this situation?
6. What is your Life Principle on this issue? Would you be willing to risk your job to
protect your employees?
2-7d An Organization’s Responsibility to Its
Customers
Customers are another group of essential stakeholders. A corporation must gain and retain
loyal buyers if it is to stay in business for long. Treating customers well usually increases
profits and helps shareholders.
But when, if ever, does an organization go too far? Is a leader acting appropriately when
she puts customers first in a way that significantly diminishes the bottom line? The share-
holder model says no. What do you say?
^ Ethics Case: Mickey Weighs In ^
As we have seen, many food companies manipulate products to maximize their appeal,
without regard to the health of their customers. Disney is taking a different approach—
announcing recently that only healthy foods can be advertised on its children’s television
channels, radio stations, and websites. Candy, fast food, and sugared cereals are banned from
Mickey land. Kicked to the curb are such childhood favorites as Lunchables and Capri Sun drinks.
In addition, sodium must be reduced by one quarter in food served at its theme parks. Nor does
Disney permit its characters to associate with unhealthy foods. NomoreMickey Pop-Tarts or Buzz
LightyearHappyMeals. SaidDisney chairman, Robert Iger, “Companies in a position to helpwith
solutions to childhood obesity should do just that.”18
Disney will certainly lose advertising, but would not say howmuch. Food sales at its theme
parks may decline if children find the options less appealing. Its licensing revenues are also
affected by its decisions to remove Disney characters from the likes of Pop-Tarts and Happy
Meals.
On the other hand, this healthy initiative will enhance its reputation, at least with
parents, who increasingly seek healthy food options for their children. Disney will profit
from license fees it receives for the use of a Mickey Check logo on healthy food in grocery
aisles and restaurants. This food initiative may also help forestall more onerous government
regulation.
18Brooks Barnes, “Promoting Nutrition, Disney to Restrict Junk-Food Ads,” New York Times, June 5,
2012.
40 U N I T 1 The Legal Environment
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QUESTIONS
1. What obligation does Disney have to its young customers? Does it owe them anything
other than entertainment?
2. How much advertising and licensing revenue would you be willing to give up to
protect children from ads for unhealthy foods? Does your answer depend on how
profitable the division is?
3. Does this information make you more likely to buy Disney products or allow your
children to watch Disney TV?
4. What if this initiative had not come down from the highest levels in the company?
Would you have been willing to fight for it?
5. What would Mill or Kant have said? What result with the Front Page Test?
6. What ethics traps does Disney face?
7. What is your Life Principle? How much profitability (or income) are you willing to
give up to protect children you do not know?
2-7e Organization’s Responsibility to Overseas Contract
Workers
Do an American company’s ethical obligations end at the border? What ethical duties does
an American manager owe to stakeholders in countries where the culture and economic
circumstances are very different? Should American companies (and consumers) buy goods
that are produced in sweatshop factories?
Industrialization has always been the first stepping stone out of dire poverty—it was in
England in centuries past, and it is now in the developing world. Eventually, higher
productivity leads to higher wages. In China, factory managers have complained that their
employees want to work even longer hours to earn more money. The results in China have
been nothing short of remarkable. During the Industrial Revolution in England, per capita
output doubled in 58 years; in China, it took only 10 years.
During the past 50 years, Taiwan and South Korea welcomed sweatshops. During the
same period, India resisted what it perceived to be foreign exploitation. Although all three
countries started at the same economic level, Taiwan and South Korea today have much
lower levels of infant mortality and much higher levels of education than India.19
In theory, then, sweatshops might not be all bad. But are there limits? Consider the
following case.
^ Ethics Case: A Worm in the Apple ^
“Riots, Suicides and More,” blares an Internet headline about a FoxConn factory where
iPhones and other Apple products are assembled. Apple is not alone in facing supplier
scandals. So have Nike, Coca-Cola, and Gap, among many others. Do companies have
an obligation to the employees of their suppliers? If so, how can they, or anyone, be sure
what is really going on in a factory on the other side of the world? Professor Richard Locke
of MIT has studied supply chain issues.20 His conclusions:
19The data in this and the preceding paragraph are from Nicholas D. Kristof and Sheryl Wu Dunn,
“Two Cheers for Sweatshops,” New York Times Magazine, September 24, 2000, p. 70.
20
“When the jobs inspector calls,” The Economist, March 31, 2012.
CHAPTER 2 Ethics and Corporate Social Responsibility 41
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• The first step that many companies took to improve working conditions overseas was
to establish a code of conduct and then perform audits. Professor Locke found that
these coercive practices do not work and that compliance is at best sporadic. For
example, despite Hewlett-Packard’s best efforts, only a handful of its 276 overseas
factories consistently met its standards.
• A more collaborative approach worked better—when the auditors sent by
multinationals saw their role as less of a police officer and more as a partner,
committed to problem-solving and sharing of best practices.
• It can be hard to improve conditions without also changing a company’s business
model. One of the reasons that Apple uses Chinese manufacturers such as FoxConn
is that its workers have fewer overtime restrictions. Just before the first iPhone was
released, Steve Jobs decided that the screens had to be unscratchable glass instead of
plastic. One Chinese company supplied a team of engineers that was housed in a
dormitory and willing to work around the clock to design the right glass. When the
glass arrived at FoxConn in the middle of the night, thousands of assemblers were put
to work immediately.
What would you do in the following circumstances if you were in charge:
• In clothing factories, workers often remove the protective guards from their sewing
machines, because the guards slow the flow of work. As a result, many workers suffer
needle punctures. Factories resist the cost of buying new guards because the workers
just take them off again. Is there a solution?
• In a factory in Central America, powerful chemicals were used to remove stains from
clothing. The fumes from these chemicals were a health hazard but ventilation
systems were too expensive. What could be done?21
• Timberland, Nike, and Hewlett-Packard have recognized that selling large numbers
of new products creates great variation in demand and therefore pressure on factory
workers to work overtime. What can a company do to reduce this pressure?
2-8 WHEN THE GOING GETS TOUGH
We have talked about the kinds of ethical issues that you are likely to face in your career. If
you find yourself working for a company that tolerates an intolerable level of unethical
behavior, you face three choices.
2-8a Loyalty
It is always important to pick one’s battles. For example, a firm’s accounting department must
make many decisions about which reasonable people could disagree. Just because their
judgment is different from yours does not mean that they are behaving unethically. Being a
team player means allowing other people to make their own choices sometimes. However, the
difference between being a team player and starting down the slippery slope can be very
narrow. If you are carrying out a decision, or simply observing one, that makes you uncomfor-
table, then it is time to consult your Life Principles and review the section on ethics traps.
21These examples are from Richard Locke, Matthew Amengual, and Akshay Mangla, “Virtue out of
Necessity?: Compliance, Commitment and the Improvement of Labor Conditions in Global Supply
Chains,” available at Princeton.edu.
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2-8b Exit
When faced with the unacceptable, one option is to walk out the door quietly. You resign “to
spend more time with your family,” “to explore other opportunities,” or “to accept an offer that
is too good to refuse.”This approach may be the safest for you because you are not ruffling any
feathers or making any enemies. It is a small world, and you never know when someone you
have offended will be in a position to do you harm. But a quiet exit leaves the bad guys in
position to continue the unsavory behavior. For example, the CEO was sexually harassing
Laura, but she left quietly for fear that if she reported him, he would harm her career. No one
likes to hire a troublemaker. So the CEO proceeded to attack other women at the company
until finally a senior man got wind of what was going on and confronted the chief. In short, the
braver option is to exit loudly—reporting the wrong-doing on the way out the door.
2-8c Voice
As we saw in our discussion of conformity, wrong-doing often occurs because everyone just
goes along to get along. One valiant soul with the courage to say, “This is wrong,” can be a
powerful force for the good. But confrontation may not be the only, or even the best, use of
your voice. Learning to persuade, cajole, or provide better options are all important leadership
skills. For example, Keith felt that the CEO of his company was about to make a bad decision,
but he was unable to persuade the man to choose a different alternative. When Keith turned
out to be correct, the CEO gave him no credit, saying, “You are equally responsible because
your arguments weren’t compelling enough.” Keith thought the man had a point.
2-9 CORPORATE SOCIAL
RESPONSIBILITY (CSR)
So far, we have largely been talking about a company’s duty not to cause harm. But do
companies have a corporate social responsibility—that is, an obligation to contribute posi-
tively to the world around it? Do businesses have an affirmative duty to do good? You
remember Milton Friedman’s view that a manager’s obligation is to make the company as
profitable as possible while also complying with the law. Harvard Professor Michael Porter
has written that CSR often benefits a company. For example, improving economic and
social conditions overseas can create new customers with money to spend. Educational
programs may provide a better workforce. However, Porter observes:
The acid test of good corporate philanthropy is whether the desired social change is so beneficial to
the company that the organization would pursue the change even if no one ever knew about it.22
Thus, for example, Yoplait has periodically run a “Save Lids to Save Lives” campaign.
For every Yoplait lid mailed in, the company makes a donation to the Susan G. Komen breast
cancer charity. During these campaigns, Yoplait gains market share. Should companies be
willing to improve the world even if their efforts reduce profitability?
^ Ethics Case: The Beauty of a Well-Fed Child ^
Cosmetic companies often use gift-with-purchase offers to promote their products. For
example, with any $45 Estee Lauder purchase at Bloomingdale’s, you can choose a free
Corporate social
responsibility
An organization’s obligation to
contribute positively to the
world around it.
22Michael E. Porter and Mark R. Kramer, “The Competitive Advantage of Corporate Philanthropy,”
Harvard Business Review (December 2002).
CHAPTER 2 Ethics and Corporate Social Responsibility 43
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seven piece gift of creams and makeup valued at over $165, plus a special-edition Lily
Pulitzer cosmetic bag.
But Clarins has put a new spin on these offers with what it calls “gift with purpose.”
Buy two Clarins items at Macy’s and you will receive six trial-size products and the company
will pay the United Nations World Food Program enough for 10 school meals.
Because so many cosmetic companies do gift-with-purchase offers, it is difficult for any
one company to stand out from the crowd. That is Clarins’ goal with this offer. The
company hopes that cosmetic buyers, many of whom are women with children, will find
this opportunity to feed children particularly compelling. Says the Macy’s vice president for
national media relations and cause marketing, “With no energy or lift on the customers’ part,
they get this really feel-good element with the shopping experience.”23
QUESTIONS
1. If you were an executive at Clarins or Macy’s, what would you want to know before
approving this promotion?
2. Howimportant is it to improve the imageof these twocompanies?Would thispromotiondoso?
3. Would you approve this promotion if it were not profitable on its own account? How
much of a subsidy would you be willing to grant?
Chapter Conclusion
Many times in your life, you will be tempted to do something that you know in your heart of
hearts is wrong. Referring to your own Life Principles, being aware of potential traps, will
help you to make the right decisions. But it is also important that you be able to afford to do
the right thing. Having a reserve fund to cover six months’ living expenses makes it easier
for you to leave a job that does not agree with your personal ethics. Too many times, people
make the wrong, and sometimes the illegal decision, for financial reasons.
Managers wonder what they can do to create an ethical environment in their companies.
In the end, the surest way to infuse ethics throughout an organization is for top executives to
behave ethically themselves. Few will bother to do the right thing unless they observe that
their bosses value and support such behavior. Even employees who are ethical in their
personal lives may find it difficult to uphold their standards at work if those around them
behave differently. To ensure a more ethical world, managers must be an example for others,
both within and outside their organizations.
EXAM REVIEW
1. ETHICS The law dictates how a person must behave. Ethics governs how people should
behave. Any decision that affects people or animals is an ethics decision. (p. 24)
2. LIFE PRINCIPLES Life Principles are the rules by which you live your life.
If you develop these Life Principles now, you will be better prepared when facing
ethics dilemmas in the future. (pp. 25–26)
23Adam Andrew Newman, “A Cosmetic Freebie with a Cause,” New York Times, April 7, 2013.
44 U N I T 1 The Legal Environment
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3. THE ROLE OF BUSINESS IN SOCIETY An ongoing debate about whether
managers should focus only on what is best for shareholders or whether they should
consider the interests of other stakeholders as well. (pp. 26–27)
4. WHY BE ETHICAL?
• Society as a whole benefits from ethical behavior.
• People feel better when they behave ethically.
• Unethical behavior can be very costly. (pp. 27–28)
5. THEORIES OF ETHICS
• Utilitarian thinkers such as John Stuart Mill believe that the right decision
maximizes overall happiness and minimizes overall pain.
• Deontological thinkers such as Immanuel Kant believe that the ends do not
justify the means. Rather, it is important to do the right thing, no matter the result.
• With his categorical imperative, Kant argued that you should not do something
unless you would be willing to have everyone else do it, too.
• John Rawls asked us to consider what type of society we would establish if we did
not know whether we would be one of life’s winners or losers. He called this
situation “the veil of ignorance.”
• Under the Front Page Test, you ask yourself what you would do if your actions
were going to be reported publicly on or offline. (pp. 28–30)
6. ETHICS TRAPS
• Money
• Rationalization
• Conformity
• Following orders
• Euphemisms
• Lost in a crowd
• Blind spots (pp. 31–34)
7. TO AVOID ETHICS TRAPS:
• Do not trust your first instinct.
• Remember your Life Principles. (pp. 35–36)
8. KANTIAN EVASION A truthful statement that is nonetheless misleading. (p. 34)
9. MANAGING AN UNETHICAL ENVIRONMENT When faced with unethical
behavior, you have three choices:
• Loyalty
• Exit (either quiet or noisy)
• Voice (pp. 42–43)
10. CORPORATE SOCIAL RESPONSIBILITY An organization’s obligation to
contribute positively to the world around it. (p. 43)
CHAPTER 2 Ethics and Corporate Social Responsibility 45
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MULTIPLE-CHOICE QUESTIONS
1. Milton Friedman was a strong believer in the model. He
argue that a corporate leader’s sole obligation is to make money for the company’s
owners.
(a) shareholder; did
(b) shareholder; did not
(c) stakeholder; did
(d) stakeholder; did not
2. Which of the following wrote the book Utilitarianism and believed that moral actions
should “generate the greatest good for the greatest number”?
(a) Milton Friedman
(b) John Stuart Mill
(c) Immanuel Kant
(d) John Rawls
3. Which of the following believed that the dignity of human beings must be
respected, and that the most ethical decisions are made out of a sense of
obligation?
(a) Milton Friedman
(b) John Stuart Mill
(c) Immanuel Kant
(d) John Rawls
4. Kant believed that:
(a) It is ethical to tell a lie if necessary to protect an innocent person from great
harm.
(b) It is ethical to tell a lie if the benefit of the lie outweighs the cost.
(c) It is ethical to make a true, but misleading, statement.
(d) It is wrong to tell an outright lie or to mislead.
5. The following statement is true:
(a) Most people are honest most of the time.
(b) Even people who do not believe in God are more likely to behave honestly after
reading the Ten Commandments.
(c) When confronted with wrong-doing, most people immediately recognize what is
happening.
(d) People make their best ethical decisions when in a hurry.
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ESSAY QUESTIONS
1. The Senate recently released a report on wrongdoing at JP Morgan Chase. It found
that bank executives lied to investors and the public. Also, traders, with the
knowledge of top management, changed risk limits to facilitate more trading and then
violated even these higher limits. Executives revalued the bank’s investment
portfolio to reduce apparent losses. JP Morgan’s internal investigation failed to find
this wrongdoing. Into what ethics traps did these JP Morgan employees fall? What
options did the executives and traders have for dealing with this wrongdoing?
2. Located in Bath, Maine, Bath Iron Works builds high tech warships for the Navy.
Winning Navy contracts is crucial to the company’s success—it means jobs for the
community and profits for the shareholders. Navy officials held a meeting at Bath’s
offices with its executives and those of a competitor to review the specs for an
upcoming bid. Both companies desperately wanted to win the contract. After the
meeting, a Bath worker realized that one of the Navy officials had left a folder on a
chair labeled: “Business Sensitive.” It contained information about the competitors’
bid that would be a huge advantage to Bath. William Haggett, the Bath CEO, was
notified about the file just as he was walking out the door to give a luncheon speech.
What should he do? What pitfalls did he face? What result if he considered Mill, Kant,
or the Front Page test?
3. A group of medical schools conducted a study on very premature babies—those born
between 24 and 27 weeks of gestation (instead of the normal 40 weeks). These
children face a high risk of blindness and death. The goal of the study was to
determine which level of oxygen in a baby’s incubator produced the best results.
Before enrolling families in the study, the investigators did not tell them that being in
the study could increase their child’s risk of blindness or death. The study made some
important discoveries: the level at which too much oxygen increased the risk of
blindness and level at which too little increased the risk of death. What would Mill
and Kant say about this decision not to tell the families?
4. Because Raina processes payroll at her company, she knows how much everyone
earns, including the top executives. This information could make for some good
gossip, but she has kept it all completely secret. She just found out, however, that her
boss knew that it is against company policy for her to do payroll for C-level
employees. Yesterday, the CEO went to her boss to confirm that he, the boss, was
personally doing the processing for top management. Her boss lied to the CEO and
said that he was. Then he begged Raina not to tell the truth if the CEO checked with
her. Raina just got a message that the CEO wants to see her. What does she say if he
asks about the payroll?
5. Each year, the sale of Girl Scout cookies is the major fund-raiser for local troops. But
because the organization was criticized for promoting such unhealthy food, it
introduced a new cookie, Mango Cremes with Nutrifusion. It promotes this cookie as
a vitamin-laden, natural whole food. “A delicious way to get your vitamins.” But these
vitamins are a minuscule part of the cookie. The rest has more bad saturated fat than
an Oreo. The Girl Scouts do much good for many girls. And to do this good, they need
to raise money. What would Kant and Mill say? What about the Front Page test? What
do you say?
6. When James Kilts became CEO of Gillette Co., the consumer products giant had
been a mainstay of the Boston community for a hundred years. But the organization
was going through hard times: its stock was trading at less than half its peak price, and
CHAPTER 2 Ethics and Corporate Social Responsibility 47
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some of its established brands of razors were suffering under intense competitive
pressure. In four short years, Kilts turned Gillette around—strengthening its core
brands, cutting jobs, and paying off debt. With the company’s stock up 61 percent,
Kilts had added $20 billion in shareholder value.
Then Kilts suddenly sold Gillette to Procter & Gamble (P&G) for $57 billion. So
short was Kilts’s stay in Boston that he never moved his family from their home in Rye,
New York. The deal was sweet for Gillette shareholders—the company’s stock price
went up 13 percent in one day. And tasty also for Kilts—his payoff was $153 million,
including a $23.9 million reward from P&G for havingmade the deal and for a “change in
control” clause in his employment contract that was worth $12.6 million. In addition,
P&G agreed to pay him $8 million a year to serve as vice chairman after the merger.
When he retired, his pension would be $1.2 million per year. Moreover, two of his top
lieutenants were offered payments totaling $57 million.
Any downside to this deal? Four percent of the Gillette workforce—6,000
employees—were fired. If the payouts to the top three Gillette executives were
divided among these 6,000, each unemployed worker would receive $35,000. The
loss of this many employees (4,000 of whom lived in New England) had a ripple
effect throughout the area’s economy. Although Gillette shareholders certainly
benefited in the short run from the sale, their profit would have been even
greater without this $210 million payout to the executives. Moreover, about half
the increase in Gillette revenues during the time that Kilts was running the show
were attributable to currency fluctuations. A cheaper dollar increased revenue
overseas. If the dollar had moved in the opposite direction, there might not have
been any increase in revenue. Indeed, for the first two years after Kilts joined
Gillette, the stock price declined. It was not until the dollar turned down that the
stock price improved.
Do CEOs who receive sweeteners have too strong an incentive to sell their
companies? Is it unseemly for them to be paid so much when many employees will
lose their jobs?
DISCUSSION QUESTIONS
1. While waiting in line in a supermarket, you
observe a woman trying to pay with food stamps.
Under the law, food stamps cannot be used to pay
for prepared items so the register would not accept
the stamps in payment for a $6 container of
chicken noodle soup from the deli counter. The
woman explained that she was sick and did not
have the energy to cook. She just wanted to go
home and go to bed. In general, you agree that this
law is reasonable—people on limited budgets
should not be buying more expensive prepared
food. But the woman is sick. Would it be ethical for
you to pay for her chicken soup if she agreed to pay
for $6 worth of your grocery items?
2. In Japan, automobile GPS systems come equipped
with an option for converting them into
televisions so that drivers can watch their favorite
shows, yes, while driving. “We can’t help but
respond to our customers’ needs,” says a
company spokesperson.24 Although his company
does not recommend the practice of watching while
driving, he explained that it is the driver’s
responsibility to make this decision. Is it right to sell a
product that could cause great harm to innocent
bystanders? Where does the company’s responsibility
end and the consumer’s begin? What would Mill
and Kant say?
24Chester Dawson, “Drivers Use Navigation Systems to Tune In,” Wall Street Journal, April 23, 2013.
48 U N I T 1 The Legal Environment
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3. Darby has been working for 14 months at Holden
Associates, a large management consulting firm.
She is earning $75,000 a year, which sounds good
but does not go very far in New York City. It turns
out that her peers at competing firms are typically
paid 20 percent more and receive larger annual
bonuses. Darby works about 60 hours a week—
more if she is traveling. A number of times, she has
had to reschedule her vacation or cancel personal
plans to meet client deadlines. She hopes to go to
business school in a year and has already begun the
application process.
Holden has a policy that permits any employee
who works as late as 8:00 p.m. to eat dinner at
company expense. The employee can also take a taxi
home. Darby is in the habit of staying until 8:00 p.m.
every night, whether or not her workload requires it.
Then she orders enough food for dinner, with
leftovers for lunch the next day. She has managed to
cut her grocery bill to virtually nothing. Sometimes
she invites her boyfriend to join her for dinner. As a
student, he is always hungry and broke. Darby often
uses the Holden taxi to take them back to his
apartment, although the cab fare is twice as high as to
her own place.
Sometimes Darby stays late to work on her
business school applications. Naturally, she uses
Holden equipment to print out and photocopy the
finished applications. Darby has also been known to
return online purchases through the Holden
mailroom on the company dime. Many employees do
that, and the mailroom workers do not seem to mind.
Is Darby doing anything wrong? What ethics
traps is she facing? What would your Life Principle
be in this situation?
4. Steve supervises a team of account managers. One
night at a company outing, Lawrence, a visiting
account manager, made some wildly inappropriate
sexual remarks to Maddie, who is on Steve’s team.
When she told Steve, he was uncertain what to do, so
he asked his boss. She was concerned that if Steve
took the matter further and Lawrence was fired or
even disciplined, her whole area would suffer.
Lawrence was one of the best accountmanagers in the
region, and everyone was overworked as it was. She
told Steve to get Maddie to drop the matter. Just tell
her that these things happen, and Lawrence did not
mean anything by it.
What should Steve do? What ethics traps does
he face? What would be your Life Principle in this
situation?
5. David has just spoken with a member of his sales
team who has not met her sales goals for some
months. She has also missed 30 days of work in the
past six months. It turns out that she is in the process
of getting a divorce, and her teenage children are
reacting very badly. Some of the missed days have
been for court, others because the children have
refused to go to school. If David’s team does not
meet its sales goals, no one will get a bonus, and his
job may be at risk. What should he do?
6. Many people enjoy rap music at least in part because
of its edgy, troublemaking vibe. The problem is that
some of this music could cause real trouble, Thus,
Ice-T’s song “Cop Killer” generated significant
controversy when it was released. Among other
things, its lyrics celebrated the idea of slitting a
policeman’s throat. Rick Ross rapped about
drugging and raping a woman. TimeWarner Inc. did
not withdraw Ice T’s song, but Reebok fired Ross
over his lyrics. One difference: Time Warner was
struggling with a $15 billion debt and a depressed
stock price. Reebok at first refused to take action but
then singing group UltraViolet began circulating an
online petition against the song and staged a protest
at the main Reebok store in New York.
What obligation do media companies have to
their audience? What factors matter when making
a decision about content?
7. You are negotiating a new labor contract with
union officials. The contract covers a plant that has
experienced operating losses over the past several
years. You want to negotiate concessions from
labor to reduce the losses. However, labor is
refusing any compromises. You could tell them
that, without concessions, the plant will be closed,
although that is not true.
Is bluffing ethical? Under what circumstances?
What would Kant and Mill say? What result under
the Front Page test? What is your Life Principle?
8. Craig Newmark and Jim Buckmaster founded
craigslist, the most popular website in the country
for classified ads. Rather than maximizing its
profits, craigslist instead focused on developing a
community among its users. It was a place to find
an apartment, a pet, a job, a couch, a date, a
babysitter and, it turned out, a prostitute. Most of
the ads on craigslist were free, but blatant ads for
sex were not. Much of the company’s revenue was
from these illegal services. Many of the prostitutes
available on craigslist were not independent
CHAPTER 2 Ethics and Corporate Social Responsibility 49
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entrepreneurs; they were women and girls bought
and sold against their will. To fight sex
trafficking, craigslist required credit cards and
phone numbers, and it reported any suspicious
ads. Law enforcement officials pressured craigslist
to close the sex section of its website. But some
people argued that blocking these ads was a
violation of free speech and would just drive this
business more underground where law enforcement
officials were less likely to be able to find it.
Others said that banning these ads made the
business model of selling children for sex less
profitable. Does it seem that trafficking women
and children was in keeping with the founders’
personal ethics code? What were their options?
Could they have had any real impact on this
thriving industry? What pitfalls did they face?
9. You are a president of a small, highly rated, liberal
college in California. Many of the dining hall
workers are Latino. Some of these workers are
trying to organize a union, which would
dramatically increase the college’s costs at a time
of budget pressure. One of your vice presidents
suggests hiring a law firm to review the college’s
employment records to make sure all employees
are in the United States legally. What would
you do?
10. Many socially responsible funds are now
available to investors who want to make ethical
choices. For example, the Appleseed Fund
avoids tobacco products, alcoholic beverages,
gambling, weapons systems, or pornography
while the TIAA-CREF Social Choice Equity
Premier Fund invests in companies that are
“strong stewards of the environment,” devoted
to serving local communities and committed to
high labor standards. Are socially responsible
funds attractive to you? Does it matter if they
are less profitable than other alternatives? How
much less profitable? Do you now, or will you
in the future, use them in saving for your own
retirement?
50 U N I T 1 The Legal Environment
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CHAPTER3
DISPUTE
RESOLUTION
Tony Caruso had not returned for dinner, and
his wife, Karen, was nervous. She put on some
sandals and hurried across the dunes, a half mile
to the ocean shore. She soon came upon Tony’s
dog, Blue, tied to an old picket fence. Tony’s
shoes and clothing were piled neatly nearby.
Karen and friends searched frantically through-
out the evening.
A little past midnight, Tony’s body washed
ashore, his lungs filled with water. A local doctor con-
cluded he had accidentally drowned.
Karen and her friends were not the only ones who
were distraught. Tony had been partners with Beth
Smiles in an environmental consulting business, Enviro-
Vision. They were good friends, and Beth was emo-
tionally devastated. When she was able to focus on
business issues, Beth filed an insurance claim with the
Coastal Insurance Group. Beth hated to think about
Tony’s death in financial terms, but she was relieved
that the struggling business would receive $2 million on
the life insurance policy.
Several months after filing the claim, Beth received this reply from Coastal: “Under the
policy issued to Enviro-Vision, we are conditionally liable in the amount of $1 million in the
event of Mr. Caruso’s death. If his death is accidental, we are conditionally liable to pay
double indemnity of $2 million. But pursuant to section H(5), death by suicide is not
covered.
“After a thorough investigation, we have concluded that Anthony Caruso’s death
was an act of suicide, as defined in section B(11) of the policy. Your claim is denied in
its entirety.” Beth was furious. She was convinced Tony was incapable of suicide. And
her company could not afford the $2 million loss. She decided to consult her lawyer,
Chris Pruitt.
A little past midnight,
Tony’s body washed
ashore, his lungs filled
with water.
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3-1 THREE FUNDAMENTAL AREAS OF LAW
This case is a fictionalized version of several real cases based on double indemnity insurance
policies. In this chapter, we follow Beth’s dispute with Coastal from initial interview through
appeal, using it to examine three fundamental areas of law: the structure of our court
systems, civil lawsuits, and alternative dispute resolution.
When Beth Smiles meets with her lawyer, Chris Pruitt brings a second attorney from his
firm, Janet Booker, who is an experienced litigator; that is, a lawyer who handles court cases.
If they file a lawsuit, Janet will be in charge, so Chris wants her there for the first meeting.
Janet probes about Tony’s home life, the status of the business, his personal finances,
everything. Beth becomes upset that Janet doesn’t seem sympathetic, but Chris explains
that Janet is doing her job: she needs all the information, good and bad.
3-1a Litigation versus Alternative Dispute Resolution
Janet starts thinking about the two methods of dispute resolution: litigation and alternative
dispute resolution. Litigation refers to lawsuits, the process of filing claims in court, and
ultimately going to trial. Alternative dispute resolution is any other formal or informal
process used to settle disputes without resorting to a trial. It is increasingly popular with
corporations and individuals alike because it is generally cheaper and faster than litigation,
and we will focus on this topic in the last part of this chapter.
3-2 COURT SYSTEMS
The United States has over 50 systems of courts. One nationwide system of federal courts serves
the entire country. In addition, each individual state—such as California, Florida, and Texas—
has its court system. The state and federal courts are in different buildings, have different
judges, and hear different kinds of cases. Each has special powers and certain limitations.
3-2a State Courts
The typical state court system forms a pyramid, as Exhibit 3.1 shows. Some states have
minor variations on the exhibit. For example, Texas has two top courts: a Supreme Court for
civil cases and a Court of Criminal Appeals for criminal cases.
TRIAL COURTS
Almost all cases start in trial courts, which are endlessly portrayed on television and in film.
There is one judge, and there will often (but not always) be a jury. This is the only court to
hear testimony from witnesses and receive evidence. Trial courts determine the facts of a
particular dispute and apply to those facts the law given by statutes or earlier court decisions.
In the Enviro-Vision dispute, the trial court will decide all important facts that are in
dispute. How did Tony Caruso die? Did he drown? Assuming he drowned, was his death
accidental or suicide? Once the jury has decided the facts, it will apply the law to those facts.
If Tony Caruso died accidentally, contract law provides that Beth Smiles is entitled to
double indemnity benefits. If the jury decides he killed himself, Beth gets nothing.
Facts are critical. That may sound obvious, but in a course devoted to legal principles, it
is easy to lose track of the key role that factual determinations play in the resolution of any
dispute. In the Enviro-Vision case, we will see that one bit of factual evidence goes
undetected, with costly consequences.
Jurisdiction refers to a court’s power to hear a case. In state or federal court, a plaintiff
may start a lawsuit only in a court that has jurisdiction over that kind of case. Some courts
have very limited jurisdiction, while others have the power to hear almost any case.
Litigation
The process of filing claims
in court and ultimately going
to trial.
Alternative dispute
resolution
Any other formal or informal
process used to settle disputes
without resorting to a trial.
Trial courts
Determine the facts of a
particular dispute and apply to
those facts the law given by
earlier appellate court
decisions.
Jurisdiction
A court’s power to hear a case.
Litigator
A lawyer who handles court
cases.
52 U N I T 1 The Legal Environment
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SUBJECT MATTER JURISDICTION
Subject matter jurisdiction means that a court has the authority to hear a particular type
of case.
Trial Courts of Limited Jurisdiction These courts may hear only certain types of
cases. Small claims court has jurisdiction only over civil lawsuits involving a maximum of,
say, $5,000 (the amount varies from state to state). A juvenile court hears only cases
involving minors. Probate court is devoted to settling the estates of deceased persons,
though in some states it will hear certain other cases as well.
State Supreme Court
Appeal Courts
Appellate
Courts
General
Civil Division
Trial Courts of General Jurisdiction Trial Courts of Limited Jurisdiction
General
Criminal
Division
Probate
Division
Small
Claims
Division
Domestic
Relations
Division
Municipal
Division
Land
Division
Juvenile
Division
EXHIB IT 3 .1 A trial court determines facts, while an appeals court ensures that the lower court correctly
applied the law to those facts.
Subject matter jurisdiction
A court has the authority to
hear a particular type of case.
CHAPTER 3 Dispute Resolution 53
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Trial Courts of General Jurisdiction Trial courts of general jurisdiction, how-
ever, can hear a very broad range of cases. The most important court, for our purposes,
is the general civil division. This court may hear virtually any civil lawsuit. In one day it
might hear a $450 million shareholders’ derivative lawsuit, an employment issue in-
volving freedom of religion, and a foreclosure on a mortgage. Most of the cases we
study start in this court.1 If Enviro-Vision’s case against Coastal goes to trial in a state
court, it will begin in the trial court of general jurisdiction.
PERSONAL JURISDICTION
In addition to subject matter jurisdiction, courts must also have personal jurisdiction over
the defendant. Personal jurisdiction is the legal authority to require the defendant to stand
trial, pay judgments, and the like. When plaintiffs file lawsuits, defendants sometimes make
a special appearance to challenge a court’s personal jurisdiction. If the court agrees with the
defendant’s argument, the lawsuit will be dismissed.
Personal jurisdiction generally exists, if one or more of the following occur:
1. For individuals, the defendant is a resident of the state in which a lawsuit is filed.
For companies, the defendant is doing business in that state.
2. The defendant takes a formal step to defend a lawsuit. Most papers filed with a
court count as formal steps, but special appearances do not.
3. A summons is served on a defendant. A summons is the court’s written notice that
a lawsuit has been filed against the defendant. The summons must be delivered to
the defendant when she is physically within the state in which the lawsuit is filed.
For example, Texarkana straddles the Texas/Arkansas border. If a lawsuit is filed in a
Texas court, a defendant who lives in Arkansas can be served if, when walking down the
street in Texarkana, she steps across the state line into Texas. Corporations are required to
hire a registered agent in any state in which they do business. If a registered agent receives a
summons, then the corporation is served.
4. A long-arm statute applies. If all else fails—the defendant does not reside in the state,
does not defend the lawsuit, and has not been served with a summons while in the
state—a court still can obtain jurisdiction under long-arm statutes. These statutes
typically claim jurisdiction over someone who commits a tort, signs a contract, or
conducts “regular business activities” in the state.
As a general rule, courts tend to apply long-arm statutes aggressively, hauling defend-
ants into their courtrooms. However, the due process guarantees in the United States
Constitution require fundamental fairness in the application of long-arm statutes. Therefore,
courts can claim personal jurisdiction only if a defendant has had minimum contacts with a
state. In other words, it is unfair to require a defendant to stand trial in another state if he
has had no meaningful interaction with that state.
In the following Landmark Case, the Supreme Court explains its views on this
important constitutional issue.
Long-arm statute
A statute that gives a court
jurisdiction over someone who
commits a tort, signs a
contract, or conducts “regular
business activities” in the state.
Personal jurisdiction
The legal authority to require
the defendant to stand trial, pay
judgments, and the like.
Summons
The court’s written notice that
a lawsuit has been filed against
the defendant.
1Note that the actual name of the court will vary from state to state. In many states, it is called superior
court because it has power superior to the courts of limited jurisdiction. In New York, it is called
supreme court (anything to confuse the layperson); in some states, it is called court of common pleas; in
Oregon and other states, it is a circuit court. They are all civil trial courts of general jurisdiction. Within
this branch, some states are beginning to establish specialized business courts to hear complex
commercial disputes. At least one state has created a cybercourt for high-tech cases. Lawyers will
argue their cases by teleconference and present evidence via streaming video.
54 U N I T 1 The Legal Environment
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APPELLATE COURTS
Appellate courts are entirely different from trial courts. Three or more judges hear the
case. There are no juries, ever. These courts do not hear witnesses or take new
evidence. They hear appeals of cases already tried below. Appeals courts generally
accept the facts given to them by trial courts and review the trial record to see if the
court made errors of law.
Higher courts generally defer to lower courts on factual findings. Juries and trial court
judges see all evidence as it is presented, and they are in the best position to evaluate it. An
appeals court will accept a factual finding unless there was no evidence at all to support it. If
the jury decides that Tony Caruso committed suicide, the appeals court will normally accept
that fact, even if the appeals judges consider the jury’s conclusion dubious. On the other
hand, if a jury concluded that Tony had been murdered, an appeals court would overturn
that finding if neither side had introduced any evidence of murder during the trial.
An appeals court reviews the trial record tomake sure that the lower court correctly applied the
law to the facts. If the trial court made an error of law, the appeals court may require a new trial.
Suppose the jury concludes that Tony Caruso committed suicide but votes to award Enviro-Vision
$1million because it feels sorry for Beth Smiles. That is an error of law: If Tony committed suicide,
Beth is entitled to nothing. An appellate court will reverse the decision. Or suppose that the trial
judge permitted a friend of Tony’s to state that he was certain Tony would never commit suicide.
Landmark Case
Facts: Although Interna-
tional Shoe manufactured
footwear only in St.
Louis, Missouri, it sold
its products nationwide.
It did not have offices or
warehouses in the state of
Washington, but it did
send about a dozen sales-
people there. The sales-
people rented space in hotels and businesses, displayed
sample products, and took orders. They were not author-
ized to collect payment from customers.
When the State of Washington sought contributions to
the state’s unemployment fund, International Shoe refused
to pay. Washington sued. The company argued that it was
not engaged in business in the state and, therefore, that
Washington courts had no jurisdiction over it.
The Supreme Court of Washington ruled that Inter-
national Shoe did have sufficient contacts with the state to
justify a lawsuit there. International Shoe appealed to the
United States Supreme Court.
Issue: Did International
Shoe have sufficient mini-
mum contacts in the state
of Washington to permit
jurisdiction there?
Decision: Yes, the com-
pany had minimum con-
tacts with the state.
Reasoning: Agents for
International Shoe have
operated continuously in Washington for many years.
Their presence has been more than occasional or
casual. And the agents’ activities have generated a sig-
nificant number of sales for the company. Washington’s
collection action is directly related to commercially
valuable activities that took place within the state’s
borders.
Due Process merely requires reasonable fairness.
International Shoe has benefitted greatly from activities
in Washington, and it faces no injustice if this suit pro-
ceeds. The minimum contacts doctrine is satisfied.
Affirmed.
Error of law
Because of this, the appeals
court may require a new trial.
INTERNATIONAL SHOE CO. V.
STATE OF WASHINGTON
326 U.S. 310
Supreme Court of the United States, 1945
C A S E S U M M A R Y
Appeals courts
Generally accept the facts given
to them by trial courts and
review the trial record to see if
the court made errors of law.
CHAPTER 3 Dispute Resolution 55
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Normally, such opinions are not permissible at trial, and it was a legal error for the judge to allow the
jury to hear it.
Court of Appeals The party that loses at the trial court may appeal to the intermediate
court of appeals. The party filing the appeal is the appellant. The party opposing the appeal
(because it won at trial) is the appellee.
This court allows both sides to submit written arguments on the case, called briefs.
Each side then appears for oral argument, usually before a panel of three judges. The
appellant’s lawyer has about 15 minutes to convince the judges that the trial court made
serious errors of law, and that the decision should be reversed; that is, nullified. The
appellee’s lawyer has the same time to persuade the court that the trial court acted correctly,
and that the result should be affirmed; that is, permitted to stand.
State Supreme Court This is the highest court in the state, and it accepts some
appeals from the court of appeals. In most states, there is no absolute right to appeal to
the Supreme Court. If the high court regards a legal issue as important, it accepts the
case. It then takes briefs and hears oral argument just as the appeals court did. If it
considers the matter unimportant or the law well-established, it refuses to hear the case,
meaning that the court of appeals’ ruling is the final word on the case.2
In most states, seven judges, often called justices, sit on the Supreme Court. They have
the final word on state law.
3-2b Federal Courts
As discussed in Chapter 1, federal courts are established by the United States Constitution,
which limits what kinds of cases can be brought in any federal court. See Exhibit 3.2. For
our purposes, two kinds of civil lawsuits are permitted in federal court: federal question
cases and diversity cases.
FEDERAL QUESTION CASES
A claim based on the United States Constitution, a federal statute, or a federal treaty is
called a federal question case.3Federal courts have jurisdiction over these cases. If the
Environmental Protection Agency (a part of the federal government) orders Logging
Company not to cut in a particular forest, and Logging Company claims that the agency
has wrongly deprived it of its property, that suit is based on a federal statute and is thus a
federal question. If Little Retailer sues Mega Retailer, claiming that Mega has established a
monopoly, that claim is also based on a statute—the Sherman Antitrust Act—and creates
federal question jurisdiction. Enviro-Vision’s potential suit merely concerns an insurance
contract. The federal district court has no federal question jurisdiction over the case.
DIVERSITY CASES
Even if no federal law is at issue, federal courts have diversity jurisdiction when (1) the
plaintiff and defendant are citizens of different states and (2) the amount in dispute exceeds
$75,000. The theory behind diversity jurisdiction is that courts of one state might be biased
against citizens of another state. To ensure fairness, the parties have the option to use a
federal court as a neutral playing field.
2In some states with smaller populations, there is no intermediate appeals court. All appeals from trial
courts go directly to the state supreme court.
328 U.S.C. §1331 governs federal question jurisdiction, and 28 U.S.C. §1332 covers diversity
jurisdiction.
Diversity jurisdiction
(1) When the plaintiff and
defendant are citizens of
different states and (2) When
the amount in dispute exceeds
$75,000.
Appellant
The party filing the appeal.
Appellee
The party opposing the appeal.
Briefs
Written arguments on
the case.
Reversed
Nullified.
Affirmed
Permitted to stand.
Federal question
A case in which the claim is
based on the United States
Constitution, a federal statute,
or a federal treaty.
56 U N I T 1 The Legal Environment
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Enviro-Vision is located in Oregon and Coastal Insurance is incorporated in Georgia.4
They are citizens of different states and the amount in dispute far exceeds $75,000. Janet
could file this case in a United States District Court based on diversity jurisdiction.
TRIAL COURTS
United States District Court This is the primary trial court in the federal system.
The nation is divided into about 94 districts, and each has a district court. States with
smaller populations have one district. States with larger populations have several; Florida is
divided geographically into three districts.
Appellate
Courts
United States Supreme Court
United States
Courts of
Appeals
(12 Circuits)
United States
Court of
Appeals for the
Federal Circuit
U.S. District
Courts
U.S.
Bankruptcy
Courts
U.S. Tax
Courts
Various
Federal
Agencies
Administrative Agencies
U.S. Court of
International
Trade
U.S. Patent
& Trademark
Office
U
&U.S. ClaimsCourts
Trial CourtsTrial Courts
EXHIB IT 3 .2 The Fedral Court System
4For diversity purposes, a corporation is a citizen of the state in which it is incorporated and the state in
which it has its principal place of business.
©
C
en
g
ag
e
Le
ar
n
in
g
CHAPTER 3 Dispute Resolution 57
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Other Trial Courts There are other, specialized trial courts in the federal system.
Bankruptcy Court, Tax Court, and the United States Court of International Trade all handle
name-appropriate cases. The United States Claims Court hears cases brought against the
United States, typically on contract disputes. The Foreign Intelligence Surveillance Court is
a very specialized, secret court, which oversees requests for surveillance warrants against
suspected foreign agents.
Judges The President of the United States nominates all federal court judges, from district
court to Supreme Court. The nominees must be confirmed by the Senate. Once confirmed,
federal judges serve for “life in good behavior.”Many federal judges literally stay on the job for
life. When Judge Wesley Brown of Kansas died at the age of 104 in 2012, he held the record as
the oldest active federal judge in history. He served on the bench for five decades.
APPELLATE COURTS
United States Courts of Appeals These are the intermediate courts of appeals. As
the map below shows, they are divided into “circuits,” which are geographical areas. There
are 11 numbered circuits, hearing appeals from district courts. For example, an appeal from
the Northern District of Illinois would go to the Court of Appeals for the Seventh Circuit.
A twelfth court, the Court of Appeals for the District of Columbia, hears appeals only
from the district court of Washington, D.C. This is a particularly powerful court because so
many suits about federal statutes begin in the district court for the District of Columbia.
Also in Washington is the Thirteenth Court of Appeals, known as the Federal Circuit. It
hears appeals from specialized trial courts, as shown in Exhibit 3.2.
Within one circuit there are many circuit judges, up to about 50 judges in the largest
circuit, the Ninth. When a case is appealed, three judges hear the appeal, taking briefs and
hearing oral arguments.
United States Supreme Court This is the highest court in the country. There are
nine justices on the Court. One justice is the chief justice and the other eight are associate
justices. When they decide a case, each justice casts an equal vote. The chief justice’s
special power comes from his authority to assign opinions to a given justice. The justice
assigned to write an opinion has an opportunity to control the precise language and thus to
influence the voting by other justices.
The Supreme Court has the power to hear appeals in any federal case, and in certain cases
that began in state courts. Generally, it is up to the Court whether or not it will accept a case. A
party that wants the Supreme Court to review a lower court ruling must file a petition for a writ
of certiorari, asking the Court to hear the case. Four of the nine justices must vote in favor of
hearing a case before a writ will be granted. TheCourt receives several thousand requests every
year but usually accepts fewer than 100. Most cases accepted involve either an important issue
of constitutional law or an interpretation of a major federal statute.
EXAM Strategy
Question: Mark has sued his neighbor, Janelle, based on the state common law of
negligence. He is testifying in court, explaining how Janelle backed a rented truck out
of her driveway and slammed into his Lamborghini, causing $82,000 in damages.
Where would this take place?
(a) State appeals court
(b) United States Court of Appeals
(c) State trial court
Writ of certiorari
A petition asking the Supreme
Court to hear a case.
58 U N I T 1 The Legal Environment
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(d) Federal District Court
(e) Either state trial court or Federal District Court
Strategy: The question asks about trial and appellate courts, and also about state
versus federal courts. One issue at a time, please. What are the different functions of
trial and appellate courts? Trial courts use witnesses, and often juries, to resolve
factual disputes. Appellate courts never hear witnesses and never have juries. Applying
that distinction to these facts tells us whether we are in a trial or appeals court.
Next Issue: State trial courts may hear lawsuits on virtually any issue. Federal District
Courts may only hear two kinds of cases: federal question (those involving a statute or
constitutional provision); or diversity (where the parties are from different states and
the amount at issue is $75,000 or higher). Apply what we know to the facts here.
Result: We are in a trial court because Mark is testifying. Could we be in Federal
District Court? No. The suit is based on state common law. This is not a diversity case
because the parties live in the same state. We are in a state trial court.
9
10
9
5
4
2
6
3
3
8
1
1
Guam
Northern
Mariana
Islands
Alaska
Hawaii
New Mexico
Arizona
Utah
Colorado
Wyoming
Nebraska
South Dakota
North Dakota Minnesota
Iowa
Northern
Iowa
Southern
Montana
Idaho
Oregon
Nevada
Kansas
Texas
Northern
Texas
Southern
Texas
Western
Louisiana
Eastern
Louisiana
Western
Washington
Western
Washington
Eastern
California
Central
California
Southern
California
Eastern
California N
orthern
Oklahoma
Eastern
Oklahoma
Western
Louisiana
Middle
Texas
Eastern
Arkansas
Western
Arkansas
Eastern
Wisconsin
Western
Michigan
Western
Michigan
Eastern
Maine
N.H.
Vt.
Ohio
Northern
Ohio
Southern
Illinois
Northern
Illinois
SouthernMissouriWestern Missouri
Eastern
Illinois
Central
Indiana
Northern
Indiana
Southern
Michigan
Western
Wisconsin
Eastern
New York
Northern
New York
Eastern
Mass. Rhode
Island
Pa.
Western Pa.
Eastern
District
of Columbia
D.C. Circuit
Washington D.C.
Federal Circuit
Washington D.C.
Virgin Islands
Georgia
Southern
Georgia
Southern
Georgia
Middle
Georgia
Northern
South
Carolina
Alabama
Northern
Ala.
Southern
Ala.
Middle
Delaware
Mississippi
Northern
N. Carolina
Eastern
N. Carolina
Middle
N. Carolina
Western
Tenn.
Eastern
Tenn. Middle
Tenn.
Western
Kentucky
Western
Kentucky
Eastern
Virginia
Eastern
Virginia Western
W. Virginia
Southern
W. Virginia
Northern
Md.
Florida Northern
Florida
Middle
Florida
Southern
Puerto Rico
New York
Western
11
7
Mississippi
Southern
Oklahoma
Northern
Pennsylvania
Middle
New Jersey
New York
South
Legend
Circuit boundaries
State boundaries
District boundaries
Conn.
CHAPTER 3 Dispute Resolution 59
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3-3 LITIGATION
Janet Booker decides to file the Enviro-Vision suit in the Oregon trial court. She thinks that
a state court judge may take the issue more seriously than a federal district court judge.
3-3a Pleadings
The documents that begin a lawsuit are called the pleadings. These consist of the com-
plaint, the answer, and sometimes a reply.
COMPLAINT
The plaintiff files in court a complaint, which is a short, plain statement of the facts she is
alleging and the legal claims she is making. The purpose of the complaint is to inform the
defendant of the general nature of the claims and the need to come into court and protect
his interests.
Janet Booker files the complaint, as shown below. Since Enviro-Vision is a partnership,
she files the suit on behalf of Beth personally.
STATE OF OREGON
CIRCUIT COURT
Multnomah County Civil Action No. _________
__________________
Elizabeth Smiles,
Plaintiff
JURY TRIAL DEMANDED
v.
Coastal Insurance Company, Inc.,
Defendant
_____________________
COMPLAINT
Plaintiff Elizabeth Smiles states that:
1. She is a citizen of Multnomah County, Oregon.
2. Defendant Coastal Insurance Company, Inc., is incorporated under the laws of Georgia and
has as its usual place of business 148 Thrift Street, Savannah, Georgia.
3. On or about July 5, 2012, plaintiff Smiles (“Smiles”), Defendant Coastal Insurance Co, Inc.
(“Coastal”) and Anthony Caruso entered into an insurance contract (“the contract”), a copy of
which is annexed hereto as Exhibit “A.” This contract was signed by all parties or their
authorized agents, in Multnomah County, Oregon.
4. The contract obligates Coastal to pay to Smiles the sum of two million dollars ($2 million) if
Anthony Caruso should die accidentally.
5. On or about September 20, 2012, Anthony Caruso accidentally drowned and died while swimming.
6. Coastal has refused to pay any sum pursuant to the contract.
7. Coastal has knowingly, willingly and unreasonably refused to honor its obligations under the
contract.
WHEREFORE, plaintiff Elizabeth Smiles demands judgment against defendant Coastal for all monies
due under the contract; demands triple damages for Coastal’s knowing, willing, and unreasonable
refusal to honor its obligations; and demands all costs and attorney’s fees, with interest.
ELIZABETH SMILES,
By her attorney,
[Signed]
Janet Booker
Pruitt, Booker & Bother
983 Joy Avenue
Portland, OR
October 18, 2012
Complaint
A short, plain statement of the
facts alleged and the legal
claims made.
Pleadings
The documents that begin a
lawsuit, consisting of the
complaint, the answer, and
sometimes a reply.
60 U N I T 1 The Legal Environment
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SERVICE
When she files the complaint in court, Janet gets a summons, which is a paper ordering the
defendant to answer the complaint within 20 days. A sheriff or constable then serves the two
papers by delivering them to the defendant. Coastal’s headquarters are in Georgia, so the
state of Oregon has required Coastal to specify someone as its agent for receipt of service in
Oregon.
ANSWER
Once the complaint and summons are served, Coastal has 20 days in which to file an answer.
Coastal’s answer, shown below, is a brief reply to each of the allegations in the complaint.
The answer tells the court and the plaintiff exactly what issues are in dispute. Since Coastal
admits that the parties entered into the contract that Beth claims they did, there is no need
for her to prove that in court. The court can focus its attention on the disputed issue:
whether Tony Caruso died accidentally.
STATE OF OREGON
CIRCUIT COURT
Multnomah County Civil Action No. 09-5626
_________________
Elizabeth Smiles,
Plaintiff
v.
Coastal Insurance Company, Inc.,
Defendant
_____________________
ANSWER
Defendant Coastal Insurance Company, Inc., answers the complaint as follows:
1. Admit.
2. Admit.
3. Admit.
4. Admit.
5. Deny.
6. Admit.
7. Deny.
COASTAL INSURANCE COMPANY, INC.,
By its attorney,
[Signed]
Richard B. Stewart
Kiley, Robbins, Stewart & Glote
333 Victory Boulevard
Portland, OR
October 30, 2012
If the defendant fails to answer in time, the plaintiff will ask for a default judgment. In
granting a default judgment, the judge accepts every allegation in the complaint as true and
renders a decision that the plaintiff wins without a trial.
Recently, two men sued PepsiCo, claiming that the company stole the idea for Aquafina
water from them. They argued that they should receive a portion of the profits for every
bottle of Aquafina ever sold.
PepsiCo failed to file a timely answer, and the judge entered a default judgment in the
amount of $1.26 billion. On appeal, the default judgment was overturned and PepsiCo was
able to escape paying the massive sum, but other defendants are sometimes not so lucky.
It is important to respond to courts on time.
Default judgment
A decision that the plaintiff wins
without trial because the
defendant failed to answer
in time.
CHAPTER 3 Dispute Resolution 61
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COUNTER-CLAIM
Sometimes a defendant does more than merely answer a complaint and files a counter-claim,
meaning a second lawsuit by the defendant against the plaintiff. Suppose that after her complaint
was filed in court, Beth had written a letter to the newspaper, calling Coastal a bunch of “thieves
and scoundrels who spend their days mired in fraud and larceny.” Coastal would not have found
that amusing. The company’s answer would have included a counterclaim against Beth for libel,
claiming that she falsely accused the insurer of serious criminal acts. Coastal would have
demanded money damages.
If Coastal counter-claimed, Beth would have to file a reply, which is simply an answer to
a counter-claim. Beth’s reply would be similar to Coastal’s answer, admitting or denying the
various allegations.
CLASS ACTIONS
Suppose Janet uncovers evidence that Coastal denies 80 percent of all life insurance
claims, calling them suicide. She could ask the court to permit a class action. If the court
granted her request, she would represent the entire group of plaintiffs, including those
who are unaware of the lawsuit or even unaware they were harmed. Class actions can give
the plaintiffs much greater leverage, since the defendant’s potential liability is vastly
increased. In the back of her mind, Janet has thoughts of a class action, if she can uncover
evidence that Coastal has used a claim of suicide to deny coverage to a large number of
claimants.
Notice how potent a class action can be. From his small town in Maine, Ernie decides to
get rich quickly. On the Internet, he advertises “Energy Breakthrough! Cut your heating
costs 15 percent for only $25.” In response, 100,000 people send him their money, and they
receive a photocopied graph, illustrating that if you wear two sweaters instead of one, you
will feel 15 percent warmer. Ernie has deceitfully earned $2,500,000 in pure profit. What can
the angry homeowners do? Under the laws of fraud and consumer protection, they have a
legitimate claim to their $25, and perhaps even to treble damages ($75). But few will sue,
because the time and effort required would be greater than the money recovered.
Economists analyze such legal issues in terms of efficiency.The laws against Ernie’s fraud are
clear and well-intended, but they will not help in this case because it is too expensive for 100,000
people to litigate such a small claim. The effort would be hugely inefficient, both for the home-
owners and for society generally. The economic reality may permit Ernie to evade the law’s
grasp.
That is one reason we have class actions. A dozen or so “heating plan” buyers can
all hire the same lawyer. This attorney will file court papers in Maine on behalf of
everyone, nationwide, who has been swindled by Ernie—including the 99,988 people
who have yet to be notified that they are part of the case. Now the con artist, instead of
facing a few harmless suits for $25, must respond to a multimillion-dollar claim being
handled by an experienced lawyer. Treble damages become menacing: three times
$25 times 100,000 is no joke, even to a cynic like Ernie. He may also be forced to
pay for the plaintiffs’ attorney, as well as all costs of notifying class members and
disbursing money to them. With one lawyer representing an entire class, the legal
system has become fiercely efficient.
Congress recently passed a statute designed to force large, multi-state class actions out
of state courts, into federal. Proponents of the new law complained that state courts often
gave excessive verdicts, even for frivolous lawsuits. They said the cases hurt businesses
while enriching lawyers. Opponents argued that the new law was designed to shield large
corporations from paying for the harm they caused by sending the cases into a federal
system that is often hostile to such suits.
Counter-claim
A second lawsuit by the
defendant against the plaintiff.
Class action
An individual represents the
entire group of plaintiffs,
including those who are
unaware of the lawsuit or even
unaware they were harmed.
Reply
An answer to a counter-claim.
62 U N I T 1 The Legal Environment
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JUDGMENT ON THE PLEADINGS
A party can ask the court for a judgment based simply on the pleadings themselves, by
filing a motion to dismiss. A motion is a formal request to the court that the court take
some step or issue some order. During a lawsuit, the parties file many motions.
A motion to dismiss is a request that the court terminate a case without permitting it
to go further. Suppose that a state law requires claims on life insurance contracts to be
filed within three years, and Beth files her claim four years after Tony’s death. Coastal
would move to dismiss based on this late filing. The court might well agree, and Beth
would never get into court.
DISCOVERY
Few cases are dismissed on the pleadings. Most proceed quickly to the next step. Discovery
is the critical, pre-trial opportunity for both parties to learn the strengths and weaknesses of
the opponent’s case.
The theory behind civil litigation is that the best outcome is a negotiated settlement and
that parties will move toward agreement if they understand the opponent’s case. That is
likeliest to occur if both sides have an opportunity to examine the evidence the other side will
bring to trial. Further, if a case does go all the way to trial, efficient and fair litigation cannot take
place in a courtroom filled with surprises. On television dramas, witnesses say astonishing
things that amaze the courtroom (and keep viewers hooked through the next commercial). In
real trials, the lawyers know in advance the answers to practically all questions asked because
discovery has allowed them to see the opponent’s documents and question its witnesses. The
following are the most important forms of discovery.
Interrogatories These are written questions that the opposing party must answer, in
writing, under oath.
Depositions These provide a chance for one party’s lawyer to question the other party,
or a potential witness, under oath. The person being questioned is the deponent. Lawyers
for both parties are present. During depositions, and in trial, good lawyers choose words
carefully and ask questions calculated to advance their cause. A fine line separates ethical,
probing questions from those that are tricky, and a similar line divides answers that are
merely unhelpful from perjury.
Production of Documents and Things Each side may ask the other side to produce
relevant documents for inspection and copying; to produce physical objects, such as part of a
car alleged to be defective; and for permission to enter on land to make an inspection, for
example, at the scene of an accident.
Physical and Mental Examination A party may ask the court to order an examina-
tion of the other party, if his physical or mental condition is relevant, for example, in a case
of medical malpractice.
Janet Booker begins her discovery with interrogatories. Her goal is to learn Coastal’s basic
position and factual evidence and then follow up with more detailed questioning during
depositions. Her interrogatories ask for every fact Coastal relied on in denying the claim. She
asks for the names of all witnesses, the identity of all documents, including electronic records,
the description of all things or objects that they considered. She requests the names of all
corporate officers who played any role in the decision and of any expert witnesses Coastal plans
to call. Interrogatory No. 18 demands extensive information on all other claims in the past three
years that Coastal has denied based on alleged suicide. Janet is looking for evidence that would
support a class action.
Beth remarks on how thorough the interrogatories are. “This will tell us what their case
is.” Janet frowns and looks less optimistic: she has done this before.
Discovery
The pre-trial opportunity for
both parties to learn the
strengths and weaknesses of
the opponent’s case.
Deponent
The person being questioned in
a deposition.
Motion
A formal request to the court
that the court take some step
or issue some order.
Motion to dismiss
A request that the court
terminate a case without
permitting it to go further.
CHAPTER 3 Dispute Resolution 63
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Coastal has 30 days to answer Janet’s interrogatories. Before it responds, Coastal mails
to Janet a notice of deposition, stating its intention to depose Beth Smiles. Beth and Janet
will go to the office of Coastal’s lawyer, and Beth will answer questions under oath. But at
the same time Coastal sends this notice, it sends 25 other notices of deposition. The company
will depose Karen Caruso as soon as Beth’s deposition is over. Coastal also plans to depose
all seven employees of Enviro-Vision; three neighbors who lived near Tony and Karen’s
beach house; two policemen who participated in the search; the doctor and two nurses
involved in the case; Tony’s physician; Jerry Johnson, Tony’s tennis partner; Craig Bergson,
a college roommate; a couple who had dinner with Tony and Karen a week before his death;
and several other people.
Beth is appalled. Janet explains that some of these people might have relevant information.
But there may be another reason that Coastal is doing this: the company wants to make this
litigation hurt. Janet will have to attend every one of these depositions. Costs will skyrocket.
Janet files a motion for a protective order. This is a request that the court limit Coastal’s
discovery by decreasing the number of depositions. Janet also calls Coastal’s lawyer, Rich
Stewart, and suggests that they discuss what depositions are really necessary. Rich insists
that all of the depositions are important. This is a $2 million case, and Coastal is entitled to
protect itself. As both lawyers know, the parties are entitled to discover anything that could
reasonably lead to valid evidence.
Before Beth’s deposition date arrives, Rich sends Coast-
al’s answers to Enviro-Vision’s interrogatories. The answers
contain no useful information whatsoever. For example,
Interrogatory No. 10 asked, “If you claim that Anthony
Caruso committed suicide, describe every fact upon which
you rely in reaching that conclusion.” Coastal’s answer sim-
ply says, “His state of mind, his poor business affairs, and the
circumstances of his death all indicate suicide.”
Janet calls Rich and complains that the interrogatory
answers are a bad joke. Rich disagrees, saying that it is the
best information they have so early in the case. After they
debate it for 20 minutes, Rich offers to settle the case for
$100,000. Janet refuses and makes no counteroffer.
Janet files a motion to compel answers to interroga-
tories, in other words, a formal request that the court order
Coastal to supply more complete answers. Janet submits a memorandum with the motion,
which is a supporting argument. Although it is only a few pages long, the memorandum
takes several hours of online research and writing to prepare—more costs. Janet also informs
Rich Stewart that Beth will not appear for the deposition, since Coastal’s interrogatory
answers are inadequate.
Rich now files hismotion to compel, asking the court to order Beth Smiles to appear for her
deposition. The court hears all of themotions together. Janet argues that Coastal’s interrogatory
answers are hopelessly uninformative and defeat the whole purpose of discovery. She claims
that Coastal’s large number of depositions creates a huge and unfair expense for a small firm.
Rich claims that the interrogatory answers are the best that Coastal can do thus far and that
Coastal will supplement the answers when more information becomes available. He argues
against Interrogatory No. 18, the one in which Janet asked for the names of other policyholders
whomCoastal considered suicides. He claims that Janet is engaging in a fishing expedition that
would violate the privacy of Coastal’s insurance customers and provide no information relevant
to this case. He demands that Janet make Beth available for a deposition.
These discovery rulings are critical because they will color the entire lawsuit. A trial judge
has to make many discovery decisions before a case reaches trial. At times, the judge must
weigh the need of one party to see documents against the other side’s need for privacy. One
device a judge can use in reaching a discovery ruling is an in camera inspection, meaning that
But there may be another
reason that Coastal is
doing this: the company
wants to make this
litigation hurt.
Motion for a protective
order
Request that the court limit
discovery.
Memorandum
A document detailing the
arguments in support of a
motion.
In camera inspection
A judge’s private review of
evidence to determine whether
it should be provided to the
opposing party.
64 U N I T 1 The Legal Environment
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the judge views the requested documents alone, with no lawyers present, and decides whether
the other side is entitled to view them.
E-Discovery The biggest change in litigation in the last decade is the explosive rise of
electronic discovery. Companies send hundreds, or thousands, or millions of emails—every
day. Many have attachments, sometimes hundreds of pages long. In addition, businesses
large and small have vast amounts of data stored electronically. All of this information is
potentially subject to discovery.
It is enormously time-consuming and expensive for companies to locate all of
the relevant material, separate it from irrelevant or confidential matter, and furnish it. A
firm may be obligated to furnish millions of emails to the opposing party. In one recent case,
a defendant had to pay 31 lawyers full time, for six months, just to wade through the e-ocean
of documents and figure out which had to be supplied and how to produce it. Not
surprisingly, this data eruption has created a new industry: high-tech companies that assist
law firms in finding, sorting, and delivering electronic data.
Who is to say what must be supplied? What if an email string contains individual
emails that are clearly privileged (meaning a party need not divulge them), but others
that are not privileged? May a company refuse to furnish the entire string? Many will
try. However, some courts have ruled that companies seeking to protect email strings
must create a log describing every individual email and allow the court to determine
which are privileged.5
When the cost of furnishing the data becomes burdensome, who should pay, the party
seeking the information or the one supplying it? In one million-dollar corporate lawsuit, the
defendant turned over 3,000 emails and 211,000 other documents. But the trial judge noted that
many of the email attachments—sometimes 12 to an email—had gone missing, and required the
company to produce them. The defendant protested that finding the attachments would cost an
additional $206,000. The judge ordered the company to do it, and bear the full cost.
Both sides in litigation sometimes use gamesmanship during discovery. Thus, if an
individual sues a large corporation, for example, the company may deliberately make discovery
so expensive that the plaintiff cannot afford the legal fees. And if a plaintiff has a poor case, he
might intentionally try to make the discovery process more expensive for the defendant than
his settlement offer. Even if a defendant expects to win at trial, an offer to settle a case for
$50,000 can look like a bargain if discovery alone will cost $100,000. Some defendants refuse,
but others are more pragmatic.
The following case illustrates another common discovery problem: refusal by one side to
appear for deposition. Did the defendant cynically believe that long delay would win the day,
given that the plaintiff was 78 years old? What can a court do in such a case?
STINTON V. ROBIN’S WOOD, INC.
45 A.D. 3d 203, 842 NYS2d 477
New York App. Div., 2007
C A S E S U M M A R Y
Facts: Ethel Flanzraich, 78 years old, slipped and fell on
the steps of property owned by Robin’s Wood. She
broke her left leg and left arm. Flanzraich sued, claiming
that Robin’s Wood caused her fall by negligently paint-
ing the stairs. The defendant’s employee, Anthony
Monforte, had painted the steps. In its answer to the
complaint, Robin’s Wood denied all the significant alle-
gations.
5Universal Service Fund Telephone Billing Practices Litigation, 232 F.R.D. 669 (D. Kan. 2005).
CHAPTER 3 Dispute Resolution 65
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In the Enviro-Vision case, the judge rules that Coastal must furnish more complete
answers to the interrogatories, especially as to why the company denied the claim. However,
he rules against Interrogatory No. 18, the one concerning other claims Coastal has denied. This
simple ruling kills Janet’s hope ofmaking a class action of the case. He orders Beth to appear for
the deposition. As to future depositions, Coastal may take any 10 but then may take additional
depositions only by demonstrating to the court that the deponents have useful information.
Rich proceeds to take Beth’s deposition. It takes two full days. He asks about Enviro-
Vision’s past and present. He learns that Tony appeared to have won their biggest contract ever
from Rapid City, Oregon, but that he then lost it when he had a fight with Rapid City’s mayor.
He inquires into Tony’s mood, learns that he was depressed, and probes in every direction he
can to find evidence of suicidal motivation. Janet and Rich argue frequently over questions and
whether Beth should have to answer them. At times, Janet is persuaded and permits Beth to
answer; other times, she instructs Beth not to answer. For example, toward the end of the
second day, Rich asks Beth whether she and Tony had been sexually involved. Janet instructs
Beth not to answer. This fight necessitates another trip into court to determine whether Beth
must answer. The judge rules that Beth must discuss Tony’s romantic life only if Coastal has
some evidence that he was involved with someone outside his marriage. The company lacks
any such evidence.
Now limited to 10 depositions, Rich selects his nine other deponents carefully. For
example, he decides to depose only one of the two nurses; he chooses to question Jerry
Johnson, the tennis partner, but not Craig Bergson, the former roommate; and so forth. When
we look at the many legal issues this case raises, his choices seem minor. In fact, unbeknownst
to Rich or anyone else, his choices may determine the outcome of the case. As we will see later,
Craig Bergson has evidence that is possibly crucial to the lawsuit. If Rich decides not to depose
him, neither side will ever learn the evidence and the jury will never hear it. A jury can decide a
case only based on the evidence presented to it. Facts are elusive—and often controlling.
During a preliminary conference with the trial judge,
the parties agreed to hold depositions of both parties on
August 4. Flanzraich appeared for deposition, but Robin’s
Wood did not furnish its employee, Monforte, nor did it
offer any other company representative. The court then
ordered the deposition of the defendant to take place the
following April 2. Again, Robin’s Wood produced neither
Monforte nor anyone else. On July 16, the court ordered the
defendant to produce its representative within 30 days.
Once more, no one showed up for deposition.
On August 18—over one year after the original deposition
date—Flanzraich moved to strike the defendant’s answer,
meaning that the plaintiff would win by default. The com-
pany argued that it had made diligent efforts to locate Mon-
forte and force him to appear. However, all the letters sent to
Monforte were addressed care of Robin’s Wood. Finally, the
company stated that it no longer employed Monforte.
The trial judge granted the motion to strike the answer.
That meant that Robin’s Wood was liable for Flanzraich’s
fall. The only remaining issue was damages. The court
determined that Robin’s Wood owed $22,631 for medical
expenses, $150,000 for past pain and suffering, and
$300,000 for future pain and suffering. One day later, Flanz-
raich died of other causes. Robin’s Wood appealed.
Issue: Did the trial court abuse its discretion by striking the
defendant’s answer?
Decision: No, the trial court did not abuse its discretion.
Affirmed.
Reasoning: Normally, a lawsuit must be decided on the
evidence and reasonable conclusions. However, if a de-
fendant fails to respond to discovery requests, and its failure
is willful, extreme, and disrespectful of the court, a trial
judge may strike the defendant’s answer altogether.
Robin’s Wood failed to comply with three orders to
appear for deposition. The company never produced Mon-
forte while he worked there. It failed to notify the plaintiff
when Monforte left, and it made no effort to produce
another employee for deposition. The company did every-
thing it could to ensure that Flanzraich would never speak
with its worker. Had the company at least produced another
representative, Flanzraich could have learned where Mon-
forte had gone because the record indicates Robin’s Wood
knew his whereabouts.
These delays were particularly menacing to Flanz-
raich’s case because she was elderly—a fact well known
to the company. A trial judge may respond to such offen-
sive conduct with appropriate orders.
66 U N I T 1 The Legal Environment
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In each deposition, Rich carefully probes with his questions, sometimes trying to learn
what he actually does not know, sometimes trying to pin down the witness to a specific version
of facts so that Rich knows how the witness will testify at trial. Neighbors at the beach testify
that Tony seemed tense; one testifies about seeing Tony, unhappy, on the beach with his dog.
Another testifies he had never before seen Blue tied up on the beach. Karen Caruso admits that
Tony had been somewhat tense and unhappy the last couple of months. She reluctantly
discusses their marriage, admitting there were problems.
Other Discovery Rich sends Requests to Produce Documents, seeking medical
records about Tony. Once again, the parties fight over which records are relevant, but Rich
gets most of what he wants. Janet does less discovery than Rich because most of the
witnesses she will call are friendly witnesses. She can interview them privately without
giving any information to Coastal. With the help of Beth and Karen, Janet builds her case
just as carefully as Rich, choosing the witnesses who will bolster the view that Tony was in
good spirits and died accidentally.
She deposes all the officers of Coastal who participated in the decision to deny
insurance coverage. She is particularly aggressive in pinning them down as to the limited
information they had when they denied Beth’s claim.
SUMMARY JUDGMENT
When discovery is completed, both sides may consider seeking summary judgment.
Summary judgment is a ruling by the court that no trial is necessary because no essential facts
are in dispute. The purpose of a trial is to determine the facts of the case; that is, to decide who
did what to whom, why, when, and with what consequences. If there are no relevant facts in
dispute, then there is no need for a trial.
In the following case, the defendant won summary judgment, meaning that the case never
went to trial. And yet, this was only the beginning of trouble for that defendant, Bill Clinton.
JONES V. CLINTON
990 F. Supp. 657, 1998 U.S. Dist. LEXIS 3902
United States District Court for the Eastern District of Arkansas, 1998
C A S E S U M M A R Y
Facts: In 1991, Bill Clinton was governor of Arkansas.
Paula Jones worked for a state agency, the Arkansas
Industrial Development Commission (AIDC). When
Clinton became president, Jones sued him, claiming
that he had sexually harassed her. She alleged that in
May 1991, the governor arranged for her to meet him in a
hotel room in Little Rock, Arkansas. When they were alone,
he put his hand on her leg and slid it toward her pelvis. She
escaped from his grasp, exclaimed, “What are you doing?”
and said she was “not that kind of girl.”Upset and confused,
she sat on a sofa near the door. She claimed that Clinton
approached her, “lowered his trousers and underwear,
exposed his penis, and told her to kiss it.” Jones was
horrified, jumped up, and said she had to leave. Clinton
responded by saying, “Well, I don’t want to make you do
anything you don’t want to do,” and pulled his pants up. He
added that if she got in trouble for leaving work, Jones
should “have Dave call me immediately and I’ll take care
of it.”He also said, “You are smart. Let’s keep this between
ourselves.” Jones remained at AIDC until February 1993,
when she moved to California because of her husband’s job
transfer.
President Clinton denied all the allegations. He also
filed for summary judgment, claiming that Jones had not
alleged facts that justified a trial. Jones opposed the
motion for summary judgment.
Issue: Was Clinton entitled to summary judgment, or was
Jones entitled to a trial?
Decision: Jones failed to make out a claim of sexual
harassment. Summary judgment was granted for the
president.
Summary judgment
A ruling by the court that
no trial is necessary because
no essential facts are
in dispute.
CHAPTER 3 Dispute Resolution 67
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In other words, the court acknowledged that there were factual disputes, but
concluded that even if Jones proved each of her allegations, she would still lose the
case, because her allegations fell short of a legitimate case of sexual harassment. Jones
appealed the case. Later the same year, as the appeal was pending and the House of
Representatives was considering whether to impeach President Clinton, the parties
settled the dispute. Clinton, without acknowledging any of the allegations, agreed to
pay Jones $850,000 to drop the suit.
Janet and Rich each consider moving for summary judgment, but both correctly decide
that they would lose. There is one major fact in dispute: did Tony Caruso commit suicide?
Only a jury may decide that issue. As long as there is some evidence supporting each side of a
key factual dispute, the court may not grant summary judgment.
EXAM Strategy
Question: You are a judge. Mel has sued Kevin, claiming that while Kevin was
drunk, he negligently drove his car down Mel’s street, and destroyed rare trees on a
lot that Mel owns, next to his house. Mel’s complaint stated that three witnesses at a
bar saw Kevin take at least eight drinks less than an hour before the damage was
done. In Kevin’s answer, he denied causing the damage and denied being in the bar
that night.
Kevin’s lawyer has moved for summary judgment. He proves that three weeks
before the alleged accident, Mel sold the lot to Tatiana.
Mel’s lawyer opposes summary judgment. He produces a security camera tape
proving that Kevin was in the bar, drinking beer, 34 minutes before the damage was
done. He produces a signed statement from Sandy, a landscape gardener who lives
across the street from the scene. Sandy states that she heard a crash, hurried to the
windows, and saw Kevin’s car weaving away from the damaged trees. She is a land-
scape gardener and estimates the tree damage at $30,000 to $40,000. How should you
rule on the motion?
Strategy: Do not be fooled by red herrings about Kevin’s drinking or the value of the
trees. Stick to the question: should you grant summary judgment? Trials are necessary
to resolve disputes about essential factual issues. Summary judgment is appropriate
when there are no essential facts in dispute. Is there an essential fact not in dispute?
Find it. Apply the rule. Being a judge is easy!
Result: There are facts in dispute, but none of them are essential. It makes no
difference whether Kevin was drunk or sober, whether he caused the harm or was at
home in bed. Because Mel does not own the property, he cannot recover for the
damage to it. He cannot win. You should grant Kevin’s summary judgment motion.
Reasoning: To establish this type of sexual harassment
case, a plaintiff must show that her refusal to submit to
unwelcome sexual advances resulted in specific harm to
her job.
Jones received every merit increase and cost-of-living
allowance for which she was eligible. Her only job transfer
involved a minor change in working conditions, with no
reduction in pay or benefits. Jones claims that she was
obligated to sit in a less private area, often with no work to
do, and was the only female employee not to receive
flowers on Secretary’s Day. However, even if these alle-
gations are true, all are trivial and none is sufficient to
create a sexual harassment suit. Jones has demonstrated
no specific harm to her job.
68 U N I T 1 The Legal Environment
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FINAL PREPARATION
Well over 90 percent of all lawsuits are settled before trial. But the parties in the Enviro-Vision
dispute are unable to compromise, so each side gears up for trial. The attorneys make lists of all
witnesses they will call. They then prepare each witness very carefully, rehearsing the ques-
tions they will ask. It is considered ethical and proper to rehearse the questions, provided the
answers are honest and come from the witness. It is unethical and illegal for a lawyer to tell a
witness what to say. It also makes for a weaker presentation of evidence—witnesses giving
scripted answers are often easy to spot. The lawyers also have colleagues cross-examine each
witness, so that the witnesses are ready for the questions the other side’s lawyer will ask.
This preparation takes hours and hours, for many days. Beth is frustrated that she cannot do
thework she needs to for Enviro-Vision because she is spending somuch time preparing the case.
Other employees have to prepare as well, especially for cross- examination byRich Stewart, and it
is a terrible drain on the small firm.More than a year after Janet filed her complaint, they are ready
to begin trial.
3-4 TRIAL
3-4a Adversary System
Our system of justice assumes that the best way to bring out the truth is for the two
contesting sides to present the strongest case possible to a neutral factfinder. Each side
presents its witnesses and then the opponent has a chance to cross-examine. The adversary
system presumes that by putting a witness on the stand and letting both lawyers question
her, the truth will emerge.
The judge runs the trial. Each lawyer sits at a large table near the front. Beth, looking
tense and unhappy, sits with Janet. Rich sits with a Coastal executive. In the back of the
courtroom are benches for the public. On one bench sits Craig Bergson. He will watch the
entire proceeding with intense interest and a strange feeling of unease. He is convinced he
knows what really happened.
Janet has demanded a jury trial for Beth’s case, and Judge Rowland announces that they
will now impanel the jury.
3-4b Right to Jury Trial
Not all cases are tried to a jury. As a general rule, both plaintiff and defendant have a right to
demand a jury trial when the lawsuit is one for money damages. For example, in a typical contract
lawsuit, such as Beth’s insurance claim, both plaintiff and defendant have a jury trial right whether
they are in state or federal court. Even in such a case, though, the parties may waive the jury right,
meaning they agree to try the case to a judge. Also, if the plaintiff is seeking an equitable remedy
such as an injunction or other court-ordered enforcement, there is no jury right for either party.
3-4c Voir Dire
The process of selecting a jury is called voir dire, which means “to speak the truth.”6 The
court’s goal is to select an impartial jury; the lawyers will each try to get a jury as favorable to
their side as possible. A court sends letters to potential jurors who live in its county. Those
who do not report for jury duty face significant consequences.
6Students of French note that voir means “to see” and assume that voir dire should translate as “to see,
to speak.” However, the legal term is centuries old and derives not from modern French but from Old
French, in which voir meant “truth.”
Voir dire
The process of selecting a jury.
CHAPTER 3 Dispute Resolution 69
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When voir dire begins, potential jurors are questioned individually, sometimes by the
judge and sometimes by the two lawyers, as each side tries to ferret out potential bias.
Each lawyer may make any number of challenges for cause, claiming that a juror has
demonstrated probable bias. For example, if a prospective juror in the Enviro-Vision case
works for an insurance company, the judge will excuse her on the assumption that she
would be biased in favor of Coastal. If the judge perceives no bias, the lawyer may still
make a limited number of peremptory challenges, entitling him to excuse that juror for
virtually any reason, which need not be stated in court. For example, if Rich believes that
a juror seems hostile to him personally, he will use a peremptory challenge to excuse that
juror, even if the judge sensed no animosity. The process continues until 14 jurors are
seated. Twelve will comprise the jury; the other two are alternates who hear the case and
remain available in the event one of the impaneled jurors becomes ill or otherwise cannot
continue.
Although jury selection for a case can sometimes take many days, in the Enviro-Vision
case, the first day of the hearing ends with the jury selected. In the hallway outside the
court, Rich offers Janet $200,000 to settle. Janet reports the offer to Beth and they agree to
reject it. Craig Bergson drives home, emotionally confused. Only three weeks before his
death, Tony had accidentally met his old roommate and they had had several drinks. Craig
believes that what Tony told him answers the riddle of this case.
PEREDA V. PARAJON
957 So.2d 1194
Florida Court of Appeals, 2007
C A S E S U M M A R Y
Facts: Maria Parajon sued Diana Pereda for injuring her
in a car accident. During voir dire, Parajon’s lawyer asked
the panel of prospective jurors these questions: “Is there
anybody sitting on this panel now that has ever been
under the care of a physician for personal injuries,
whether you had a lawsuit or not? In other words, you
may not have had any sort of lawsuit, but you slipped and
fell—you had any accidents?”
Several of the prospective jurors raised their hands,
allowing the lawyers to question more deeply into possible
bias. However, Lisa Berg, a prospective juror who happened
to be a lawyer, did not respond. Berg and others were seated
as jurors, and ultimately awarded Parajon $450,000 for med-
ical damages and pain and suffering.
After the trial, questioned in court by the judge,
Berg admitted that three years earlier she had been injured in
a car accident, hired a lawyer to sue, and settled out of court for
$4,000. Asked about the settlement, Berg replied, “I think
everyone always wants more money.”
Parajon moved for a new trial but the judge denied
the motion. Parajon appealed.
Issue: Is Parajon entitled to a new trial based on
Berg’s failure to disclose her own personal injury law-
suit?
Decision: Yes, Parajon is entitled to a new trial.
Reversed and remanded for a new trial.
Reasoning: When a juror does not accurately answer
questions during voir dire, a new trial is called for if the
following three criteria are met:
First, the information is relevant and material to
the case. Second, the juror concealed it. Third,
the lawyers made a diligent effort to seek the infor-
mation.
Berg’s own car accident was relevant and material
because it might have influenced her opinion in the
case. As a lawyer herself, Berg knew that the question
applied to her, and she deliberately chose not to
answer it. The fact that other prospective jurors
answered the question indicated that Parajon’s lawyers
made a diligent and reasonable attempt to get the
information.
Peremptory challenges
The right to excuse a juror for
virtually any reason.
Challenges for cause
A claim that a juror has
demonstrated probable bias.
70 U N I T 1 The Legal Environment
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3-4d Opening Statements
The next day, each attorney makes an opening statement to the jury, summarizing the proof
he or she expects to offer, with the plaintiff going first. Janet focuses on Tony’s successful
life, his business and strong marriage, and the tragedy of his accidental death.7
Rich works hard to establish a friendly rapport with the jury. If members of the jury like
him, they will tend to pay more attention to his presentation of evidence. He expresses regret
about the death. Nonetheless, suicide is a clear exclusion from the policy. If insurance
companies are forced to pay claims never bargained for, everyone’s insurance rates will go up.
3-4e Burden of Proof
In civil cases, the plaintiff has the burden of proof. That means that the plaintiff must
convince the jury that its version of the case is correct; the defendant is not obligated to
disprove the allegations.
The plaintiff’s burden in a civil lawsuit is to prove its case by a preponderance of the
evidence. It must convince the jury that its version of the facts is at least slightly more likely
than the defendant’s version. Some courts describe this as a “51-49” persuasion; that is, that
plaintiff s proof must “just tip” credibility in its favor. By contrast, in a criminal case, the
prosecution must demonstrate beyond a reasonable doubt that the defendant is guilty. The
burden of proof in a criminal case is much tougher because the likely consequences are, too.
See Exhibit 3.3.
3-4f Plaintiff ’s Case
Because the plaintiff has the burden of proof, Janet puts in her case first. She wants to prove
two things. First, that Tony died. That is easy because the death certificate clearly
demonstrates it and Coastal does not seriously contest it. Second, in order to win double
Civil Lawsuit Criminal Prosecution
Defendant
Plaintiff
Defendant
Prosecution
EXHIB IT 3 .3 Burden of Proof. In a civil lawsuit, a plaintiff wins with a mere
preponderance of the evidence. But the prosecution must persuade a
jury beyond a reasonable doubt in order to win a criminal conviction.
Preponderance of the
evidence
The plaintiff’s burden in a civil
lawsuit.
Beyond a reasonable
doubt
The government’s burden in a
criminal prosecution.
©
C
en
g
ag
e
Le
ar
n
in
g
7Janet Booker has dropped her claim for triple damages against Coastal. To have any hope of such a
verdict, she would have to show that Coastal had no legitimate reason at all for denying the claim.
Discovery has convinced her that Coastal will demonstrate some rational reasons for what it did.
CHAPTER 3 Dispute Resolution 71
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indemnity damages, she must show that the death was accidental. She will do this with the
testimony of the witnesses she calls, one after the other. Her first witness is Beth. When a
lawyer asks questions of her own witness, it is direct examination. Janet brings out all the
evidence she wants the jury to hear: that the business was basically sound, though tem-
porarily troubled, that Tony was a hard worker, why the company took out life insurance
policies, and so forth.
Then Rich has a chance to cross-examine Beth, which means to ask questions of an
opposing witness. He will try to create doubt in the jury’s mind. He asks Beth only
questions for which he is certain of the answers, based on discovery. Rich gets Beth to
admit that the firm was not doing well the year of Tony’s death; that Tony had lost the
best client the firm ever had; that Beth had reduced salaries; and that Tony had been
depressed about business.
3-4g Rules of Evidence
The lawyers are not free simply to ask any question they want. The law of evidence
determines what questions a lawyer may ask and how the questions are to be phrased,
what answers a witness may give, and what documents may be introduced. The goal is to
get the best evidence possible before the jurors so they can decide what really happened. In
general, witnesses may only testify about things they saw or heard.
These rules are complex, and a thorough look at them is beyond the scope of this
chapter. However, they can be just as important in resolving a dispute as the underlying
substantive law. Suppose that a plaintiff’s case depends upon the jury hearing about a
certain conversation, but the rules of evidence prevent the lawyer from asking about it. That
conversation might just as well never have occurred.
Janet calls an expert witness, a marine geologist, who testifies about the tides and
currents in the area where Tony’s body was found. The expert testifies that even experi-
enced swimmers can be overwhelmed by a sudden shift in currents. Rich objects strenu-
ously that this is irrelevant, because there is no testimony that there was such a current at
the time of Tony’s death. The judge permits the testimony.
Karen Caruso testifies that Tony was in “reasonably good” spirits the day of his death,
and that he often took Blue for walks along the beach. Karen testifies that Blue was part
Newfoundland. Rich objects that testimony about Blue’s pedigree is irrelevant, but Janet
insists it will show why Blue was tied up. The judge allows the testimony. Karen says that
whenever Blue saw them swim, he would instinctively go into the water and pull them to
shore. Does that explain why Blue was tied up? Only the jury can answer.
Cross-examination is grim for Karen. Rich slowly but methodically questions her about
Tony’s state of mind and brings out the problems with the company, his depression, and
tension within the marriage. Janet’s other witnesses testify essentially as they did during
their depositions.
3-4h Motion for Directed Verdict
At the close of the plaintiff’s case, Rich moves for a directed verdict; that is, a ruling that the
plaintiff has entirely failed to prove some aspect of her case. Rich is seeking to win without
even putting in his own case. He argues that it was Beth’s burden to prove that Tony died
accidentally and that she has entirely failed to do that.
A directed verdict is permissible only if the evidence so clearly favors the defendant that
reasonable minds could not disagree on it. If reasonable minds could disagree, the motion
must be denied. Here, Judge Rowland rules that the plaintiff has put in enough evidence of
accidental death that a reasonable person could find in Beth’s favor. The motion is denied.
There is no downside for Rich to ask for a directed verdict. The trial continues as if he
had never made such a motion.
Directed verdict
A ruling that the plaintiff has
entirely failed to prove some
aspect of her case.
Cross-examine
To ask questions of an opposing
witness.
Direct examination
When a lawyer questions her
own witness.
72 U N I T 1 The Legal Environment
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3-4i Defendant’s Case
Rich now puts in his case, exactly as Janet did, except that he happens to have fewer
witnesses. He calls the examining doctor, who admits that Tony could have committed
suicide by swimming out too far. On cross-examination, Janet gets the doctor to acknowl-
edge that he has no idea whether Tony intentionally drowned. Rich also questions several
neighbors as to how depressed Tony had seemed and how unusual it was that Blue was tied
up. Some of the witnesses Rich deposed, such as the tennis partner Jerry Johnson, have
nothing that will help Coastal’s case, so he does not call them.
Craig Bergson, sitting in the back of the courtroom, thinks how different the trial would
have been had he been called as a witness. When he and Tony had the fateful drink, Tony
had been distraught: business was terrible, he was involved in an extramarital affair that he
could not end, and he saw no way out of his problems. He had no one to talk to and had
been hugely relieved to speak with Craig. Several times Tony had said, “I just can’t go on
like this. I don’t want to, anymore.” Craig thought Tony seemed suicidal and urged him to
see a therapist Craig knew and trusted. Tony had said that it was good advice, but Craig is
unsure whether Tony sought any help.
This evidence would have affected the case. Had Rich known of the conversation, he
would have deposed Craig and the therapist. Coastal’s case would have been far stronger,
perhaps overwhelming. But Craig’s evidence will never be heard. Facts are critical. Rich’s
decision to depose other witnesses and omit Craig may influence the verdict more than any
rule of law.
3-4j Closing Arguments
Both lawyers sum up their case to the jury, explaining how they hope the jury will interpret
what they have heard. Janet summarizes the plaintiff’s version of the facts, claiming that
Blue was tied up so that Tony could swim without worrying about him. Rich claims that
business and personal pressures had overwhelmed Tony. He tied up his dog, neatly folded
his clothes, and took his own life.
3-4k Jury Instructions
Judge Rowland instructs the jury as to its duty. He tells them that they are to evaluate the
case based only on the evidence they heard at trial, relying on their own experience and
common sense.
He explains the law and the burden of proof, telling the jury that it is Beth’s obligation to
prove that Tony died. If Beth has proven that Tony died, she is entitled to $1 million; if she
has proven that his death was accidental, she is entitled to $2 million. However, if Coastal has
proven suicide, Beth receives nothing. Finally, he states that if they are unable to decide
between accidental death and suicide, there is a legal presumption that it was accidental. Rich
asks Judge Rowland to rephrase the “legal presumption” part, but the judge declines.
3-4l Verdict
The jury deliberates informally, with all jurors entitled to voice their opinion. Some
deliberations take two hours; some take two weeks. Many states require a unanimous
verdict; others require only, for example, a 10–2 vote in civil cases.
This case presents a close call. No one saw Tony die. Yet even though they cannot
know with certainty, the jury’s decision will probably be the final word on whether he took
his own life. After a day and a half of deliberating, the jury notifies the judge that it has
reached a verdict. Rich quickly makes a new offer: $350,000. (The two sides have the right
to settle a case until the moment when the last appeal is decided.) Beth hesitates but turns
it down.
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The judge summons the lawyers to court, and Beth goes as well. The judge asks the
foreman if the jury has reached a decision. He states that it has: The jury finds that Tony
Caruso drowned accidentally, and awards Beth Smiles $2 million.
3-4m Motions after the Verdict
Rich immediately moves for a judgment non obstante veredicto (JNOV), meaning a judgment
notwithstanding the jury’s verdict. He is asking the judge to overturn the jury’s verdict.
Rich argues that the jury’s decision went against all of the evidence. He also claims that the
judge’s instructions were wrong and misled the jury.
Judge Rowland denies the JNOV. Rich immediately moves for a new trial, making the
same claim, and the judge denies the motion. Beth is elated that the case is finally over—
until Janet says she expects an appeal. Craig Bergson, leaving the courtroom, wonders if he
did the right thing. He felt sympathy for Beth and none for Coastal. Yet now he is neither
happy nor proud.
3-5 APPEALS
Two days later, Rich files an appeal to the court of appeals. The same day, he phones Janet
and increases his settlement offer to $425,000. Beth is tempted but wants Janet’s advice.
Janet says the risks of an appeal are that the court will order a new trial, and they would start
all over. But to accept this offer is to forfeit over $1.5 million. Beth is unsure what to do. The
firm desperately needs cash now, and appeals may take years. Janet suggests they wait until
oral argument, another eight months.
Rich files a brief arguing that there were two basic errors at the trial: first, that the jury’s
verdict is clearly contrary to the evidence; and second, that the judge gave the wrong
instructions to the jury. Janet files a reply brief, opposing Rich on both issues. In her brief,
Janet cites many cases that she claims are precedent: earlier decisions by the state appellate
courts on similar or identical issues.
Eight months later, the lawyers representing Coastal and Enviro-Vision appear in the
court of appeals to argue their case. Rich, the appellant, goes first. The judges frequently
interrupt his argument with questions. They show little sympathy for his claim that the
verdict was against the facts. They seem more sympathetic with his second point, that the
instructions were wrong.
When Janet argues, all of their questions concern the judge’s instructions. It appears
they believe the instructions were in error. The judges take the case under advisement,
meaning they will decide some time in the future—maybe in two weeks, maybe in five
months.
3-5a Appeals Court Options
The court of appeals can affirm the trial court, allowing the decision to stand. The court
may modify the decision, for example, by affirming that the plaintiff wins but decreasing the
size of the award. (That is unlikely here; Beth is entitled to $2 million or nothing.) The
court might reverse and remand, nullifying the lower court’s decision and returning the case
to the lower court for a new trial. Or it could simply reverse, turning the loser (Coastal) into
the winner, with no new trial.
What will it do here? On the factual issue, it will probably rule in Beth’s favor. There
was evidence from which a jury could conclude that Tony died accidentally. It is true that
there was also considerable evidence to support Coastal’s position, but that is probably not
enough to overturn the verdict. If reasonable people could disagree on what the evidence
proves, an appellate court generally refuses to change the jury’s factual findings. The court
Reverse and remand
To nullify the lower decision
and return the case for
reconsideration or retrial.
Judgment non obstante
veredicto
A judgment notwithstanding
the jury’s verdict.
Precedent
Earlier decisions by the state
appellate courts on similar or
identical issues.
Affirm
To allow the decision to stand.
Modify
To affirm the outcome but with
changes.
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of appeals is likely to rule that a reasonable jury could have found accidental death, even if
the appellate judges personally suspect that Tony may have killed himself.
The judge’s instructions raise a more difficult problem. Some states would require a
more complex statement about “presumptions.”8
What does a court of appeals do if it decides the trial court’s instructions were wrong? If
it believes the error rendered the trial and verdict unfair, it will remand the case; that is,
send it back to the lower court for a new trial. However, the court may conclude that the
mistake was harmless error. A trial judge cannot do a perfect job, and not every error is fatal.
The court may decide the verdict was fair in spite of the mistake.
Janet and Beth talk. Beth is very anxious and wants to settle. She does not want to wait
four or five months, only to learn that they must start all over. Janet urges that they wait a
few weeks to hear from Rich: They don’t want to seem too eager.
A week later, Rich telephones and offers $500,000. Janet turns it down, but says she will
ask Beth if she wants to make a counter-offer. She and Beth talk. They agree that they will
settle for $1 million. Janet then calls Rich and offers to settle for $1.7 million. Rich and Janet
debate the merits of the case. Rich later calls back and offers $750,000, saying he doubts
that he can go any higher. Janet counters with $1.4 million, saying she doubts she can go any
lower. They argue, both predicting that they will win on appeal.
Rich calls, offers $900,000 and says, “That’s it. No more.” Janet argues for $1.2 million,
expecting to nudge Rich up to $1 million. He doesn’t nudge, instead saying, “Take it or
leave it.” Janet and Beth talk it over. Janet telephones Rich and accepts $900,000 to settle
the case.
If they had waited for the court of appeals decision, would Beth have won? It is
impossible to know. It is certain, though, that whoever lost would have appealed. Months
would have passed waiting to learn if the state supreme court would accept the case. If that
court had agreed to hear the appeal, Beth would have endured another year of waiting, brief
writing, oral argument, and tense hoping. The high court has all of the options discussed: to
affirm, modify, reverse and remand, or simply reverse.
3-6 ALTERNATIVE DISPUTE RESOLUTION
As we have seen in the previous section, trials can be trying. Lawsuits can cause prolonged
periods of stress, significant legal bills, and general unpleasantness. Many people and
companies prefer to settle cases out of court. Alternative dispute resolution (ADR) provides
several semi-formal methods of resolving conflicts. We will look at different types of ADR
and analyze their strengths and weaknesses.
3-6a Negotiation
In most cases, the parties negotiate, whether personally or through lawyers. Fortunately, the
great majority of disputes are resolved this way. Negotiation often begins as soon as a
dispute arises and may last a few days or several years.
8Judge Rowland probably should have said, “The law presumes that death is accidental, not suicide.
So if there were no evidence either way, the plaintiff would win because we presume accident. But if
there is competing evidence, the presumption becomes irrelevant. If you think that Coastal Insurance
has introduced some evidence of suicide, then forget the legal presumption. You must then decide
what happened based on what you have seen and heard in court, and on any inferences you choose to
draw.” Note that the judge’s instructions were different, though similar.
Harmless error
A mistake by the trial judge that
was too minor to affect the
outcome.
CHAPTER 3 Dispute Resolution 75
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3-6b Mediation
Mediation is the fastest growing method of dispute resolution in the United States.
Here, a neutral person, called a mediator, attempts to guide the two disputing parties
toward a voluntary settlement. (In some cases, there may be two or more mediators, but
we will use the singular.) Generally, the two disputants voluntarily enter mediation,
although some judges order the parties to try this form of ADR before allowing a case to
go to trial.
A mediator does not render a decision in the dispute, but uses a variety of skills to move
the parties toward agreement. Often a mediator will shuttle between the antagonists,
hearing their arguments, sorting out the serious issues from the less important, prompting
the parties and lawyers alike to consider new perspectives, and looking for areas of agree-
ment. Mediators must earn the trust of both parties, listen closely, try to diffuse anger and
fear, and build the will to settle. Good mediators do not need a law degree, but they must
have a sense of humor and low blood pressure.
Mediation has several major advantages. Because the parties maintain control of the
process, the two antagonists can speak freely. They need not fear conceding too much,
because no settlement takes effect until both parties sign. All discussions are confidential,
further encouraging candid talk. This is particularly helpful in cases involving proprietary
information that might be revealed during a trial.
Of all forms of dispute resolution, mediation probably offers the strongest “win-
win” potential. Since the goal is voluntary settlement, neither party needs to fear that it
will end up the loser. This is in sharp contrast to litigation, where one party is very
likely to lose. Removing the fear of defeat often encourages thinking and talking that
are more open and realistic than negotiations held in the midst of a lawsuit. Studies
show that over 75 percent of mediated cases do reach a voluntary settlement. Such an
agreement is particularly valuable to parties that wish to preserve a long-term relation-
ship. Consider two companies that have done business successfully for 10 years but now
are in the midst of a million-dollar trade dispute. A lawsuit could last three or more
years and destroy any chance of future trade. However, if the parties mediate the
disagreement, they might reach an amicable settlement within a month or two and
could quickly resume their mutually profitable business.
This form of ADR works for disputes both big and small. Two college roommates
who cannot get along may find that a three-hour mediation session restores tranquility
in the apartment. On a larger scale, consider the work of former U.S. Senator George
Mitchell, who mediated the Anglo-Irish peace agreement, setting Northern Ireland on
the path to peace for the first time in three centuries. Like most good mediators,
Mitchell was remarkably patient. In an early session, Mitchell permitted the head of
one militant party to speak without interruption—for seven straight hours. The diatribe
yielded no quick results, but Mitchell believed that after Northern Ireland’s tortured
history, any nonviolent discussions represented progress.
3-6c Arbitration
In this form of ADR, the parties agree to bring in a neutral third party, but with a major
difference: The arbitrator has the power to impose an award. The arbitrator allows each side
equal time to present its case and, after deliberation, issues a binding decision, generally
without giving reasons. Unlike mediation, arbitration ensures that there will be a final result,
although the parties lose control of the outcome.
Judge Judy and similar TV court shows are examples of arbitration. Before the shows
are taped, people involved in a real dispute sign a contract in which they give up the right to
go to court over the incident and agree to be bound by the judge’s decision.
Mediator
A neutral person who attempts
to guide two disputing parties
toward a voluntary settlement.
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Parties in arbitration give up many additional rights that litigants retain, including
discovery and class action. In arbitration, as already discussed as applied to trials,
discovery allows the two sides in a lawsuit to obtain documentary and other evidence
from the opponent before the dispute is decided. Arbitration permits both sides to keep
secret many files that would have to be divulged in a court case, potentially depriving
the opposing side of valuable evidence. A party may have a stronger case than it
realizes, and the absence of discovery may permanently deny it that knowledge. As
discussed earlier in this chapter, a class action is a suit in which one injured party
represents a large group of people who have suffered similar harm. Arbitration elim-
inates this possibility, since injured employees face the employer one at a time. Finally,
the fact that an arbitrator may not provide a written, public decision bars other plaintiffs,
and society generally, from learning what happened.
Traditionally, parties sign arbitration agreements after some incident takes place. A car
accident would happen first, and the drivers would agree to arbitration second. But today,
many parties agree in advance to arbitrate any disputes that may arise in the future. For
example, a new employee may sign an agreement requiring arbitration of any future
disputes with his employer; a customer opening an account with a stockbroker or bank—
or health plan—may sign a similar form, often without realizing it. The good news is fewer
lawsuits; the bad news is you might be the person kept out of court.
Assume that you live in Miami. Using the Internet, you order a $1,000 ThinkLite
laptop computer, which arrives in a carton loaded with six fat instructional manuals and
many small leaflets. You read some of the documents and ignore others. For four weeks,
you struggle to make your computer work, to no avail. Finally, you call ThinkLite and
demand a refund, but the company refuses. You file suit in your local court, at which
time the company points out that buried among the hundreds of pages it mailed you
was a mandatory arbitration form. This document prohibits you from filing suit against
the company and states that if you have any complaint with the company, you must fly
to Chicago, pay a $2,000 arbitrator’s fee, plead your case before an arbitrator selected by
the Laptop Trade Association of America, and, should you lose, pay ThinkLite’s
attorneys’ fees, which could be several thousand dollars. Is that mandatory arbitration
provision valid? It is too early to say with finality, but thus far, the courts that have
faced such clauses have enforced them.9
Chapter Conclusion
No one will ever know for sure whether Tony Caruso took his own life. Craig Bergson’s
evidence might have tipped the scales in favor of Coastal. But even that is uncertain, since
the jury could have found him unpersuasive. After two years, the case ends with a settle-
ment and uncertainty—both typical lawsuit results. The missing witness is less common but
not extraordinary. The vaguely unsatisfying feeling about it all is only too common and
indicates why most parties settle out of court.
9See, for example, Hill v. Gateway 2000, 105 F.3d 1147, 1997 U.S. App. LEXIS 1877 (7th Cir. 1997),
upholding a similar clause.
CHAPTER 3 Dispute Resolution 77
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EXAM REVIEW
1. COURT SYSTEMS There are many systems of courts, one federal and one in each
state. A federal court will hear a case only if it involves a federal question or diversity
jurisdiction. (pp. 52–57)
2. TRIAL AND APPELLATE COURTS Trial courts determine facts and apply the
law to the facts; appeals courts generally accept the facts found by the trial court and
review the trial record for errors of law. (pp. 55–59)
Question: Jade sued Kim, claiming that Kim promised to hire her as an
in-store model for $1,000 per week for eight weeks. Kim denied making the
promise, and the jury was persuaded: Kim won. Jade has appealed, and now
she offers Steve as a witness. Steve will testify to the appeals court that he
saw Kim hire Jade as a model, exactly as Jade claimed. Will Jade win on
appeal?
Strategy: Before you answer, make sure you know the difference between trial
and appellate courts. What is the difference? Apply that distinction here. (See the
“Result” at the end of this section.)
3. PLEADINGS A complaint and an answer are the two most important pleadings;
that is, documents that start a lawsuit. (p. 60)
4. DISCOVERY Discovery is the critical pre-trial opportunity for both parties
to learn the strengths and weaknesses of the opponent’s case. Important forms
of discovery include interrogatories, depositions, production of documents
and objects, physical and mental examinations, and requests for admission.
(pp. 63–66)
5. MOTIONS A motion is a formal request to the court. (p. 63)
6. SUMMARY JUDGMENT Summary judgment is a ruling by the court that no
trial is necessary because there are no essential facts in dispute. (pp. 67–68)
7. JURY TRIALS Generally, both plaintiff and defendant may demand a jury in any
lawsuit for money damages. (p. 69)
8. VOIR DIRE Voir dire is the process of selecting jurors in order to obtain an
impartial panel. (p. 69)
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Question: You are a lawyer, representing the plaintiff in a case of alleged
employment discrimination. The court is selecting a jury. Based on questions you
have asked, you believe that juror number 3 is biased against your client. You
explain this to the judge, but she disagrees. Is there anything you can do?
Strategy: The question focuses on your rights during voir dire. If you believe that a
juror will not be fair, you may make two different types of challenge. What are they?
(See the “Result” at the end of this section.)
9. BURDEN OF PROOF The plaintiff’s burden of proof in a civil lawsuit is
preponderance of the evidence, meaning that its version of the facts must be at
least slightly more persuasive than the defendant’s. In a criminal prosecution,
the government must offer proof beyond a reasonable doubt in order to win a
conviction. (p. 71)
10. RULES OF EVIDENCE The rules of evidence determine what questions may
be asked during trial, what testimony may be given, and what documents may be
introduced. (p. 72)
11. VERDICTS The verdict is the jury’s decision in a case. The losing party may ask
the trial judge to overturn the verdict, seeking a JNOV or a new trial. Judges seldom
grant either. (pp. 73–74)
12. APPEALS An appeals court has many options. The court may affirm, upholding
the lower court’s decision; modify, changing the verdict but leaving the same party
victorious; reverse, transforming the loser into the winner; and/or remand, sending
the case back to the lower court. (pp. 74–75)
13. ADR Alternative dispute resolution is any formal or informal process to settle
disputes without a trial. Mediation, arbitration, and other forms of ADR are growing
in popularity. (pp. 75–77)
2. Result: Trial courts use witnesses to help resolve factual disputes. Appellate courts
review the record to see if there have been errors of law. Appellate courts never hear
witnesses, and they will not hear Steve. Jade will lose her appeal.
8. Result: You have already made a challenge for cause, claiming bias, but the judge
has rejected your challenge. If you have not used up all of your peremptory challenges, you
may use one to excuse this juror, without giving any reason.
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MULTIPLE-CHOICE QUESTIONS
1. The burden of proof in a civil trial is to prove a case . The burden of
proof rests with the .
(a) beyond a reasonable doubt; plaintiff
(b) by a preponderance of the evidence; plaintiff
(c) beyond a reasonable doubt; defendant
(d) by a preponderance of the evidence; defendant
2. Alice is suing Betty. After the discovery process, Alice believes that no relevant facts
are in dispute, and that there is no need for a trial. She should move for:
(a) a judgment on the pleadings
(b) a directed verdict
(c) a summary judgment
(d) a JNOV
3. Glen lives in Illinois. He applies for a job with a Missouri company, and he is told,
amazingly, that the job is open only to white applicants. He will now sue the Missouri
company under the Civil Rights Act, a federal statute. Can Glen sue in federal court?
(a) Yes, absolutely.
(b) Yes, but only if he seeks damages of at least $75,000. Otherwise, he must sue in a
state court.
(c) Yes, but only if the Missouri company agrees. Otherwise, he must sue in a state
court.
(d) No, absolutely not. He must sue in a state court.
4. A default judgment can be entered if which of the following is true?
(a) A plaintiff presents her evidence at trial and clearly fails to meet her burden
of proof.
(b) A defendant loses a lawsuit and does not pay a judgment within 180 days.
(c) A defendant fails to file an answer to a plaintiff’s complaint on time.
(d) A citizen fails to obey an order to appear for jury duty.
5. Barry and Carl are next-door neighbors. Barry’s dog digs under Carl’s fence and does
$500 worth of damage to Carl’s garden. Barry refuses to pay for the damage, claiming
that Carl’s cats “have been digging up my yard for years.”
The two argue repeatedly, and the relationship turns frosty. Of the following choices,
which has no outside decision maker and is most likely to allow the neighbors to
peacefully coexist after working out the dispute?
(a) Trial
(b) Arbitration
(c) Mediation
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ESSAY QUESTIONS
1. You plan to open a store in Chicago, specializing in rugs imported from Turkey.
You will work with a native Turk who will purchase and ship the rugs to your store.
You are wise enough to insist on a contract establishing the rights and obligations of
both parties and would prefer an ADR clause. But you do not want a clause that
will alienate your overseas partner. What kind of ADR clause should you include,
and why?
2. Which court(s) have jurisdiction over each of these lawsuits—state or federal? Explain
your reasoning for each answer.
• Pat wants to sue his next-door neighbor, Dorothy, claiming that Dorothy promised
to sell him the house next door.
• Paula, who lives in New York City, wants to sue Dizzy Movie Theatres, whose
principal place of business is Dallas. She claims that while she was in Texas on
holiday, she was injured by their negligent maintenance of a stairway. She claims
damages of $30,000.
• Phil lives in Tennessee. He wants to sue Dick, who lives in Ohio. Phil claims that
Dick agreed to sell him 3,000 acres of farmland in Ohio, worth over $2 million.
• Pete, incarcerated in a federal prison in Kansas, wants to sue the United States
government. He claims that his treatment by prison authorities violates three
federal statutes.
3. British discovery practice differs from that in the United States. Most discovery in
Britain concerns documents. The lawyers for the two sides, called solicitors, must
deliver to the opposing side a list of all relevant documents in their possession. Each
side may then request to look at and copy those it wishes. Depositions are rare. What
advantages and disadvantages are there to the British practice?
4. Trial practice also is dramatically different in Britain. The parties’ solicitors do not go
into court. Courtroom work is done by different lawyers, called barristers. The
barristers have very limited rights to interview witnesses before trial. They know the
substance of what each witness intends to say but do not rehearse questions and
answers, as in the United States. Which approach do you consider more effective?
More ethical? What is the purpose of a trial? Of pre-trial preparation?
5. Claus Scherer worked for Rockwell International and was paid over $300,000 per year.
Rockwell fired Scherer for alleged sexual harassment of several workers, including his
secretary, Terry Pendy. Scherer sued in United States District Court, alleging that
Rockwell’s real motive in firing him was his high salary.
Rockwell moved for summary judgment, offering deposition transcripts of various
employees. Pendy’s deposition detailed instances of harassment, including comments
about her body, instances of unwelcome touching, and discussions of extramarital
affairs. Another deposition, from a Rockwell employee who investigated the
allegations, included complaints by other employees as to Scherer’s harassment. In his
own deposition, which he offered to oppose summary judgment, Scherer testified that
he could not recall the incidents alleged by Pendy and others. He denied generally
that he had sexually harassed anyone. The district court granted summary judgment
for Rockwell. Was its ruling correct?
CHAPTER 3 Dispute Resolution 81
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DISCUSSION QUESTIONS
1. In the Tony Caruso case described throughout this
chapter, the defendant offers to settle the case at
several stages. Knowing what you do now about
litigation, would you have accepted any of the
offers? If so, which one(s)? If not, why not?
2. The burden of proof in civil cases is fairly low.
A plaintiff wins a lawsuit if he is 51 percent
convincing, and then he collects 100 percent of his
damages. Is this result reasonable? Should a
plaintiff in a civil case be required to prove his case
beyond a reasonable doubt? Or, if a plaintiff is
only 51 percent convincing, should he get only
51 percent of his damages?
3. Large numbers of employees have signed
mandatory arbitration agreements in employment
contracts. Courts usually uphold these clauses.
Imagine that you signed a contract with an
arbitration agreement, that the company later
mistreated you, and that you could not sue in
court. Would you be upset? Or would you be
relieved to go through the faster and cheaper
process of arbitration?
4. Imagine a state law that allows for residents to sue
“spammers”—those who send uninvited
commercial messages through email—for $30. One
particularly prolific spammer sends messages to
hundreds of thousands of people.
John Smith, a lawyer, signs up 100,000 people to
participate in a class-action lawsuit. According to
the agreements with his many clients, Smith will
keep one-third of any winnings. In the end, Smith
wins a $3 million verdict and pockets $1 million.
Each individual plaintiff receives a check for $20.
Is this lawsuit a reasonable use of the court’s
resources? Why or why not?
5. Higher courts are reluctant to review a lower
court’s factual findings. Should this be so? Would
appeals be fairer if appellate courts reviewed
everything?
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CHAPTER4
COMMON LAW,
STATUTORY
LAW, AND
ADMINISTRATIVE
LAW
Jason observes a toddler wander onto the railroad
tracks and hears a train approaching. He has plenty of time to pull the child from the tracks
with no risk to himself, but chooses to do nothing. The youngster is killed. The child’s family
sues Jason for his callous behavior, and a court determines that Jason owes—nothing.
“Why can’t they just fix the law?” students and professionals often ask, in response to
Jason’s impunity and countless other legal oddities. Their exasperation is understandable.
This chapter cannot guarantee intellectual tranquility, but it should diminish the sense of
bizarreness that law can instill. We will look at three sources of law: common law, statutory
law, and administrative law. Most of the law you learn in the course comes from one of
these sources. The substantive law will make more sense when you have a solid feel for
how it was created.
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4-1 COMMON LAW
Jason and the toddler present a classic legal puzzle: What, if anything, must a bystander do
when he sees someone in danger? We will examine this issue to see how the common law
works.
The common law is judge-made law. It is the sum total of all the cases decided by
appellate courts. The common law of Pennsylvania consists of all cases decided by appellate
courts in that state. The Illinois common law is made up of all of the cases decided by
Illinois appellate courts. Two hundred years ago, almost all of the law was common law.
Today, common law still predominates in tort, contract, and agency law, and it is very
important in property, employment, and some other areas.
4-1a Stare Decisis
A law course is not a law course without random Latin phrases. Stare decisis means “let the
decision stand.” It is the essence of the common law. Once a court has decided a particular
issue, it will generally apply the same rule in similar cases in the future. Suppose the highest
court of Arizona must decide whether a contract signed by a 16-year-old can be enforced
against him. The court will look to see if there is precedent; that is, whether the high court
of Arizona has already decided a similar case. The Arizona court looks and finds several
earlier cases, all holding that such contracts may not be enforced against a minor. The court
will probably apply that precedent and refuse to enforce the contract in this case. Courts do
not always follow precedent, but they generally do: stare decisis.
A desire for predictability created the doctrine of stare decisis. The value of predictability
is apparent: People must know what the law is. If contract law changed daily, an entrepre-
neur who leased factory space and then started buying machinery would be uncertain if the
factory would actually be available when she was ready to move in. Will the landlord slip out
of the lease? Will the machinery be ready on time? The law must be knowable. Yet there
must also be flexibility in the law, some means to respond to new problems and a changing
social climate. Sometimes, we are better off if we are not encumbered by ironclad rules
established before electricity was discovered. These two ideas are in conflict: The more
flexibility we permit, the less predictability we enjoy. We will watch the conflict play out in
the bystander cases.
4-1b Bystander Cases
This country inherited from England a simple rule about a bystander’s obligations: You have
no duty to assist someone in peril unless you created the danger. In Union Pacific Railway Co. v.
Cappier,1 through no fault of the railroad, a train struck a man. Railroad employees saw the
incident happen but did nothing to assist him. By the time help arrived, the victim had died.
The court held that the railroad had no duty to help the injured man:
With the humane side of the question courts are not concerned. It is the omission or negligent
discharge of legal duties only which come within the sphere of judicial cognizance. For with-
holding relief from the suffering, for failure to respond to the calls of worthy charity, or for
faltering in the bestowment of brotherly love on the unfortunate, penalties are found not in the
laws of men but in [the laws of God].
As harsh as this judgment might seem, it was an accurate statement of the law at that time
in both England and the United States: Bystanders need do nothing. Contemporary writers
found the rule inhumane and cruel, and even judges criticized it. But—stare decisis—they
Common law
Judge-made law.
166 Kan. 649, 72 P. 281 (1903).
Stare decisis
“Let the decision stand,” that is,
the ruling from a previous case.
Precedent
An earlier case that decided
the issue.
84 U N I T 1 The Legal Environment
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followed it. With a rule this old and well established, no court was willing to scuttle it. What
courts did do was seek openings for small changes.
Eighteen years after the Kansas case of Cappier, a court in nearby Iowa found the basis
for one exception. Ed Carey was a farm laborer, working for Frank Davis. While in the
fields, Carey fainted from sunstroke and remained unconscious. Davis simply hauled him to
a nearby wagon and left him in the sun for an additional four hours, causing serious
permanent injury. The court’s response:
It is unquestionably the well-settled rule that the master is under no legal duty to care for a sick or
injured servant for whose illness or injury he is not at fault. Though not unjust in principle, this
rule, if carried unflinchingly and without exception to its logical extreme, is sometimes productive
of shocking results. To avoid this criticism [we hold that where] a servant suffers serious injury, or
is suddenly stricken down in a manner indicating the immediate and emergent need of aid to
save him from death or serious harm, the master, if present is in duty bound to take such
reasonable measures as may be practicable to relieve him, even though such master be not
chargeable with fault in bringing about the emergency.2
And this is how the common law often changes: bit by tiny bit. In Iowa, a bystander
could now be liable if he was the employer and if the worker was suddenly stricken and if
it was an emergency and if the employer was present. That is a small change but an
important one.
For the next 50 years, changes in bystander law came very slowly. Consider Osterlind v.
Hill, a case from 1928.3 Osterlind rented a canoe from Hill’s boatyard, paddled into the lake,
and promptly fell into the water. For 30 minutes, he clung to the side of the canoe and
shouted for help. Hill heard the cries but did nothing; Osterlind drowned. Was Hill liable?
No, said the court: A bystander has no liability. Not until half a century later did the same
court reverse its position and begin to require assistance in extreme cases. Fifty years is a
long time for the unfortunate Osterlind to hold on.4
In the 1970s, changes came more quickly.
TARASOFF V. REGENTS OF THE UNIVERSITY
OF CALIFORNIA
17 Cal.3d 425, 551 P.2d 334, 131 Cal. Rptr. 14
Supreme Court of California, 1976
C A S E S U M M A R Y
Facts: On October 27, 1969, Prosenjit Poddar killed Tati-
ana Tarasoff. Tatiana’s parents claimed that two months
earlier Poddar had confided his intention to kill Tatiana to
Dr. Lawrence Moore, a psychologist employed by the Uni-
versity of California at Berkeley. They sued the university,
claiming that Dr. Moore should have warned Tatiana and/or
should have arranged for Poddar’s confinement.
Issue: Did Dr. Moore have a duty to Tatiana Tarasoff, and
did he breach that duty?
Decision: Yes, Dr. Moore had a duty to Tatiana Tarasoff.
Reasoning: Under the common law, one person gener-
ally owes no duty to control the conduct of another or to
warn anyone who is in danger. However, courts make an
2Carey v. Davis, 190 Iowa 720, 180 N.W. 889 (1921).
3263 Mass. 73, 160 N.E. 301 (1928).
4Pridgen v. Boston Housing Authority, 364 Mass. 696, 308 N.E.2d 467 (Mass. 1974).
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 85
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The Tarasoff exception applies when there is some special relationship, such as therapist–
patient. What if there is no such relationship? Remember the Soldano v. O’Daniels case from
Chapter 1, in which the bartender refused to call the police.
As in the earlier cases we have seen, this lawsuit presented an emergency. But the
exception created in Carey v. Davis applied only if the bystander was an employer, and that
in Tarasoff only for a doctor. In Soldano, the bystander was neither. Should the law require
him to act, that is, should it carve a new exception? Here is what the California court decided:
Many citizens simply “don’t want to get involved.” No rule should be adopted [requiring] a
citizen to open up his or her house to a stranger so that the latter may use the telephone to call for
emergency assistance. … [S]uch an action may be fraught with danger. It does not follow,
however, that use of a telephone in a public portion of a business should be refused for a
legitimate emergency call.
We conclude that the bartender owed a duty to [Soldano] to permit the patron from Happy
Jack’s to place a call to the police or to place the call himself. It bears emphasizing that the duty in
this case does not require that one must go to the aid of another. That is not the issue here. The
employee was not the good samaritan intent on aiding another. The patron was.
And so, courts have made several subtle changes to the common law rule. Let’s apply
them to the opening scenario. If the toddler’s family sues Jason, will they be successful?
Probably not.
Jason did not have a duty or a special relationship of trust with the toddler. Jason did not
stand in the way of someone else trying to call the police. He may be morally culpable for
refusing to save a life, but he will not be legally liable unless an entirely new change to the
common law occurs.
The bystander rule, that hardy oak, is alive and well. Various initials have been carved
into its bark—the exceptions we have seen and a variety of others—but the trunk is strong
and the leaves green. Perhaps someday the proliferating exceptions will topple it, but the
process of the common law is slow, and that day is nowhere in sight.
EXAM Strategy
Question: When Rachel is walking her dog, Bozo, she watches a skydiver float to
earth. He lands in an enormous tree, suspended 45 feet above ground. “Help!” the
man shouts. Rachel hurries to the tree and sees the skydiver bleeding profusely.
She takes out her cell phone to call 911 for help, but just then Bozo runs away. Rachel
darts after the dog, afraid that he will jump in a nearby pond and emerge smelling
of mud. She forgets about the skydiver and takes Bozo home. Three hours later,
the skydiver expires.
exception when the defendant has a special relationship
to a dangerous person or potential victim. A therapist is
someone who has just such a special relationship with a
patient.
It is very difficult to predict whether a patient
presents a serious danger of violence, and no one can
be expected to do a perfect job. A therapist must exercise
only the reasonable degree of skill, knowledge, and
care ordinarily possessed by others in the field. In this case,
however, there is no dispute about whether Dr. Moore
could have foreseen violence or predicted that Poddar
would kill Tatiana. Once a therapist determines, or reason-
ably should determine, that a patient poses a serious danger
of violence to someone, he must make reasonable efforts to
protect the potential victim. The Tarasoffs have stated a
legitimate claim against Dr. Moore.
86 U N I T 1 The Legal Environment
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The victim’s family sues Rachel. She defends by saying she feared that Bozo would
have an allergic reaction to mud, and that in any case she could not have climbed 45
feet up a tree to save the man. The family argues that the dog is not allergic to mud,
that even if he is, a pet’s inconvenience pales compared to human life, and that Rachel
could have phoned for emergency help without climbing an inch. Please rule.
Strategy: The family’s arguments might seem compelling, but are they relevant?
Rachel is a bystander, someone who perceives another in danger. What is the rule
concerning a bystander’s obligation to act? Apply the rule to the facts of this case.
Result: A bystander has no duty to assist someone in peril unless she created the
danger. Rachel did not create the skydiver’s predicament. She had no obligation to do
anything. Rachel wins.
4-2 STATUTORY LAW
More law is created by statute than by the courts. Statutes affect each of us every day,
in our business, professional, and personal lives. When the system works correctly, this
is the one part of the law over which “we the people” have control. We elect the
legislators who pass state statutes; we vote for the senators and representatives who
create federal statutes.
Every other November, voters in all 50 states cast ballots for members of Congress. The
winners of congressional elections convene in Washington, D.C., and create statutes. In this
section, we look at how Congress does its work creating statutes.5 Using the Civil Rights Act
as a backdrop, we will follow a bill as it makes its way through Congress and beyond.
4-2a Bills
Congress is organized into two houses, the House of Representatives and the Senate. Either
house may originate a proposed statute, that is called a bill. To become law, the bill must be
voted on and approved by both houses. Once both houses pass it, they will send it to the
President. If the President signs the bill, it becomes law and is then a statute. If the
President opposes the bill, he will veto it, in which case it is not law.6
If you visit either house of Congress, you will probably find half a dozen legislators on
the floor, with one person talking and no one listening. This is because most of the work is
done in committees. Both houses are organized into dozens of committees, each with
special functions. The House currently has about 25 committees (further divided into about
150 subcommittees), and the Senate has approximately 20 committees (with about 86
subcommittees). For example, the Armed Services Committee of each house oversees the
huge defense budget and the workings of the armed forces. Labor committees handle
legislation concerning organized labor and working conditions. Banking committees develop
expertise on financial institutions. Judiciary committees review nominees to the federal
courts. There are dozens of other committees, some very powerful, because they control
vast amounts of money, and some relatively weak. Few of us ever think about the House
Agricultural Subcommittee on Specialty Crops. But if we owned a family peanut farm, we
would pay close attention to the subcommittee’s agenda, because those members of Con-
gress would pay close attention to us.
Bill
A proposed statute, submitted
to Congress or a state
legislature.
Veto
The power of the President to
reject legislation passed by
Congress.
5State legislatures operate similarly in creating state laws.
6Congress may, however, attempt to override the veto. See the discussion following.
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 87
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When a bill is proposed in either house, it is referred to the committee that specializes
in that subject. Why are bills proposed in the first place? For any of several reasons:
• New Issue, New Worry. If society begins to focus on a new issue, Congress may
respond with legislation. We consider below, for example, the congressional response
in the 1960s to employment discrimination.
• Unpopular Judicial Ruling. If Congress disagrees with a judicial interpretation of
a statute, the legislators may pass a new statute to modify or “undo” the court
decision. For example, if the Supreme Court misinterprets a statute about musical
copyrights, Congress may pass a new law correcting the Court’s error. However,
the legislators have no such power to modify a court decision based on the
Constitution. When the Supreme Court ruled that lawyers had a right under the
First Amendment to advertise their services, Congress lacked the power to change
the decision.
• Criminal Law. Statutory law, unlike common law, is prospective. Legislators are
hoping to control the future. And that is why almost all criminal law is statutory.
A court cannot retroactively announce that it has been a crime for a retailer to accept
kickbacks from a wholesaler. Everyone must know the rules in advance because
the consequences—prison, a felony record, etc.—are so harsh.
4-2b Discrimination: Congress and the Courts
The civil rights movement of the 1950s and 1960s convinced most citizens that African
Americans suffered significant and unacceptable discrimination in jobs, housing, voting,
schools, and other basic areas of life. Demonstrations and boycotts, marches and counter-
marches, church bombings and killings persuaded the nation that the problem was vast
and urgent.
In 1963, President Kennedy proposed legislation to guarantee equal rights in these
areas. The bill went to the House Judiciary Committee, which heard testimony for
weeks. Witnesses testified that blacks were often unable to vote because of their race,
that landlords and home sellers adamantly refused to sell or rent to African Americans,
that education was grossly unequal, and that blacks were routinely denied good jobs in
many industries. Eventually, the Judiciary Committee approved the bill and sent it to
the full House.
The bill was dozens of pages long and divided into “titles,” with each title covering
a major issue. Title VII concerned employment. We will consider the progress of Title
VII in Congress and in the courts. Here is one section of Title VII, as reported to the
House floor:7
Sec. 703(a). It shall be an unlawful employment practice for an employer—to fail or refuse to hire
or to discharge any individual, or otherwise to discriminate against any individual with respect to
his compensation, terms, conditions, or privileges of employment, because of such individual’s
race, color, religion, or national origin; or
to limit, segregate, or classify his employees in any way which would deprive or tend to deprive
any individual of employment opportunities or otherwise adversely affect his status as an employee,
because of such individual’s race, color, religion, or national origin.
7The section number in the House bill was actually 704(a); we use 703 here because that is the
number of the section when the bill became law and the number to which the Supreme Court refers in
later litigation.
88 U N I T 1 The Legal Environment
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4-2c Debate
The proposed bill was intensely controversial and sparked argument throughout
Congress. Here are some excerpts from one day’s debate on the House floor, on
February 8, 1964:8
MR. WAGGONNER. I speak to you in all sincerity and ask for the right to discriminate if I so
choose because I think it is my right. I think it is my right to choose my social companions. I think
it is my right if I am a businessman to run it as I please, to do with my own as I will. I think that is
a right the Constitution gives to every man. I want the continued right to discriminate and I want
the other man to have the right to continue to discriminate against me, because I am discrimi-
nated against every day. I do not feel inferior about it.
I ask you to forget about politics, forget about everything except the integrity of the individual,
leaving to the people of this country the right to live their lives in the manner they choose to live.
Do not destroy this democracy for a Socialist government. A vote for this bill is no less.
MR. CONTE. If the serious cleavage which pitted brother against brother and citizen against
citizen during the tragedy of the Civil War is ever to be justified, it can be justified in this House
and then in the other body with the passage of this legislation which can and must reaffirm the
rights to all individuals which are inherent in our Constitution.
The distinguished poet Mark Van Doren has said that “equality is absolute or no, nothing
between can stand,” and nothing should now stand between us and the passage of strong and
effective civil rights legislation. It is to this that we are united in a strong bipartisan coalition
today, and when the laws of the land proclaim that the 88th Congress acted effectively, judi-
ciously, and wisely, we can take pride in our accomplishments as free men.
Other debate was less rhetorical and aimed more at getting information. The following
exchange anticipates a 30-year controversy on quotas:
MR. JOHANSEN. I have asked for this time to raise a question and I would ask particularly for the
attention of the gentleman from New York [Mr. Goodell] because of a remark he made—and
I am not quarreling with it. I understood him to say there is no plan for balanced employment or
for quotas in this legislation I am raising a question as to whether in the effort to eliminate
discrimination—and incidentally that is an undefined term in the bill—we may get to a situation
in which employers and conceivably union leaders, will insist on legislation providing for a quota
system as a matter of self-protection.
Now let us suppose this hypothetical situation exists with 100 jobs to be filled. Let us say
150 persons apply and suppose 75 of them are Negro and 75 of them are white. Supposing the
employer hires 75 white men. [Does anyone] have a right to claim they have been discriminated
against on the basis of color?
MR. GOODELL. It is the intention of the legislation that if applicants are equal in all other
respects there will be no restriction. One may choose from among equals. So long as there is no
distinction on the basis of race, creed, or color it will not violate the act.
The debate on racial issues carried on. Later in the day, Congressman Smith of Virginia
offered an amendment that could scarcely have been smaller—or more important:
Amendment offered by Mr. Smith of Virginia: On page 68, line 23, after the word “religion,”
insert the word “sex.”
In other words, Smith was asking that discrimination on the basis of sex also be
outlawed, along with the existing grounds of race, color, national origin, and religion.
Congressman Smith’s proposal produced the following comments:
8The order of speakers is rearranged, and the remarks are edited.
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 89
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MR. CELLER. You know, the French have a phrase for it when they speak of women and
men. They say “vive la différence.” I think the French are right. Imagine the upheaval that
would result from adoption of blanket language requiring total equality. Would male citizens
be justified in insisting that women share with them the burdens of compulsory military
service? What would become of traditional family relationships? What about alimony? What
would become of the crimes of rape and statutory rape? I think the amendment seems
illogical, ill timed, ill placed, and improper.
MRS. ST. GEORGE. Mr. Chairman, I was somewhat amazed when I came on the floor this
afternoon to hear the very distinguished chairman of the Committee on the Judiciary [Mr. Celler]
make the remark that he considered the amendment at this point illogical. I can think of nothing
more logical than this amendment at this point.
There are still many States where women cannot serve on juries. There are still many States
where women do not have equal educational opportunities. In most States and, in fact, I figure it
would be safe to say, in all States—women do not get equal pay for equal work. That is a very
well known fact. And to say that this is illogical. What is illogical about it? All you are doing is
simply correcting something that goes back, frankly to the Dark Ages.
The debate continued. Some supported the “sex” amendment because they were
determined to end sexual bias. But politics are complex. Some opponents of civil rights
supported the amendment because they believed that it would make the legislation less
popular and cause Congress to defeat the entire Civil Rights bill.
That strategy did not work. The amendment passed, and sex was added as a protected
trait. And, after more debate and several votes, the entire bill passed the House. It went to
the Senate, where it followed a similar route from the Judiciary Committee to the full
Senate. Much of the Senate debate was similar to what we have seen. But some senators
raised a new issue, concerning §703(2), which prohibited segregating or classifying employ-
ees based on any of the protected categories (race, color, national origin, religion, or sex).
Senator Tower was concerned that §703(2) meant that an employee in a protected
category could never be given any sort of job test. So the Senate amended §703 to include
a new subsection:
Sec. 703(h). Notwithstanding any other provision of this title, it shall not be an unlawful employ-
ment practice for an employer … to give and to act upon the results of any professionally
developed ability test provided that such test is not designed, intended or used to discriminate
because of race, color, religion, sex or national origin.
With that amendment, and many others, the bill passed the Senate.
CONFERENCE COMMITTEE
Civil rights legislation had now passed both houses, but the bills were no longer the same
due to the many amendments. This is true with most legislation. The next step is for the
two houses to send representatives to a House-Senate Conference Committee. This
committee examines all of the differences between the two bills and tries to reach a
compromise. With the Civil Rights bill, Senator Tower’s amendment was left in; other
Senate amendments were taken out. When the Conference Committee had settled every
difference between the two versions, the new, modified bill was sent back to each house
for a new vote.
The House of Representatives and the Senate again angrily debated the compromise
language reported from the Conference Committee. Finally, after years of violent public demon-
strations and months of debate, each house passed the same bill. President Johnson promptly
signed it. The Civil Rights Act of 1964 was law. See Exhibit 4.1.
90 U N I T 1 The Legal Environment
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But the passing of a statute is not always the end of the story. Sometimes courts must
interpret congressional language and intent.
4-2d Statutory Interpretation
Title VII of the Civil Rights Act obviously prohibited an employer from saying to a job
applicant, “We don’t hire minorities.” In some parts of the country, that had been common
practice; after the Civil Rights Act passed, it became rare. Employers who routinely hired
whites only, or promoted only whites, found themselves losing lawsuits. A new group of
cases arose, those in which some job standard was set that appeared to be racially neutral,
yet had a discriminatory effect. In North Carolina, the Duke Power Co. required that
applicants for higher paying, promotional positions meet two requirements: They must
have a high school diploma and they must pass a standardized written test. There was no
evidence that either requirement related to successful job performance. Blacks met the
President
House of
Representatives
Conference
Committee
Senate
Banking,
Finance &
Urban Affairs
Education
and Labor
Judiciary
Committee
Armed
Services Agriculture
Ways and
Means
Judiciary
Committee
Armed
Services
Foreign
Relations
Appropriation
Aeronautical
& Space
Sciences
1
2
3
4
5 5
6 7
8
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EXHIB IT 4 .1 The two houses of Congress are organized into dozens of committees, a few of which are shown
here. The path of the 1964 Civil Rights Act (somewhat simplified) was as follows: [1] The House
Judiciary Committee approved the bill and sent it to the full House; [2] the full House passed the bill
and sent it to the Senate, where it was assigned to the Senate Judiciary Committee; [3] the Senate
Judiciary Committee passed an amended version of the bill and sent it to the full Senate; [4] the full
Senate passed the bill with additional amendments. Since the Senate version was now different from
the bill the House passed, the bill went to a Conference Committee. The Conference Committee
[5] reached a compromise and sent the new version of the bill back to both houses. Each house
passed the compromise bill (6 and 7) and sent it to the President, who signed it into law (8).
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 91
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requirements in lower percentages than whites, and consequently whites obtained a dis-
proportionate share of the good jobs.
Title VII did not precisely address this kind of case. It clearly outlawed overt discrimi-
nation. Was Duke Power’s policy overt discrimination, or was it protected by Senator
Tower’s amendment, §703(h)? The case went all the way to the Supreme Court, where
the Court had to interpret the new law.
Courts are often called upon to interpret a statute, that is, to explain precisely what the
language means and how it applies in a given case. There are three primary steps in a court’s
statutory interpretation:
• Plain Meaning Rule. When a statute’s words have ordinary, everyday significance,
the court will simply apply those words. Section 703(a)(1) of the Civil Rights Act
prohibits firing someone because of her religion. Could an employer who had fired a
Catholic because of her religion argue that Catholicism is not really a religion, but
more of a social group? No. The word “religion” has a plain meaning, and courts
apply its commonsense definition.
• Legislative History and Intent. If the language is unclear, the court must look deeper.
Section 703(a)(2) prohibits classifying employees in ways that are discriminatory. Does
that section prevent an employer from requiring high school diplomas, as Duke Power
did? The explicit language of the statute does not answer the question. The court will
look at the law’s history to determine the intent of the legislature. The court will
examine committee hearings, reports, and the floor debates that we have seen.
• Public Policy. If the legislative history is unclear, courts will rely on general public
policies, such as reducing crime, creating equal opportunity, and so forth. They may
include in this examination some of their own prior decisions. Courts assume that the
legislature is aware of prior judicial decisions, and if the legislature did not change
those decisions, the statute will be interpreted to incorporate them.
Here is how the Supreme Court interpreted the 1964 Civil Rights Act.
Landmark Case
Facts: See the discussion
of the Duke Power Com-
pany’s job requirements
in the “Statutory Interpre-
tation” section above.
Issue: Did Title VII of
the 1964 Civil Rights Act
require that employment
tests be job-related?
Decision: Yes, employ-
ment tests must be job-related.
Reasoning: Congress’s goal in enacting Title VII is plain
from its language: to achieve equality of opportunity and
remove barriers that have favored whites. An employer may
not use any practice, proce-
dure, or test that perpetu-
ates discrimination. This is
true not only for overtly
discriminatory behavior but
also for conduct that appears
fair yet has a discriminatory
effect. The key is business
necessity. An employment
test or restriction that
excludes blacks is prohibited unless it is required to do the
particular job. In this case, neither the high school completion
requirement nor the general intelligence test is related to job
performance, and therefore neither is permissible.
GRIGGS V. DUKE POWER CO.
401 U.S. 424, 91 S. Ct. 849, 1971 U.S. LEXIS 134
United States Supreme Court, 1971
C A S E S U M M A R Y
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And so the highest Court ruled that if a job requirement had a discriminatory impact,
the employer could use that requirement only if it was related to job performance. Many
more cases arose. For almost two decades courts held that, once workers showed that a job
requirement had a discriminatory effect, the employer had the burden to prove that the
requirement was necessary for the business. The requirement had to be essential to achieve
an important goal. If there was any way to achieve that goal without discriminatory impact,
the employer had to use it.
4-2e Changing Times
But things changed. In 1989, a more conservative Supreme Court decided Wards Cove
Packing Co. v. Atonio.9 The plaintiffs were nonwhite workers in salmon canneries in Alaska.
The canneries had two types of jobs: skilled and unskilled. Nonwhites (Filipinos and Alaska
Natives) invariably worked as low-paid, unskilled workers, canning the fish. The higher
paid, skilled positions were filled almost entirely with white workers, who were hired during
the off-season in Washington and Oregon.
There was no overt discrimination. But plaintiffs claimed that various practices led to
the racial imbalances. The practices included failing to promote from within the company,
hiring through separate channels (cannery jobs were done through a union hall, skilled
positions were filled out of state), nepotism, and an English language requirement. Once
again the case reached the Supreme Court, where Justice White wrote the Court’s opinion.
If the plaintiffs succeeded in showing that the job requirements led to racial imbalance,
said the Court, the employer now only had to demonstrate that the requirement or practice
“serves, in a significant way, the legitimate employment goals of the employer [T]here is no
requirement that the challenged practice be ‘essential’ or ‘indispensable’ to the employer’s
business.” In other words, the Court removed the “business necessity” requirement of
Griggs and replaced it with “legitimate employment goals.”
4-2f Voters’ Role
The response to Wards Cove was quick. Liberals decried it; conservatives hailed it.
Everyone agreed that it was a major change that would make it substantially harder for
plaintiffs to bring successful discrimination cases. Democrats introduced bills to reverse
the interpretation of Wards Cove. President George H. W. Bush strongly opposed any
new bill. He said it would lead to “quotas,” that is, that employers would feel obligated
to hire a certain percentage of workers from all racial categories to protect themselves
from suits. This was the issue that Congressman Johansen had raised in the original
House debate in 1964.
Both houses passed bills restoring the “business necessity” holding of Griggs. Again there
were differences, and a Conference Committee resolved them. After acrimonious debate,
both houses passed the compromise bill in October 1990. Was it therefore law? No. President
Bush immediately vetoed the bill. He said it would compel employers to adopt quotas.
4-2g Congressional Override
When the President vetoes a bill, Congress has one last chance to make it law: an override.
If both houses repass the bill, each by a two-thirds margin, it becomes law over the
President’s veto. Congress attempted to pass the 1990 Civil Rights bill over the Bush veto,
but it fell short in the Senate by one vote.
9490 U.S. 642, 109 S. Ct. 2115, 1989 U.S. LEXIS 2794 (1989).
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 93
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Civil rights advocates tried again, in January 1991, introducing a new bill to reverse the
Wards Cove rule. Again both houses debated and bargained. The new bill stated that, once
an employee proves that a particular employment practice causes a discriminatory impact,
the employer must “demonstrate that the challenged practice is job related for the position
in question and consistent with business necessity.”
Now the two sides fought over the exact meanings of two terms: “job related” and
“business necessity.” Each side offered definitions, but they could not reach agreement. It
appeared that the entire bill would founder over those terms. So Congress did what it often
does when faced with a problem of definition: It dropped the issue. Liberals and conserva-
tives agreed not to define the troublesome terms. They would leave that task to courts to
perform through statutory interpretation.
With the definitions left out, the new bill passed both houses. In November 1991,
President Bush signed the bill into law. The President stated that the new bill had
been improved and no longer threatened to create racial quotas. His opponents
charged he had reversed course for political reasons, anticipating the 1992 presidential
election.
And so, the Congress restored the “business necessity” interpretation to its own 1964
Civil Rights Act. No one would say, however, that it had been a simple process.
EXAM Strategy
Question: Kelly Hackworth took a leave of absence from her job at Progressive
Insurance to care for her ailing mother. When she offered to return, Progressive
refused to give her the same job or one like it. She sued based on the Family
Medical Leave Act, a federal statute that requires firms to give workers
returning from family leave their original job or an equivalent one. However, the
statute excludes from its coverage workers whose company employs “fewer than
50 people within 75 miles” of the worker’s jobsite. Between Ms. Hackworth’s
jobsite in Norman, Oklahoma, and the company’s Oklahoma City workplace
(less than 75 miles away), Progressive employed 47 people. At its Lawton,
Oklahoma facility, Progressive employed three more people—but Lawton was
75.6 miles (wouldn’t you know it) away from Norman. Progressive argued
that the job was not covered by the statute. Hackworth claimed that this
distance should be considered “within 75 miles,” thereby rendering her eligible
for FMLA leave. Even if it were not, she urged, it would be absurd to disqualify her
from important rights based on a disparity of six-tenths of a mile. Please rule.
Strategy: The question asks you to interpret a statute. How do courts do that? There
are three steps: the plain meaning rule; legislative history; and public policy. Apply
those steps to these facts.
Result: In this real case, the court ruled that the plain meaning of “within 75 miles”
was 75 miles or less. Lawton was not 75 miles or less from Norman. The statute did not
apply and Ms. Hackworth lost.10
10Hackworth v. Progressive Casualty Ins. Co., 468 F.3d 722 (10th Cir. 2006).
94 U N I T 1 The Legal Environment
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4-3 ADMINISTRATIVE LAW
Before beginning this section, please return your seat to its upright position. Stow the tray
firmly in the seatback in front of you. Turn off any laptops, cell phones, or other electronic
devices. Sound familiar? Administrative agencies affect each
of us every day in hundreds of ways. They have become the
fourth branch of government. Supporters believe that they
provide unique expertise in complex areas; detractors regard
them as unelected government run amok.
Many administrative agencies are familiar. The Fed-
eral Aviation Administration, which requires all airlines to
ensure that your seats are upright before takeoff and land-
ing, is an administrative agency. The Internal Revenue
Service expects to hear from us every April 15. The En-
vironmental Protection Agency regulates the water quality of
the river in your town. The Federal Trade Commission over-
sees the commercials that shout at you from your television set.
Other agencies are less familiar. You may never have
heard of the Bureau of Land Management, but if you go
into the oil and gas industry, you will learn that this power-
ful agency has more control over your land than you do. If you develop real estate in Palos
Hills, Illinois, you will tremble every time the Appearance Commission of the City of Palos
Hills speaks, since you cannot construct a new building without its approval. If your soft-
ware corporation wants to hire an Argentine expert on databases, you will get to know the
complex workings of Immigration and Customs Enforcement: No one lawfully enters this
country without its nod of approval.
4-3a Background
By the 1880s, trains crisscrossed America. But this technological miracle became an eco-
nomic headache. Congress worried that the railroads’ economic muscle enabled a few
powerful corporations to reap unfair profits. The railroad industry needed closer regulation.
Who would do it? Courts decide individual cases; they do not regulate industries. Congress
itself passes statutes, but it has no personnel to oversee the day-to-day working of a huge
industry. For example, Congress lacks the expertise to establish rates for freight passing
from Kansas City to Chicago, and it has no personnel to enforce rates once they are set.
A new entity was needed. Congress passed the Interstate Commerce Act, creating the
Interstate Commerce Commission (ICC), the first administrative agency. The ICC began
regulating freight and passenger transportation over the growing rail system and continued
to do so for over 100 years. Congress gave the ICC power to regulate rates and investigate
harmful practices, to hold hearings, issue orders, and punish railroads that did not comply.
The ICC was able to hire and develop a staff that was expert in the issues that Congress
wanted controlled. The agency had enough flexibility to deal with the problems in a variety
of ways: by regulating, investigating, and punishing. And that is what has made adminis-
trative agencies an attractive solution for Congress: One entity, focusing on one industry,
can combine expertise and flexibility. However, the ICC also developed great power, which
voters could not reach, and thereby started the great and lasting conflict over the role
of agencies.
During the Great Depression of the 1930s, the Roosevelt administration and Congress
created dozens of new agencies. Many were based on social demands, such as the need of
the elderly population for a secure income. Political and social conditions dominated again
Before beginning this
section, please return
your seat to its upright
position. Stow the tray
firmly in the seatback in
front of you.
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 95
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in the 1960s, as Congress created agencies, such as the Equal Employment Opportunity
Commission, to combat discrimination.
Then during the 1980s, the Reagan administration made an effort to decrease the number
and strength of the agencies. For several years some agencies declined in influence, though
others did not. Today, there is still controversy about how much power agencies should have.
4-3b Classification of Agencies
Agencies exist at the federal, state, and local level. We will focus on federal agencies
because they have national impact and great power. Most of the principles discussed apply
to state and local agencies as well. Virtually any business or profession you choose to work in
will be regulated by at least one administrative agency, and it may be regulated by several.
EXECUTIVE-INDEPENDENT
Some federal agencies are part of the executive branch, while others are independent
agencies. This is a major distinction. The President has much greater control of executive
agencies for the simple reason that he can fire the agency head at any time. An executive
agency will seldom diverge far from the President’s preferred policies. Some familiar
executive agencies are the Internal Revenue Service (part of the Treasury Department);
the Federal Bureau of Investigation (Department of Justice); the Food and Drug Admin-
istration (Department of Health and Human Services); and the Nuclear Regulatory Com-
mission (Department of Energy).
The President has no such removal power over independent agencies. The Federal
Communications Commission (FCC) is an independent agency. For many corporations
involved in broadcasting, the FCC has more day-to-day influence on their business than
Congress, the courts, and the President combined. Other powerful independent agencies
are the Federal Trade Commission, the Securities and Exchange Commission, the National
Labor Relations Board, and the Environmental Protection Agency.
ENABLING LEGISLATION
Congress creates a federal agency by passing enabling legislation. The Interstate Commerce
Act was the enabling legislation that established the ICC. Typically, the enabling legislation
describes the problems that Congress believes need regulation, establishes an agency to do
it, and defines the agency’s powers.
Critics argue that Congress is delegating to another body powers that only the legislature
or courts are supposed to exercise. This puts administrative agencies above the voters. But
legal attacks on administrative agencies have consistently failed for several decades. Courts
acknowledge that agencies have become an integral part of a complex economy, and so long
as there are some limits on an agency’s discretion, courts will generally uphold its powers.
4-4 POWER OF AGENCIES
Administrative agencies use three kinds of power to do the work assigned to them: They
make rules, they investigate, and they adjudicate.
4-4a Rulemaking
One of the most important functions of an administrative agency is to make rules. In making
rules, the agency attempts, prospectively, to establish fair and uniform behavior for all
businesses in the affected area. To create a new rule is to promulgate it. Agencies promul-
gate two types of rules: legislative and interpretive.
Enabling legislation
Laws passed by Congress that
establish federal agencies and
define their powers.
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TYPES OF RULES: LEGISLATIVE AND INTERPRETIVE
Legislative rules are the most important agency rules, and they are much like statutes. Here,
an agency creates law by requiring businesses or private citizens to act in a certain way.
Suppose you operate a website for young shoppers, aged 10 to 18. Like most online
merchants, you consider yourself free to collect as much data as possible about consumers.
Wrong. The Federal Trade Commission, a federal agency, has promulgated detailed rules
governing any site directed to young children. Before obtaining private data from these
immature consumers, you must let them know exactly who you are, how to contact site
operators, precisely what you are seeking, and how it will be used. You must also obtain
verifiable parental consent before collecting, using, or disclosing any personal information.
Failure to follow the rules can result in a substantial civil penalty. This modest legislative
rule, in short, will be more important to your business than most statutes passed by
Congress.
Interpretive rules do not change the law. They are the agency’s interpretation of what
the law already requires. But they can still affect all of us. For example, in 1977, Congress
amended the Clean Air Act in an attempt to reduce pollution from factories. The act
required the Environmental Protection Agency (EPA) to impose emission standards on
“stationary sources” of pollution. But what did “stationary source” mean? It was the EPA’s
job to define that term. Obscure work, to be sure, yet the results could be seen and even
smelled, because the EPA’s definition would determine the quality of air entering our lungs
every time we breathe. Environmentalists wanted the term defined to include every
smokestack in a factory so that the EPA could regulate each one. The EPA, however,
developed the “bubble concept,” ruling that “stationary source” meant an entire factory,
but not the individual smokestacks. As a result, polluters could shift emission among
smokestacks in a single factory to avoid EPA regulation. Environmentalists howled that
this interpretation gutted the purpose of the statute, but to no avail. The agency had
spoken, merely by interpreting a statute.11
HOW RULES ARE MADE
Corporations fight many a court battle over whether an agency has the right to issue a
particular rule and whether it was promulgated properly. The critical issue is this: How
much participation is the public entitled to before an agency issues a rule? There are two
basic methods of rulemaking.12
Informal Rulemaking On many issues, agencies may use a simple “notice and com-
ment” method of rulemaking. The agency must publish a proposed rule in advance and
permit the public a comment period. During this period, the public may submit any
objections and arguments, with supporting data. The agency will make its decision and
publish the final rule.
For example, the Department of Transportation may use the informal rulemaking
procedure to require safety features for all new automobiles. The agency must listen to
objections from interested parties, notably car manufacturers, and it must give a written
response to the objections. The agency is required to have rational reasons for the final
choices it makes. However, it is not obligated to satisfy all parties or do their bidding.
Formal Rulemaking In the enabling legislation, Congress may require that an agency
hold a hearing before promulgating rules. Congress does this to make the agency more
accountable to the public. After the agency publishes its proposed rule, it must hold a public
11An agency’s interpretation can be challenged in court, and this one was.
12Certain rules may be made with no public participation at all. For example, an agency’s internal
business affairs and procedures can be regulated without public comment, as can its general policy
statements. None of these directly affect the public, and the public has no right to participate.
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 97
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hearing. Opponents of the rule, typically affected businesses, may cross-examine the agency
experts about the need for the rule and may testify against it. When the agency makes its
final decision about the rule, it must prepare a formal, written response to everything that
occurred at the hearing.
When used responsibly, these hearings give the public access to the agency and can
help formulate sound policy. When used irresponsibly, hearings can be manipulated to
stymie needed regulation. The most famous example concerns peanut butter. The Food
and Drug Administration (FDA) began investigating peanut butter content in 1958. It
found, for example, that Jif peanut butter, made by Procter & Gamble (P&G), had only
75 percent peanuts and 20 percent of a Crisco-type base. P&G fought the investigation, and
any changes, for years. Finally, in 1965, the FDA proposed a minimum of 90 percent
peanuts in peanut butter; P&G wanted 87 percent. The FDA wanted no more than 3
percent hydrogenated vegetable oil; P&G wanted no limit.
The hearings dragged on for months. One day, the P&G lawyer objected to the
hearing going forward because he needed to vote that day. Another time, when an FDA
official testified that consumer letters indicated the public wanted to know what was really
in peanut butter, the P&G attorney demanded that the official bring in and identify the
letters—all 20,000 of them. Finally, in 1968, a decade after beginning its investigation,
the FDA promulgated final rules requiring 90 percent peanuts but eliminating the
3 percent cap on vegetable oil.13
4-4b Investigation
Agencies do a wide variety of work, but they all need broad factual knowledge of the field
they govern. Some companies cooperate with an agency, furnishing information and even
voluntarily accepting agency recommendations. For example, the U.S. Consumer Product
Safety Commission investigates hundreds of consumer products every year and frequently
urges companies to recall goods that the agency considers defective. Many firms comply.
Other companies, however, jealously guard information, often because corporate offi-
cers believe that disclosure would lead to adverse rules. To force disclosure, agencies use
subpoenas and searches.
SUBPOENAS
A subpoena is an order to appear at a particular time and place to provide evidence. A
subpoena duces tecum requires the person to appear and bring specified documents. Busi-
nesses and other organizations intensely dislike subpoenas and resent government agents
plowing through records and questioning employees. What are the limits on an agency’s
investigation? The information sought:
• Must be relevant to a lawful agency investigation. The FCC is clearly empowered to
investigate the safety of broadcasting towers, and any documents about tower construction
are obviously relevant. Documents about employee racial statistics might indicate
discrimination, but the FCC lacks jurisdiction on that issue and thus may not demand such
documents.
• Must not be unreasonably burdensome. A court will compare the agency’s need for the
information with the intrusion on the corporation.
• Must not be privileged. The Fifth Amendment privilege against self-incrimination means
that a corporate officer accused of criminal securities violations may not be compelled to
testify about his behavior.
Subpoena
An order to appear at a
particular place and time. A
subpoena duces tecum
requires the person to produce
certain documents or things.
13For an excellent account of this high-fat hearing, see Mark J. Green, The Other Government
(New York: W. W. Norton & Co., 1978), pp. 136–150.
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Search and Seizure At times an agency will want to conduct a surprise search of an
enterprise and seize any evidence of wrongdoing. May an agency do that? Yes, although
there are limitations. When a particular industry is comprehensively regulated, courts will
assume that companies know they are subject to periodic, unannounced inspections. In
those industries, an administrative agency may conduct a search without a warrant and seize
evidence of violations. For example, the mining industry is minutely regulated, with strict
rules covering equipment, mining depths, and air quality. Mining executives understand
that they are closely watched. Accordingly, the Bureau of Mines may make unannounced,
warrantless searches to ensure safety.14
The following case established many of the principles just described.
4-4c Adjudication
To adjudicate a case is to hold a hearing about an issue and then decide it. Agencies
adjudicate countless cases. The FCC adjudicates which applicant for a new television
license is best qualified. The Occupational Safety and Health Administration (OSHA) holds
adversarial hearings to determine whether a manufacturing plant is dangerous.
Landmark Case
Facts: Biswell’spawnshop
had a license to sell “sport-
ing weapons.” Treasury
agentsdemanded to inspect
his locked storeroom with-
out a warrant, claiming that
the Gun Control Act of
1968 gave them that right.
Under this law, Treasury
agents had permission to
inspect firearm dealers’ business records, firearms, and ammuni-
tion during business hours.
Biswell voluntarily opened the storeroom, where an
agent found two sawed-off rifles. Because these guns did
not remotely meet the definition of “sporting weapons,”
Biswell was convicted on firearms charges.
The appellate court found that, because the search
violated the Fourth Amendment, the rifles could not be
admitted as evidence. It reversed the conviction, and the
government appealed to the Supreme Court.
Issue: Did the agent’s warrantless search violate the
Constitution?
Decision: No, the agent had a right to search the firearm
dealer’s premises without a warrant.
Reasoning: The Gun
Control Act of 1968 was a
valid statute aimed at regu-
lating firearms and prevent-
ing violent crime. As part of
this effort, it gave the
Treasury agents the right
to perform frequent and
unannounced inspections
of firearm dealers’ pre-
mises. What good is a firearm inspection that is announced
ahead of time? A warrant requirement would certainly frus-
trate the statute’s purpose of controlling illegal guns.
Warrants protect an individual’s expectation of privacy.
Biswell had no justifiable expectation of privacy in his store-
room, since he, like all firearms dealers, knew that his business
records, firearms, and ammunition were subject to inspection.
Biswell accepted these rules when he obtained his license.
Also he received annual reminders.
Since inspections furthered the Gun Control Act’s
important purpose and Biswell could not reasonably
expect his storeroom to be private, the seizure of the
sawed-off rifles was permissible. They should have been
admitted into evidence.
Adjudicate
To hold a formal hearing about
an issue and then decide it.
14Donovan v. Dewey, 452 U.S. 594, 101 S. Ct. 2534, 1980 U.S. LEXIS 58 (1981).
UNITED STATES V. BISWELL
406 U.S. 311
United States Supreme Court, 1972
C A S E S U M M A R Y
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 99
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Most adjudications begin with a hearing before an administrative law judge (ALJ).
There is no jury. An ALJ is an employee of the agency but is expected to be impartial in
her rulings. All parties are represented by counsel. The rules of evidence are informal, and
an ALJ may receive any testimony or documents that will help resolve the dispute.
After all evidence is taken, the ALJ makes a decision. The losing party has a right to
appeal to an appellate board within the agency. The appellate board may ignore the ALJ’s
decision. If it does not, an unhappy party may appeal to federal court.
4-5 LIMITS ON AGENCY POWER
There are four primary methods of reining in these powerful creatures: statutory, political,
judicial, and informational.
4-5a Statutory Control
As discussed, the enabling legislation of an agency provides some limits. It may require that
the agency use formal rulemaking or investigate only certain issues. The Administrative
Procedure Act imposes additional controls by requiring basic fairness in areas not regulated
by the enabling legislation.
4-5b Political Control
The President’s influence is greatest with executive agencies. Congress, though, “controls
the purse.” No agency, executive or independent, can spend money it does not have. An
agency that angers Congress risks having a particular program defunded or its entire budget
cut. Further, Congress may decide to defund an agency as a cost-cutting measure. In its
effort to balance the budget, Congress abolished the Interstate Commerce Commission,
transferring its functions to the Transportation Department.
Congress has additional control because it must approve presidential nominees to head
agencies. Before approving a nominee, Congress will attempt to determine her intentions.
And, finally, Congress may amend an agency’s enabling legislation, limiting its power.
4-5c Judicial Review
An individual or corporation directly harmed by an administrative rule, investigation, or
adjudication may generally have that action reviewed in federal court.15 The party seeking
review, for example, a corporation, must have suffered direct harm; the courts will not listen
to theoretical complaints about an agency action.16 And that party must first have taken all
possible appeals within the agency itself.17
Administrative law judge
(ALJ)
An agency employee who acts
as an impartial decision maker.
15In two narrow groups of cases, a court may not review an agency action. In a few cases, courts hold
that a decision is “committed to agency discretion,” a formal way of saying that courts will keep hands
off. This result occurs only with politically sensitive issues, such as international air routes. In some
cases, the enabling legislation makes it absolutely clear that Congress wanted no court to review
certain decisions. Courts will honor that.
16The law describes this requirement by saying that a party must have standing to bring a case. A
college student who has a theoretical belief that the EPA should not interfere with the timber industry
has no standing to challenge an EPA rule that prohibits logging in a national forest. A lumber company
that was ready to log that area has suffered a direct economic injury: It has standing to sue.
17This is the doctrine of exhaustion of remedies. A lumber company may not go into court the day after the
EPA publishes a proposed ban on logging. It must first exhaust its administrative remedies by participating
in the administrative hearing and then pursuing appeals within the agency before venturing into court.
100 U N I T 1 The Legal Environment
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STANDARD ON REVIEW
Suppose OSHA promulgates a new rule limiting the noise level within steel mills.
Certain mill operators are furious because they will have to retool their mills in order
to comply. After exhausting their administrative appeals, they file suit seeking to force
OSHA to withdraw the new rule. How does a court decide the case? Or, in legal terms,
what standard does a court use in reviewing the case? Does it simply substitute its own
opinion for that of the agency? No, it does not. The standard a court uses must take
into account:
Facts Courts generally defer to an agency’s fact finding. If OSHA finds that human
hearing starts to suffer when decibels reach a particular level, a court will probably accept
that as final. The agency is presumed to have expertise on such subjects. As long as there is
substantial evidence to support the fact decision, it will be respected.
Law Courts often—but not always—defer to an agency’s interpretation of the law.
This is due in part to the enormous range of subjects that administrative agencies
monitor. Consider the following example. “Chicken catchers” work in large poultry
operations, entering coops, manually capturing broilers, loading them into cages, and
driving them to a processing plant, where they … well, never mind. On one farm, the
catchers wanted to organize a union, but the company objected, pointing out that
agricultural workers had no right to do so. Were chicken catchers “agricultural workers”?
The National Labor Relations Board, an administrative agency, declared that chicken
catchers were in fact ordinary workers, entitled to organize. The Supreme Court ruled
that courts were obligated to give deference to the agency’s decision about chicken
catchers. If the agency’s interpretation was reasonable, it was binding, even if the court
itself might not have made the same analysis. The workers were permitted to form a
union—though the chickens were not.
In the following case, however, the Supreme Court disagreed with the FCC’s standards
about profanity on TV. The high court ruled that these standards were too vague to be
enforceable. The case contains vulgar language, so please do not read it.
FEDERAL COMMUNICATIONS COMMISSION V. FOX
TELEVISION STATIONS, INC.
132 S. Ct. 2307
United States Supreme Court, 2012
C A S E S U M M A R Y
Facts: “People have been telling me I’m on the way out
every year, right? So f*** ’em,” said Cher, on a televised
BillboardMusic Awards ceremony. A year later, on the same
program, Nicole Richie asked, “Have you ever tried to get
cow s*** out of a Prada purse? It’s not so f****** simple.”
U.S. law bans the broadcast of “any obscene, inde-
cent, or profane language.” The Federal Communications
Commission (FCC), which regulates the broadcast indus-
try, had issued guidelines indicating that the utterance of
an isolated vulgarity was acceptable so long as it was not
repeated at length. After Nicole Richie explained the
difficulties of cleaning a Prada purse, the FCC declared
a more stringent indecency policy. This stricter standard
made a single fleeting expletive punishable if the word
was, “patently offensive.” But the FCC failed to give a
clear definition of the term, and it enforced the new rule
unevenly. For example, it allowed bad language during
news interviews and films, but condemned the same
words in other contexts.
When the FCC found that Fox had violated the
agency’s standards by broadcasting Cher and Nicole
Richie’s three words, Fox argued that the new policy
was too vague and arbitrary. The appeals court agreed
with Fox. The Supreme Court granted certiorari.
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 101
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4-5d Informational Control and the Public
We started this section describing the pervasiveness of administrative agencies. We should
end it by noting one way in which all of us have some direct control over these ubiquitous
authorities: information.
A popular government, without popular information, or the means of acquiring it, is but a
Prologue to a Farce or a Tragedy—or perhaps both. Knowledge will forever govern ignorance,
and a people who mean to be their own Governors must arm themselves with the power which
knowledge gives.
James Madison, President, 1809–1817
Two federal statutes arm us with the power of knowledge.
FREEDOM OF INFORMATION ACT
Congress passed the landmark Freedom of Information Act (known as “FOIA”) in 1966. It
is designed to give all of us, citizens, businesses, and organizations alike, access to the
information that federal agencies are using. The idea is to avoid government by secrecy.
Any citizen or executive may make a “FOIA request” to any federal government
agency. It is simply a written request that the agency furnish whatever information
it has on the subject specified. Two types of data are available under FOIA. Anyone is
entitled to information about how the agency operates, how it spends its money, and
what statistics and other information it has collected on a given subject. People routinely obtain
records about agency policies, environmental hazards, consumer product safety, taxes and
spending, purchasing decisions, and agency forays into foreign affairs. A corporation that believes
that OSHA is making more inspections of its textile mills than it makes of the competition could
demand all relevant information, including OSHA’s documents on the mill itself, comparative
statistics on different inspections, OSHA’s policies on choosing inspection sites, and so forth.
Second, all citizens are entitled to any records the government has about them. You are
entitled to information that the Internal Revenue Service, or the Federal Bureau of
Investigation, has collected about you.
FOIA does not apply to Congress, the federal courts, or the executive staff at the White
House. Note also that, since FOIA applies to federal government agencies, you may not use
it to obtain information from state or local governments or private businesses.
Exemptions An agency officially has 10 days to respond to the request. In reality, most
agencies are unable to meet the deadline but are obligated to make good faith efforts. FOIA
exempts altogether nine categories from disclosure. The most important exemptions permit
Issue: Was the FCC’s indecency policy unacceptably vague
and arbitrary?
Decision: Yes, the FCC had failed to give broadcasters
fair notice of what kind of conduct could be punished.
And it did not apply the rules equally to everyone.
Reasoning: The FCC has the right to set and change its
policies. However, laws must provide a person of ordinary
intelligence with reasonable notice of what behavior is
prohibited. How could Fox have known that a fleeting
F-word on live TV was forbidden when at other times
such words were not? It could not and it did not.
Clear rules also ensure that government agencies do
not act in an arbitrary or discriminatory fashion. To be fair,
they must treat the same behavior in the same way. Never
before had the FCC penalized this conduct. In fact, even
after its stricter indecency standard was set, the FCC
allowed the utterance of the F-word in other contexts.
The FCC cannot penalize Fox if it then ignores the same
behavior in others.
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an agency to keep confidential information that relates to national security, criminal inves-
tigations, internal agency matters such as personnel or policy discussions, trade secrets or
financial institutions, or an individual’s private life.
PRIVACY ACT
This 1974 statute prohibits federal agencies from giving information about an individual
to other agencies or organizations without written consent. There are exceptions, but
overall this act has reduced the government’s exchange of information about us “behind
our back.”
EXAM Strategy
Question: Builder wants to develop 1,000 acres in rural Montana, land that is
home to the Kite Owl. The EPA rules that the Kite Owl is an endangered species,
and prohibits development of the property. The developer appeals to the court.
The EPA based its decision on five statistical studies, and the opinions of three out
of seven experts. The court looks at the same evidence and acknowledges
that the EPA decision is carefully reasoned and fair. However, the judges believe
that the other four experts were right: The owl is not endangered. Should the court
permit development?
Strategy: What is the legal standard for deciding whether a court should affirm or
reverse an agency decision? As long as there is substantial evidence to support the
factual conclusions, and a reasonable basis for the legal conclusion, the court should not
impose its judgment. Agencies are presumed to have special expertise in their areas.
As the Fox Television case tells us, an agency ruling should generally be affirmed
unless it is arbitrary and capricious. Apply that standard here.
Result: The EPA made a careful, reasoned decision. The court may disagree, but it
should not impose its views. The court must affirm the agency’s ruling and prohibit
development.
Chapter Conclusion
“Why can’t they just fix the law?” They can, and sometimes they do—but it is a difficult and
complex task. “They” includes a great many people and forces, from common law courts to
members of Congress to campaign donors to administrative agencies. The courts have made
the bystander rule slightly more humane, but it has been a long and bumpy road. Congress
managed to restore the legal interpretation of its own 1964 Civil Rights Act, but it took
months of debate and compromising. The FDA squeezed more peanuts into a jar of Jif, but
it took nearly a decade to get the lid on.
A study of law is certain to create some frustrations. This chapter cannot prevent them all.
However, an understanding of how law is made is the first step toward controlling that law.
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 103
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EXAM REVIEW
1. COMMON LAW The common law evolves in awkward fits and starts because courts
attempt to achieve two contradictory purposes: predictability and flexibility. (p. 84)
2. STARE DECISIS Stare decisis means “let the decision stand” and indicates that
once a court has decided a particular issue, it will generally apply the same rule in
future cases. (p. 84)
3. BYSTANDER RULE The common law bystander rule holds that, generally, no
one has a duty to assist someone in peril unless the bystander himself created the
danger. Courts have carved some exceptions during the last 100 years, but the basic
rule still stands. (pp. 84–85)
4. LEGISLATION Bills originate in congressional committees and go from there
to the full House of Representatives or Senate. If both houses pass the bill, the
legislation normally must go to a Conference Committee to resolve differences
between the two versions. The compromise version then goes from the Conference
Committee back to both houses, and if passed by both, to the President. If the
President signs the bill, it becomes a statute; if he vetoes it, Congress can pass it over
his veto with a two-thirds majority in each house. (pp. 87–94)
5. STATUTORY INTERPRETATION Courts interpret a statute by using the plain
meaning rule; then, if necessary, legislative history and intent; and finally, if
necessary, public policy. (pp. 91–93)
Question: Whitfield, who was black, worked for Ohio Edison. Edison fired him,
but then later offered to rehire him. Another employee argued that Edison’s
original termination of Whitfield had been race discrimination. Edison rescinded
its offer to rehire Whitfield. Whitfield sued Edison, claiming that the company
was retaliating for the other employee’s opposition to discrimination. Edison
pointed out that Title VII of the 1964 Civil Rights Act did not explicitly apply in
such cases. Among other things, Title VII prohibits an employer from retaliating
against an employee who has opposed illegal discrimination. But it does not say
anything about retaliation based on another employee’s opposition to discrimination.
Edison argued that the statute did not protect Whitfield.
Strategy: What three steps does a court use to interpret a statute? First, we apply
the plain meaning rule. Does that rule help us here? The statute neither allows
nor prohibits Edison’s conduct. The law does not mention this situation, and the
plain meaning rule is of no help. Second step: Legislative history and intent. What
did Congress intend with Title VII generally? With the provision that bars
retaliation against a protesting employee? Resolving those issues should give you
the answer to this question.
6. ADMINISTRATIVE AGENCIES Congress creates federal administrative
agencies with enabling legislation. The Administrative Procedure Act controls how
agencies do their work. (pp. 95–96)
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7. RULEMAKING Agencies may promulgate legislative rules, which generally have
the effect of statutes, or interpretive rules, which merely interpret existing statutes.
(pp. 97–98)
8. INVESTIGATION Agencies have broad investigatory powers and may use
subpoenas and, in some cases, warrantless searches to obtain information. (pp. 98–99)
Question: When Hiller Systems, Inc., was performing a safety inspection on
board the M/V Cape Diamond, an ocean-going vessel, an accident killed two men.
The Occupational Safety and Health Administration (OSHA), a federal agency,
attempted to investigate, but Hiller refused to permit any of its employees to
speak to OSHA investigators. What could OSHA do to pursue the investigation?
What limits would there have been on OSHA’s actions?
Strategy: Agencies make rules, investigate, and adjudicate. Which is involved
here? Investigation. During an investigation, what power has an agency to force
a company to produce data? What are the limits on that power?
9. ADJUDICATION Agencies adjudicate cases, meaning that they hold hearings and
decide issues. Adjudication generally begins with a hearing before an administrative
law judge and may involve an appeal to the full agency or ultimately to federal court.
(pp. 99–100)
10. AGENCY LIMITATIONS The four most important limitations on the power of
federal agencies are statutory control in the enabling legislation and the APA; political
control by Congress and the President; judicial review; and the informational control
created by the FOIA and the Privacy Act. (pp. 100–103)
5. Result: Congress passed Title VII as a bold, aggressive move to end race discrimination
in employment. Further, by specifically prohibiting retaliation against an employee,
Congress indicated it was aware that companies might punish those who spoke in favor
of the very goals of Title VII. Protecting an employee from anti-discrimination statements
made by a coworker is a very slight step beyond that, and appears consistent with the goals
of Title VII and the anti-retaliation provision. Whitfield should win, and in the real case,
he did.18
8. Result: OSHA can issue a subpoena duces tecum, demanding that those on board
the ship, and their supervisors, appear for questioning, and bring with them all relevant
documents. OSHA may ask for anything that is (1) relevant to the investigation, (2) not
unduly burdensome, and (3) not privileged. Conversations between one of the ship
inspectors and his supervisor are clearly relevant; a discussion between the supervisor
and the company’s lawyer is privileged.
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CHAPTER 4 Common Law, Statutory Law, and Administrative Law 105
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MULTIPLE-CHOICE QUESTIONS
1. A bill is vetoed by .
(a) the Speaker of the House
(b) a majority of the voting members of the Senate
(c) the President
(d) the Supreme Court
2. If a bill is vetoed, it may still become law if it is approved by .
(a) two-thirds of the Supreme Court
(b) two-thirds of registered voters
(c) two-thirds of the Congress
(d) the President
(e) an independent government agency
3. Which of the following Presidents was most influential in the passing of the Civil
Rights Act?
(a) Franklin D. Roosevelt
(b) Ronald Reagan
(c) Abraham Lincoln
(d) John F. Kennedy
(e) George W. Bush
4. Under FOIA, any citizen may demand information about.
(a) how an agency operates
(b) how an agency spends its money
(c) files that an agency has collected on the citizen herself
(d) all of the above
5. If information requested under FOIA is not exempt, an agency has to
comply with the request.
(a) 10 days
(b) 30 days
(c) 3 months
(d) 6 months
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ESSAY QUESTIONS
1. Until 1989 every state had a statute outlawing the burning of American flags. But in
Texas v. Johnson,19 the Supreme Court declared such statutes unconstitutional, saying
that flag burning is symbolic speech protected by the First Amendment.
Does Congress have the power to overrule the Court’s decision?
2. In 1988, terrorists bombed Pan Am Flight 103 over Lockerbie, Scotland, killing all
passengers on board. Congress sought to remedy security shortcomings by passing the
Aviation Security Improvement Act of 1990, which, among other things, ordered the
Federal Aviation Authority (FAA) to prescribe minimum training requirements and
staffing levels for airport security. The FAA promulgated rules according to the
informal rulemaking process. However, the FAA refused to disclose certain rules
concerning training at specific airports. A public interest group called Public Citizen,
Inc., along with family members of those who had died at Lockerbie, wanted to know
the details of airport security. What steps should they take to obtain the information?
Are they entitled to obtain it?
3. The Aviation Security Improvement Act states that the FAA can refuse to divulge
information about airport security. The FAA interprets this statement to mean that it
can withhold data in spite of the FOIA. Public Citizen and the Lockerbie family
members interpret FOIA as being the controlling statute, requiring disclosure. Is the
FAA interpretation binding?
4. An off-duty, out-of-uniform police officer and his son purchased some food from a
7-Eleven convenience store and were still in the parking lot when a carload of
teenagers became rowdy. The officer went to speak to them, and the teenagers
assaulted him. The officer shouted to his son to get the 7-Eleven clerk to call for help.
The son entered the store, told the clerk that a police officer needed help, and
instructed the clerk to call the police. He returned 30 seconds later and repeated the
request, urging the clerk to say it was a Code 13. The son claimed that the clerk
laughed at him and refused to do it. The policeman sued the store. Argument for the
Store:We sympathize with the policeman and his family, but the store has no liability.
A bystander is not obligated to come to the aid of anyone in distress unless the
bystander created the peril, and obviously the store did not do so. The policeman
should sue those who attacked him. Argument for the Police Officer:We agree that in
general a bystander has no obligation to come to the aid of one in distress. However,
when a business that is open to the public receives an urgent request to call the
police, the business should either make the call or permit someone else to do it.
5. Federal antitrust statutes are complex, but the basic goal is straightforward: To
prevent a major industry from being so dominated by a small group of corporations
that they destroy competition and injure consumers. Does Major League Baseball
violate the antitrust laws? Many observers say that it does. A small group of owners
not only dominate the industry, but actually own it, controlling the entry of new
owners into the game. This issue went to the United States Supreme Court in 1922.
Justice Holmes ruled, perhaps surprisingly, that baseball is exempt from the antitrust
laws, holding that baseball is not “trade or commerce.” Suppose that members of
Congress dislike this ruling and the current condition of baseball. What can they do?
19491 U.S. 397, 109 S. Ct. 2533, 1989 U.S. LEXIS 3115 (1989).
CHAPTER 4 Common Law, Statutory Law, and Administrative Law 107
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DISCUSSION QUESTIONS
1. Courts generally follow precedent, but in the
Tarasoff and Soldano cases discussed earlier, they
did not. Consider this chapter’s opening scenario .
Should Jason bear any legal responsibility for the
toddler’s untimely end; or should a court follow
precedent and hold Jason blameless?
2. Revisit the Fox Television Stations case. Do you agree
with the opinion? What would a sensible broadcast
obscenity policy contain? When (if ever) should a
network face fines for airing bad language?
3. Revisit United States v. Biswell. Do you agree with
the Court’s decision? Is it reasonable that
government agencies can conduct searches more
freely if a business is in an industry that is
comprehensively regulated? Should a pawnshop
face more searches than other kinds of enterprises,
or should the rules be the same for all companies?
4. FOIA applies to government agencies, but
it exempts Congress. Should top lawmakers
be obligated to comply with FOIA requests,
or would that create more problems than it
would solve?
5. Suppose you were on a state supreme court and
faced with a restaurant-choking case. Should you
require restaurant employees to know and employ
the Heimlich maneuver to assist a choking victim?
If they do a bad job, they could cause additional
injury. Should you permit them to do nothing at
all? Is there a compromise position? What social
policies are most important?
108 U N I T 1 The Legal Environment
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CHAPTER5
CONSTITUTIONAL
LAW
Theconsultant startedhis presentation to theenergy
company’s board of directors. “So I don’t have to tell
you that if theSmith-JonesBill everpassesCongress,
it will be an utter disaster for your company. The
House has already passed it. The President wants it.
The only thing that kept it from becoming law this
summer is that the Senate was too chicken to bring
it up for a vote in an election year.
“Here’s the bottom line: To be comfortable,
you need three candidates who see things your way to beat current senators who support
the bill.”
The next slide showed a large map of the United States
with three states highlighted in red. “These are your best
bets. Attempting wins here would cost $ 60 million total—
not so much for a billion-dollar-a-year operation like yours.
“The money would go to saturation advertising from
Labor Day to Election Day. I want to buy TV ads during
local news programs all day, and during most primetime
shows. I want the viewers to see your ads at least a dozen
times before they go to the polls.
“In state #1, the challenger—your candidate—is a squeaky-clean state representative, but
no one knows much about her outside her own district. She carries herself well, has a nice
family. People will like her if they see her. Your money makes sure people will see her.
“In state #2, your guy hasn’t really done much. But his grandfather was a hero at
Normandy, and his dad was a coal miner. Great-grandparents were immigrants who came
through New York with nothing in their pockets—I can see the ad with the Statue of
Liberty already. A lot of voters will appreciate his family’s story. This strategy will work
if we have the funds to tell the story often enough.
“In state #3, we go negative. Really negative. Our opponent has been in the Senate a
long time, and he’s taken maybe 100,000 photos. We have three of them showing him with
world leaders who have become unpopular of late. We’re going to use them to tell a story
about the senator putting foreign interests above American jobs and national security. People
In state #3, we go
negative. Really negative.
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are angry—they think America is losing its place in the world. Our polling
shows that this kind of campaign will be highly effective.
“You need to get into this election. All of your stakeholders benefit if the
Smith-Jones Bill dies—your workers stay on the job, your shareholders make
more money, and your customers pay lower prices. Corporations are nothing
more or less than the people who work for them, and they have the right to
express their political opinions. These ads would simply give your workers
the chance to exercise their right to free speech.”
The CFO interrupted, “Look, we’re all against the Smith-Jones Bill. But
is this plan legal?”
5-1 GOVERNMENT POWER
5-1a One in a Million
The Constitution of the United States is the greatest legal document ever written. No other
written constitution has lasted so long, governed so many, or withstood such challenge. This
amazing work was drafted in 1787, when two weeks were needed to make the horseback ride
from Boston to Philadelphia, a pair of young cities in a weak and disorganized nation. Yet
today, when that trip requires less than two hours by jet, that same Constitution successfully
governs the most powerful country on earth. This longevity is a tribute to the wisdom and
idealism of the Founding Fathers. The Constitution is not perfect, but overall, it has worked
astonishingly well and has become the model for many constitutions around the world.
The Constitution sits above everything else in our legal system. No law can conflict
with it. The chapter opener raises a constitutional issue: Does Congress have the right to
prohibit corporations from spending money to affect elections, or are these actions protected
as free speech under the First Amendment? We will explore this question later in the
chapter when we discuss the Citizens United case.
The Constitution is short and relatively easy to read. This brevity is potent. The
Founding Fathers, or Framers, wanted it to last for centuries, and they understood that
would happen only if the document permitted interpretation and “fleshing out” by later
generations. The Constitution’s versatility is striking. In this chapter, the first part provides
an overview of the Constitution, discussing how it came to be and how it is organized. The
second part describes the power given to the three branches of government. The third part
explains the individual rights the Constitution guarantees to citizens.
5-2 OVERVIEW
Thirteen American colonies declared independence from Great Britain in 1776 and gained
it in 1783. The new status was exhilarating. Ours was the first nation in modern history
founded on the idea that the people could govern themselves, democratically. The idea was
daring, brilliant, and fraught with difficulties. The states were governing themselves under
the Articles of Confederation, but these articles gave the central government no real power.
The government could not tax any state or its citizens and had no way to raise money. The
national government also lacked the power to regulate commerce between the states or
between foreign nations and any state. This state of governance was disastrous. States began
to impose taxes on goods entering from other states. The young “nation” was a collection of
poor relations, threatening to squabble themselves to death.
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In 1787, the states sent a group of 55 delegates to Philadelphia. Rather than amend the
old articles, the Framers set out to draft a new document and to create a government that
had never existed before. It was hard going. What structure should the government have?
How much power? Representatives like Alexander Hamilton, a federalist, urged a strong
central government. The new government must be able to tax and spend, regulate com-
merce, control the borders, and do all things that national governments routinely do. But
Patrick Henry and other antifederalists feared a powerful central government. They had
fought a bitter war precisely to get rid of autocratic rulers; they had seen the evil that a
distant government could inflict. The antifederalists insisted that the states retain maximum
authority, keeping political control closer to home.
The debate continues to this day, and periodically it plays a key role in elections. The
“tea party” movement, for example, is a modern group of antifederalists.
Another critical question was how much power the people should have. Many of the
delegates had little love for the common people and feared that extending this idea of
democracy too far would lead to mob rule. Antifederalists again disagreed. The British had
been thrown out, they insisted, to guarantee individual liberty and a chance to participate in
the government. Power corrupted. It must be dispersed among the people to avoid its abuse.
How to settle these basic differences? By compromise, of course. The Constitution is a
series of compromises about power. We will see many provisions granting power to one
branch of the government while at the same time restraining the authority given.
5-2a Separation of Powers
The Framers did not want to place too much power in any single place. One method of
limiting power was to create a national government divided into three branches, each
independent and equal. Each branch would act as a check on the power of the other two.
Article I of the Constitution created a Congress, which was to have legislative, or lawmak-
ing, power. Article II created the office of President, defining the scope of executive, or
enforcement, power. Article III established judicial, or interpretive, power by creating the
Supreme Court and permitting additional federal courts.
Consider how the three separate powers balance one another: Congress was given the power
to pass statutes, a major grant of power. But the President was permitted to veto, or block,
proposed statutes, a nearly equal grant. Congress, in turn, had the right to override the veto,
ensuring that the President would not become a dictator. The President was allowed to appoint
federal judges and members of his cabinet, but only with a consenting vote from the Senate.
5-2b Individual Rights
The original Constitution was silent about the rights of citizens. This void alarmed many who
feared that the new federal government would have unlimited power over their lives. So in
1791, the first 10 amendments, known as the Bill of Rights, were added to the Constitution,
guaranteeing many liberties directly to individual citizens.
In the next two sections, we look in more detail at the two sides of the great series of
compromises: power granted and rights protected.
5-3 POWER GRANTED
5-3a Congressional Power
To recap two key ideas from Chapter 1:
1. Voters in all 50 states elect representatives who go to Washington, D.C., to serve in
Congress.
Bill of Rights
The first 10 amendments to
the Constitution outlining the
rights of citizens.
CHAPTER 5 Constitutional Law 111
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2. The Congress is comprised of the House of Representatives and the Senate.
The House has 435 voting members, and states with large populations send
more representatives. The Senate has 100 members—two from each state.
Congress wields tremendous power. Its members create statutes that influence our jobs,
money, health care, military, communications, and virtually everything else. But can Con-
gress create any kind of law that it wishes? No.
Article I, section 8 is a critically important part of the Constitution. It lists the 18 types
of statutes that Congress is allowed to pass, such as imposing taxes, declaring war, and
coining money. Thus, only the national government may create currency. The state of
Illinois cannot print $20 bills with Barack Obama’s profile.
States are allowed to create all other kinds of laws for themselves because the Tenth
Amendment says, “All powers not delegated to the United States by the Constitution … are
reserved to the States.”
The Commerce Clause is the specific item in Article I, section 8, most important to
your future as a businessperson. It calls upon Congress “to regulate commerce among the
several States,” and its impact is described in the next section.
INTERSTATE COMMERCE
With the Commerce Clause, the Framers sought to accomplish several things in response to
the commercial chaos that existed under the Articles of Confederation. They wanted the
federal government to speak with one voice when regulating commercial relations with
foreign governments.1 The Framers also wanted to give Congress the power to bring
coordination and fairness to trade among the states, and to stop the states from imposing
the taxes and regulations that were wrecking the nation’s domestic trade.
Virtually all of the numerous statutes that affect businesses are passed under the
Commerce Clause. But what does it mean to regulate interstate commerce? Are all business
transactions “interstate commerce,” or are there exceptions? In the end, the courts must
interpret what the Constitution means.
SUBSTANTIAL EFFECT RULE
An important test of the Commerce Clause came in the Depression years of the 1930s, in
Wickard v. Filburn.2 The price of wheat and other grains had fluctuated wildly, severely
harming farmers and the national food market. Congress sought to stabilize prices by
limiting the bushels per acre that a farmer could grow. Filburn grew more wheat than
federal law allowed and was fined. In defense, he claimed that Congress had no right to
regulate him because none of his wheat went into interstate commerce. He sold some locally
and used the rest on his own farm as food for livestock and as seed. The Commerce Clause,
Filburn claimed, gave Congress no authority to limit what he could do.
The Supreme Court disagreed and held that Congress may regulate any activity that has
a substantial economic effect on interstate commerce. Filburn’s wheat affected interstate
commerce because the more he grew for use on his own farm, the less he would need to buy
in the open market of interstate commerce. In the end, “interstate commerce” does not
require that things travel from one state to another.
In United States v. Lopez,3 however, the Supreme Court ruled that Congress had exceeded
its power under the Commerce Clause. Congress had passed a criminal statute called the
“Gun-Free School Zones Act,” which forbade any individual from possessing a firearm in
1Michelin Tire Corp. v. Wages, Tax Commissioner, 423 U.S. 276, 96 S. Ct. 535, 1976 U.S. LEXIS 120
(1976).
2317 U.S. 111, 63 S. Ct. 82, 1942 U.S. LEXIS 1046 (1942).
3514 U.S. 549, 115 S. Ct. 1624, 1995 U.S. LEXIS 3039 (1995).
Commerce Clause
The part of Article I, Section 8,
that gives Congress the power
to regulate commerce with
foreign nations and among
states.
112 U N I T 1 The Legal Environment
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a school zone. The goal of the statute was obvious: to keep schools safe. Lopez was convicted
of violating the act and appealed his conviction all the way to the high Court, claiming that
Congress had no power to pass such a law. The government argued that the Commerce
Clause gave it the power to pass the law, but the Supreme Court was unpersuaded.
The possession of a gun in a local school zone is in no sense an economic activity that might,
through repetition elsewhere, substantially affect any sort of interstate commerce. [Lopez] was a
local student at a local school; there is no indication that he had recently moved in interstate
commerce, and there is no requirement that his possession of the firearm have any concrete tie to
interstate commerce. To uphold the Government’s contentions here, we would have to pile
inference upon inference in a manner that would bid fair to convert congressional authority under
the Commerce Clause to a general police power of the sort retained by the States. [The statute
was unconstitutional and void.]
Congress’s power is great—but still limited.
Current Application: The Patient Protection and Affordable Healthcare
Act In 2010, Congress passed the Patient Protection and Affordable Healthcare Act
and President Barack Obama signed it into law. The wide-ranging legislation was aimed at
reducing the number of uninsured Americans and also the cost of health care. Almost
immediately after it passed, many states sued and argued that the law violated the Con-
stitution by exceeding Congress’s power to regulate interstate commerce.
The challenge centered on a provision (which the press refers to as the “individual
mandate”) in the Act that required many people to purchase health insurance or face fines.
The states argued that requiring people to buy something was fundamentally different from
regulating people who voluntarily decide to participate in commerce.
Amidst contentious political debate, the lower courts were divided on whether this
healthcare statute was constitutional. In 2012, the Supreme Court had the final word in
National Federation of Independent Business v. Sebelius.4 The Justices agreed in part with the
states: Requiring individuals to obtain health insurance was not within Congress’s power
under the Commerce Clause. Nevertheless, the Court held that the individual mandate was
a constitutional exercise of another one of Congress’s powers, its taxing power. The Court
reasoned that the fines imposed on individuals without health insurance could reasonably
be characterized as a tax and were therefore constitutional.
STATE LEGISLATIVE POWER
The “dormant” or “negative” aspect of the Commerce Clause governs state efforts to
regulate interstate commerce. The dormant aspect holds that a state statute that discrimi-
nates against interstate commerce is almost always unconstitutional. Here is an example,
but please do not read it if you plan to drive later today. Michigan and New York permitted
in-state wineries to sell directly to consumers. They both denied this privilege to out-of-
state producers, who were forced to sell to wholesalers, who offered the wine to retailers,
who sold to consumers. This provision created an impossible barrier for many small vine-
yards, which did not produce enough wine to attract wholesalers. Even if they did, the
multiple resales drove their prices prohibitively high.
Local residents and out-of-state wineries sued, claiming that the state regulations violated
the dormant Commerce Clause. The Supreme Court ruled that these statutes obviously
discriminated against out-of-state vineyards; the schemes were illegal unless Michigan and
New York could demonstrate an important goal that could not be met any other way. The
states’ alleged motive was to prevent minors from purchasing wine over the Internet. How-
ever, Michigan and New York offered no evidence that such purchases were really a problem.
The Court said that minors seldom drink wine, and when they do, they seek instant
4648 F.3d 1235 (2012).
CHAPTER 5 Constitutional Law 113
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gratification, not a package in the mail. States that allowed direct shipment to consumers
reported no increase in purchases by minors. This discrimination against interstate commerce,
like most, was unconstitutional.5
Devil’s Advocate Underage drinking is a serious problem. The Court
should allow states wide leeway in their efforts to limit
alcohol consumption by minors. Even if the state regulations are imperfect, they may help
reduce underage drinking.
SUPREMACY CLAUSE
What happens when both the federal and state governments pass regulations that are
permissible, but conflicting? For example, Congress passed the federal Occupational Safety
and Health Act (OSHA) establishing many job safety standards, including those for training
workers who handle hazardous waste. Congress had the power to do so under the Com-
merce Clause. Later, Illinois passed its own hazardous waste statutes, seeking to protect
both the general public and workers. The state statute did not violate the Commerce Clause
because it imposed no restriction on interstate commerce.
Each statute specified worker training and employer licensing. But the requirements
differed. Which statute did Illinois corporations have to obey? Article VI of the Constitution
contains the answer. The Supremacy Clause states that the Constitution, and federal
statutes and treaties, shall be the supreme law of the land.
• If there is a conflict between federal and state statutes, the federal law preempts the
field, meaning it controls the issue. The state law is void.
• Even in cases where there is no conflict, if Congress demonstrates that it intends to
exercise exclusive control over an issue, federal law preempts.
Thus state law controls only when there is no conflicting federal law and Congress has
not intended to dominate the issue. In the Illinois case, the Supreme Court concluded that
Congress intended to regulate the issue exclusively. Federal law therefore preempted the
field, and local employers were obligated to obey only the federal regulations.
EXAM Strategy
Question: Dairy farming was more expensive in Massachusetts than in other states.
To help its farmers, Massachusetts taxed all milk sales, regardless of where the milk
was produced. The revenues went into a fund that was then distributed to in-state
dairy farmers. Discuss.
Strategy: By giving a subsidy to local farmers, the state is treating them differently
from out-of-state dairies. This discrepancy raises Commerce Clause issues. The
dormant aspect applies. What does it state? Apply that standard to these facts.
Result: The dormant aspect holds that a state statute that discriminates against interstate
commerce is almost always invalid. Massachusetts was subsidizing its farmers at the
expense of those from other states. The tax violates the Commerce Clause and is void.
5Granholm v. Heald, 544 U.S. 460, 1255 S. Ct. 1885 (2005).
Supremacy Clause
Makes the Constitution, and
federal statutes and treaties,
the supreme law of the land.
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5-3b Executive Power
Article II of the Constitution defines executive power. The President’s most basic job function
is to enforce the nation’s laws. Three of his key powers concern appointment, legislation, and
foreign policy.
APPOINTMENT
Administrative agencies play a powerful role in business regulation, and the President
nominates the heads of most of them. These choices dramatically influence what issues
the agencies choose to pursue and how aggressively they do it. For example, a President
who seeks to expand the scope of regulations on air quality may appoint a forceful
environmentalist to run the Environmental Protection Agency (EPA), whereas a President
who dislikes federal regulations will choose a more passive agency head.6
LEGISLATION
The President and his advisers propose bills to Congress. During the last 50 years, a vast
number of newly proposed bills have come from the executive branch. Some argue that too
many proposals come from the President and that Congress has become overly passive.
When a President proposes controversial legislation on a major issue, such as Social Security
reform, the bill can dominate the news—and Congress—for months or even years. The
President, of course, also has the power to veto bills.7
FOREIGN POLICY
The President conducts the nation’s foreign affairs, coordinating international efforts,
negotiating treaties, and so forth. The President is also the commander in chief of the
armed forces, meaning that he heads the military. But Article II does not give him the right
to declare war—only the Senate may do that. A continuing tension between the President
and Congress has resulted from the President’s use of troops overseas without a formal
declaration of war.
5-3c Judicial Power
Article III of the Constitution creates the Supreme Court and permits Congress to establish
lower courts within the federal court system.8 Federal courts have two key functions:
adjudication and judicial review.
ADJUDICATING CASES
The federal court system hears criminal and civil cases. Generally, prosecutions of federal
crimes begin in United States District Court. That same court has limited jurisdiction to
hear civil lawsuits, a subject discussed in Chapter 3, on dispute resolution.
JUDICIAL REVIEW
One of the greatest “constitutional” powers appears nowhere in the Constitution. In 1803,
the Supreme Court decided Marbury v. Madison.9 Congress had passed a relatively minor
statute that gave certain powers to the Supreme Court, and Marbury wanted the Court to
use those powers. The Court refused. In an opinion written by Chief Justice John Marshall,
the Court held that the statute violated the Constitution because Article III of the Constitution
6For a discussion of administrative agency power, see Chapter 4, on administrative law.
7For a discussion of the President’s veto power and Congress’s power to override a veto, see
Chapter 4, on statutory law.
8For a discussion of the federal court system, see Chapter 3, on dispute resolution.
95 U.S. 137, 1 Cranch 137 (1803).
CHAPTER 5 Constitutional Law 115
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did not grant the Court those powers. The details of the case were insignificant, but the ruling
was profound: Because the statute violated the Constitution, said the Court, it was void. Judicial
review refers to the power of federal courts to declare a statute or governmental action
unconstitutional and void.
This formidable grab of power has produced two centuries of controversy. The Court
was declaring that it alone had the right to evaluate acts of the other two branches of
government—the Congress and the executive—and to decide which were valid and which
were void. The Constitution nowhere grants this power. Undaunted, Marshall declared that
“[I]t is emphatically the province and duty of the judicial department to say what the law
is.” In later cases, the Supreme Court expanded on the idea, holding that it could also
nullify state statutes, rulings by state courts, and actions by federal and state officials. In this
chapter, we have already encountered an example of judicial review in the Lopez case,
where the justices declared that Congress lacked the power to pass local gun regulations.
Is judicial review good for the nation? Those who oppose it argue that federal court
judges are all appointed, not elected, and that we should not permit judges to nullify a
statute passed by elected officials because that diminishes the people’s role in their government.
Those who favor judicial review insist that there must be one cohesive interpretation of the
Constitution and the judicial branch is the logical one to provide it. The following example of
judicial review shows how immediate and emotional the issue can be. It is a criminal prosecution
for a brutal crime. Cases like this force us to examine two questions about judicial review.What is
the proper punishment for such a horrible crime? Just as important,who should make that decision—
appointed judges, or elected legislators?
KENNEDY V. LOUISIANA
554 U.S. 407
United States Supreme Court, 2008
C A S E S U M M A R Y
Facts: Patrick Kennedy raped his eight-year-old stepdaugh-
ter, referred to as L.H. A forensic expert testified that L.H.’s
physical injuries were the most severe he had ever witnessed
from a sexual assault. The jury also heard evidence that the
defendant had raped another eight-year-old. Kennedy was
convicted of aggravated rape, because the victim was under
12 years of age.
The jury voted to sentenceKennedy to death, whichwas
permitted by the Louisiana statute. The state supreme court
affirmed the death sentence, and Kennedy appealed to the
United States Supreme Court. He argued that the Louisiana
statute was unconstitutional. The Eighth Amendment prohi-
bits cruel and unusual punishment, which includes penalties
that are out of proportion to the crime. Kennedy claimed that
capital punishment was out of proportion to rape, and violated
the Eighth Amendment.
Issue: Did the Louisiana statute violate the Constitution by
permitting the death penalty in a case of child rape?
Decision: Yes, the Louisiana statute violated the Eighth
Amendment. Reversed.
Reasoning: Constitutional liberties create limits. States may
define crimes and set punishments, but the penalties must
not be excessive in light of evolving standards of decency
in modern society. The death penalty requires special
attention.
Only six states (Louisiana, Georgia,Montana, Oklahoma,
South Carolina, and Texas) allowed for a death sentence in
cases of child rape. The other 44 states either did not have
capital crimes or allow for the death penalty only when a
defendant takes a life.
The majority of the Justices determined that the crime
in this case, while horrific, was nonetheless not equivalent
to murder in its “severity and irrevocability.” It concluded
that Louisiana’s statute amounted to cruel and unusual
punishment.
Dissent by Justice Alito: The court is wrong about the
evolving standards of decency. In recent years, five states
have passed laws that impose capital punishment in capital
rape cases. They have acted in response to a significant
increase in reports of the sexual abuse of children. These
laws did not violate the Eighth Amendment.
116 U N I T 1 The Legal Environment
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Judicial Activism/Judicial Restraint The power of judicial review is potentially
dictatorial. The Supreme Court nullifies statutes passed by Congress (Marbury v. Madison,
United States v. Lopez) and executive actions. May it strike down any law it dislikes? In
theory, no—the Court should nullify only laws that violate the Constitution. But in practice,
yes—the Constitution means whatever the majority of the current justices says that it
means, since it is the Court that tells us which laws are violative.
Judicial activism refers to a court’s willingness, or even eagerness, to become
involved in major issues and to decide cases on constitutional grounds. Activists are
sometimes willing to “stretch” laws beyond their most obvious meaning. Judicial
restraint is the opposite, an attitude that courts should leave lawmaking to legislators
and nullify a law only when it unquestionably violates the Constitution. Some justices
believe that the Founding Fathers never intended the judicial branch to take a promi-
nent role in sculpting the nation’s laws and its social vision.
From the 1950s through the 1970s, the Supreme Court took an activist role, deciding
many major social issues on constitutional grounds. The landmark 1954 decision in
Brown v. Board of Education ordered an end to racial segregation in public schools, not
only changing the nation’s educational systems, but altering forever its expectations
about race.10 The Court also struck down many state laws that denied minorities the
right to vote. Beginning with Miranda v. Arizona, the Court began a sweeping reappraisal
of the police power of the state and the rights of criminal suspects during searches,
interrogations, trials, and appeals.11 And in Roe v. Wade, the Supreme Court established
certain rights to abortion, most of which remain after nearly 40 years of continuous
litigation.12
Beginning in the late 1970s, and lasting to the present, the Court has pulled back
from its social activism. Exhibit 5.1 illustrates the balance among Congress, the Pre-
sident, and the Court.
The Constitution established a federal government of checks and balances. Con-
gress may propose statutes; the President may veto them; and Congress may override
the veto. The President nominates cabinet officers, administrative heads, and Supreme
Court justices, but the Senate must confirm his nominees. Finally, the Supreme Court
(and lower federal courts) exercise judicial review over statutes and executive actions.
Unlike the other checks and balances, judicial review is not provided for in the Con-
stitution, but is a creation of the Court itself in Marbury v. Madison.
5-4 PROTECTED RIGHTS
The amendments to the Constitution protect the people of this nation from the power of
state and federal government. The First Amendment guarantees rights of free speech, free
press, and religion; the Fourth Amendment protects against illegal searches; the Fifth
Amendment ensures due process; the Sixth Amendment demands fair treatment for defen-
dants in criminal prosecutions; and the Fourteenth Amendment guarantees equal protection
of the law. We consider the First, Fifth, and Fourteenth Amendments in this chapter and
the Fourth, Fifth, and Sixth Amendments in Chapter 7, on crime.
The “people” who are protected include citizens and, for most purposes, corporations.
Corporations are considered persons and receive most of the same protections. The great
majority of these rights also extends to citizens of other countries who are in the United States.
10347 U.S. 483, 74 S. Ct. 686, 1954 U.S. LEXIS 2094 (1954).
11384 U.S. 436, 86 S. Ct. 1602, 1966 U.S. LEXIS 2817 (1966).
12410 U.S. 113, 93 S. Ct. 705, 1973 U.S. LEXIS 159 (1973).
Judicial activism
A court’s willingness to decide
issues on constitutional
grounds.
Judicial restraint
A court’s attitude that it should
leave lawmaking to legislators.
CHAPTER 5 Constitutional Law 117
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Constitutional rights generally protect only against governmental acts. The Constitution
generally does not protect us from the conduct of private parties, such as corporations or other
citizens.
5-4a Incorporation
A series of Supreme Court cases has extended virtually all of the important constitutional
protections to all levels of national, state, and local government. This process is called
incorporation because rights explicitly guaranteed at one level are incorporated into rights
that apply at other levels.
5-4b First Amendment: Free Speech
The First Amendment states that “Congress shall make no law … abridging the free-
dom of speech ….” In general, we expect our government to let people speak and hear
whatever they choose. The Founding Fathers believed democracy would work only if
the members of the electorate were free to talk, argue, listen, and exchange viewpoints
in any way they wanted. The people could only cast informed ballots if they were
informed. “Speech” also includes symbolic conduct, as the following case flamingly
illustrates.
Congress President Supreme Court
Statutes
Cabinet
Administrative
Agency Heads
Executive Actions
Confirm or Reject
Nominates
Judicial Review
NominatesOverridePropose
Veto
Confirm or Reject
Confirm or Reject
Nominates
Judicial
Review
©
C
en
g
ag
e
Le
ar
n
in
g
EXHIB IT 5.1 The Path of Legislation: The Balance among the President, the Congress, and the Court
118 U N I T 1 The Legal Environment
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POLITICAL SPEECH
Because the Framers were primarily concerned with enabling democracy to function,
political speech has been given an especially high degree of protection. Such speech
may not be barred even when it is offensive or outrageous. A speaker, for example, could
accuse a U.S. senator of being insane and could use crude, violent language to describe
him. The speech is still protected. Political speech is protected unless it is intended and
likely to create imminent lawless action.13 For example, suppose the speaker said, “The
senator is inside that restaurant. Let’s get some matches and burn the place down.”
Speech of this sort is not protected. The speaker could be arrested for attempted arson
or attempted murder.
One of the most important recent developments in constitutional law concerns
the ability of organizations to engage in political speech. In the case that follows, a
sharply divided Supreme Court weighed in on the issue raised in this chapter’s opening
scenario.
TEXAS V. JOHNSON
491 U.S. 397
United States Supreme Court, 1989
C A S E S U M M A R Y
Facts: Outside the Republican National Convention in
Dallas, Gregory Johnson participated in a protest against
policies of the Reagan administration. Participants gave
speeches and handed out leaflets. Johnson burned an
American flag. He was arrested and convicted under a
Texas statute that prohibited desecrating the flag, but the
Texas Court of Criminal Appeals reversed on the grounds
that the conviction violated the First Amendment. Texas
appealed to the United States Supreme Court.
Issue: Does the First Amendment protect flag burning?
Decision: Affirmed. The First Amendment protects flag
burning.
Reasoning: The First Amendment literally applies only
to “speech,” but the Supreme Court had already ruled
that the Amendment also protects written words and other
conduct that conveys a specific message. For example,
earlier decisions protected a student’s right to wear a black
armband in protest against American military actions.
Judged by this standard, flag burning is symbolic speech.
Texas argued that its interest in honoring the flag
justified its prosecution of Johnson, since he knew that
his action would be deeply offensive to many citizens.
However, if there is a bedrock principle underlying the
First Amendment, it is that the government may not
prohibit the expression of an idea simply because society
finds it offensive.
The best way to preserve the flag’s special role in our
lives is not to punish those who feel differently but to
persuade them that they are wrong. We do not honor our
flag by punishing those who burn it, because in doing so
we diminish the freedom that this cherished emblem
represents.
13Brandenburg v. Ohio, 395 U.S. 444, 89 S. Ct. 1827, 1969 U.S. LEXIS 1367 (1969).
CHAPTER 5 Constitutional Law 119
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TIME, PLACE, AND MANNER
Even when speech is protected, the government may regulate the time, place, and manner of
such speech. A town may require a group to apply for a permit before using a public park for
a political demonstration. The town may insist that the demonstration take place during
daylight hours and that there be adequate police supervision and sanitation provided.However, the
town may not prohibit such demonstrations outright.
Many public universities have designated “free speech zones” located in high-traffic
areas of campus that are not immediately adjacent to a large number of classrooms. The
zones allow for debates to proceed and reach many students, but they minimize the chances
that noisy demonstrations will interfere with lectures.
MORALITY AND OBSCENITY
The regulation of morality and obscenity presents additional problems. Obscenity has never
received constitutional protection. The Supreme Court has consistently held that it does not
play a valued role in our society and has refused to give protection to obscene works. That is
well and good, but it merely forces the question: What is obscene?
In Miller v. California,14 the Court created a three-part test to determine if a creative
work is obscene. The basic guidelines for the factfinder are:
• Whether the average person, applying contemporary community standards, would
find that the work, taken as a whole, appeals to the prurient interest;
• Whether the work depicts or describes, in a patently offensive way, sexual conduct
specifically defined by the applicable state law; and
• Whether the work, taken as a whole, lacks serious literary, artistic, political, or
scientific value.
CITIZENS UNITED V. FEDERAL ELECTION COMMISSION
558 U.S. 310
Supreme Court of the United States, 2010
C A S E S U M M A R Y
Facts: Citizens United, a nonprofit organization, produced
a documentary on presidential candidate Hillary Clinton.
The group wanted to run television ads promoting Hillary:
the Movie. The Bipartisan Campaign Reform Act of 2002
banned “electioneering communication” by corporations
and unions for the 30 days before a presidential primary.
Citizens United challenged the Act.
Issue: Did the Bipartisan Campaign Reform Act violate the
First Amendment?
Decision: Yes, the law violated the First Amendment.
Reasoning: Prohibiting organizations from “electioneer-
ing communications” amounts to censorship. Speech is
vital to a democracy, and it must not be suppressed.
Corporations are protected by the First Amendment,
and therefore, they have the right to express their political
views. Yet, under this statute, any negative portrayal of a
politician on television, radio, or YouTube, that takes
place near an election could be a felony.
Corruption should be curbed, but not at the expense
of free speech. Americans must be allowed to decide for
themselves which ideas are worthy of discussion. The
government cannot make the decision for them.
14413 U.S. 15, 93 S. Ct. 2607, 1973 U.S. LEXIS 149 (1973).
120 U N I T 1 The Legal Environment
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If the trial court finds that the answer to all three of those questions is “yes,” it may
judge the material obscene; the state may then prohibit the work. If the state fails to prove
any one of the three criteria, though, the work is not obscene.15 A United States District
Court ruled that “As Nasty As They Wanna Be,” recorded by 2 Live Crew, was obscene.
The appeals court, however, reversed, finding that the state had failed to prove lack of
artistic merit.16
COMMERCIAL SPEECH
Commercial speech refers to speech that has a dominant theme to propose a commercial
transaction. For example, most advertisements on television and in the newspapers are
commercial speech. This sort of speech is protected by the First Amendment, but the
government is permitted to regulate it more closely than other forms of speech.
Commercial speech that is false or misleading may be outlawed altogether. The govern-
ment may regulate other commercial speech, provided that the rules are reasonable and
directed to a legitimate goal. The following case demonstrates the very different
treatment given to this type of speech.
SALIB V. CITY OF MESA
133 P.3d 756 212 Ariz. 446
Arizona Court of Appeals, 2006
C A S E S U M M A R Y
Facts: Edward Salib owned a Winchell’s Donut House in
Mesa, Arizona. To attract customers, he displayed large
signs advertising his products in his store window. The
city ordered him to remove the signs because they vio-
lated its Sign Code, which prohibited covering more than
30% of a store’s windows with signs. Salib sued, claiming
that the Sign Code violated his First Amendment free
speech rights. The trial court gave summary judgment
for Mesa, and the store owner appealed.
Issue: Did Mesa’s Sign Code violate the First Amendment?
Decision: No, the Code placed a reasonable limit on
commercial speech. Affirmed.
Reasoning: The First Amendment guarantees free
speech rights to people and to organizations. The govern-
ment, though, can restrict commercial speech in some
circumstances. Regulators, for example, can ban false
and misleading messages. They may also place limits
on other advertisements if they pass the following three-
part test:
First, the government has a substantial interest.
Second, a restriction directly advances this interest.
Third, the restriction is narrowly tailored to meet its
goal.
In the case, the City of Mesa claimed a substantial
interest in making its business district aesthetically pleas-
ing. It argued that the Sign Code did in fact make the city
more attractive. Mesa also claimed that its 30% standard
was a narrow and reasonable compromise between its
interest in city beautification and the rights of business
owners.
The court agreed with Mesa’s arguments and
declined to second-guess the standard.
15Penthouse Intern Ltd. v. McAuliffe, 610 F.2d 1353 (5th Cir. 1980).
16960 F.2d 134 (1992).
Commercial speech
Communication, such as
advertisements, that has the
dominant theme of proposing a
business transaction.
CHAPTER 5 Constitutional Law 121
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EXAM Strategy
Question: Maria owns a lot next to a freeway that passes through Tidyville. She has
rented a billboard to Huge Mart, a nearby retailer, and a second billboard to Green, a
political party. However, Tidyville prohibits off-premises signs (those not on the
advertiser’s property) that are visible from the freeway. Tidyville’s rule is designed to
make the city more attractive, to increase property values, and to eliminate distrac-
tions that may cause freeway accidents. Huge Mart and Green sue, claiming that
Tidyville’s law violates their First Amendment rights. Who wins?
(a) Huge Mart is likely to win; Green is likely to lose.
(b) Green is likely to win; Huge Mart is likely to lose.
(c) Huge Mart and Green are both likely to win.
(d) Huge Mart and Green are both likely to lose.
Strategy: What is the difference between the two cases? Huge Mart wants the
billboard for commercial speech; Green wants it for a political message. What are the
legal standards for commercial and political free speech? Apply those standards.
Result: The government may regulate commercial speech, provided that the rules are
reasonable and directed to a legitimate goal. Political speech is given much stronger
protection, and can be prohibited only if it is intended and likely to create imminent
lawless action. The regulation outlawing advertising will be upheld, but Tidyville will
not be allowed to block political messages.
5-4c Fifth Amendment: Due
Process and the Takings Clause
You are a senior at a major state university. You feel great
about a difficult exam you took in Professor Watson’s class.
The Dean’s Office sends for you, and you enter curiously,
wondering if your exam was so good that the dean is award-
ing you a prize. Not quite. The exam proctor has accused
you of cheating. Based on the accusation, Watson has
flunked you. You protest that you are innocent and demand to know what the accusation is.
The dean says that you will learn the details at a hearing, if you wish to have one. She reminds
you that if you lose the hearing, you will be expelled from the university. Four years of work
and your entire career are suddenly on the line.
The hearing is run by Professor Holmes, who will make the final decision. Holmes is a
junior faculty member in Watson’s department. (Next year, Watson will decide Holmes’s
tenure application.) At the hearing, the proctor accuses you of copying from a student sitting
in front of you. Both Watson and Holmes have already compared the two papers and
concluded that they are strongly similar. Holmes tells you that you must convince him
the charge is wrong. You examine the papers, acknowledge that there are similarities, but
plead as best you can that you never copied. Holmes doesn’t buy it. The university expels
you, placing on your transcript a notation of cheating.
Have you received fair treatment? To answer that, we must look to the Fifth Amend-
ment, which provides several vital protections. We will consider two related provisions, the
Due Process Clause and the Takings Clause. Together, they state: “No person shall be …
Four years of work and
your entire career are
suddenly on the line.
122 U N I T 1 The Legal Environment
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deprived of life, liberty, or property without due process of law; nor shall private property be
taken for public use, without just compensation.” These clauses prevent the government
from arbitrarily taking the most valuable possessions of a citizen or corporation. The
government has the right to take a person’s liberty or property. But there are three important
limitations:
• Procedural Due Process. Before depriving anyone of liberty or property, the
government must go through certain steps, or procedures, to ensure that the result is fair.
• The Takings Clause. When the government takes property for public use, such as to
build a new highway, it has to pay a fair price.
• Substantive Due Process. Some rights are so fundamental that the government may
not take them from us at all. The substance of any law or government action may be
challenged on fundamental fairness grounds.
PROCEDURAL DUE PROCESS
The government deprives citizens or corporations of their property in a variety of ways. The
Internal Revenue Service may fine a corporation for late payment of taxes. The Customs
Service may seize goods at the border. As to liberty, the government may take it by
confining someone in a mental institution or by taking a child out of the home because of
parental neglect. The purpose of procedural due process is to ensure that before the
government takes liberty or property, the affected person has a fair chance to oppose the
action. There are two steps in analyzing a procedural due process case:
• Is the government attempting to take liberty or property?
• If so, how much process is due? (If the government is not attempting to take liberty or
property, there is no due process issue.)
Is the Government Attempting to Take Liberty or Property? Liberty inter-
ests are generally easy to spot: Confining someone in a mental institution and taking a child
from her home are both deprivations of liberty. A property interest may be obvious. Suppose
that, during a civil lawsuit, the court attaches a defendant’s house, meaning it bars the
defendant from selling the property at least until the case is decided. This way, if the plaintiff
wins, the defendant will have assets to pay the judgment. The court has clearly deprived the
defendant of an important interest in his house, and the defendant is entitled to due process.
However, a property interest may be subtler than that. A woman holding a job with a
government agency has a “property interest” in that job, because her employer has agreed
not to fire her without cause, and she can rely on it for income. If the government does fire her,
it is taking away that property interest, and she is entitled to due process. A student attending
any public school has a property interest in her education. If a public university suspends a
student as described above, it is taking her property, and she, too, should receive due process.
How Much Process Is Due? Assuming that a liberty or property interest is affected,
a court must decide how much process is due. Does the person get a formal trial, or an
informal hearing, or merely a chance to reply in writing to the charges against her? If she
gets a hearing, must it be held before the government deprives her of her property, or is it
enough that she can be heard shortly thereafter? What sort of hearing the government must
offer depends upon how important the property or liberty interest is and on whether the
government has a competing need for efficiency. The more important the interest, the more
formal the procedures must be.
Neutral Factfinder Regardless of how formal the hearing, one requirement is constant:
The factfinder must be neutral. Whether it is a superior court judge deciding a multimillion-
dollar contract suit or an employment supervisor deciding the fate of a government employee,
Takings Clause
A clause in the Fifth
Amendment that ensures that
when any governmental unit
takes private property for public
use, it must compensate the
owner.
Procedural due process
The doctrine that ensures that
before the government takes
liberty or property, the affected
person has a fair chance to
oppose the action.
Attachment
The process by which a court
bars a defendant from selling
property.
CHAPTER 5 Constitutional Law 123
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the factfinder must have no personal interest in the outcome. In Ward v. Monroeville,17the
plaintiff was a motorist who had been stopped for traffic offenses in a small town. He
protested his innocence and received a judicial hearing. But the “judge” at the hearing was
the town mayor. Traffic fines were a significant part of the town’s budget. The motorist
argued that the town was depriving him of procedural due process because the mayor had a
financial interest in the outcome of the case. The United States Supreme Court agreed and
reversed his conviction.
Attachment of Property As described earlier, a plaintiff in a civil lawsuit often seeks
to attach the defendant’s property. Attachment protects the plaintiff, but it may also harm
the defendant if, for example, he is about to close a profitable real estate deal. Attachments
used to be routine. In Connecticut v. Doehr, the Supreme Court required more caution.18
Based on Doehr, when a plaintiff seeks to attach at the beginning of the trial, a court must
look at the plaintiff’s likelihood of winning. Generally, the court must grant the defendant a
hearing before attaching the property. The defendant, represented by a lawyer, may offer
evidence as to how attachment would harm him and why it should be denied.
Government Employment A government employee must receive due process before
being fired. Generally, this means some kind of hearing, but not necessarily a formal court
hearing. The employee is entitled to know the charges against him, to hear the employer’s
evidence, and to have an opportunity to tell his side of the story. He is not entitled to have a
lawyer present. The hearing “officer” need only be a neutral employee. Further, in an
emergency, where the employee is a danger to the public or the organization, the govern-
ment may suspend with pay, before holding a hearing. It then must provide a hearing before
the decision becomes final.
Academic Suspension There is still a property interest here, but it is the least
important of those discussed. When a public school concludes that a student has failed to
meet its normal academic standards, such as by failing too many courses, it may dismiss him
without a hearing. Due process is served if the student receives notice of the reason and has
some opportunity to respond, such as by writing a letter contradicting the school’s claims.
In cases of disciplinary suspension or expulsion, courts generally require schools to
provide a higher level of due process. In the hypothetical at the beginning of this section,
the university has failed to provide adequate due process.19 The school has accused the
student of a serious infraction. The school must promptly provide details of the charge and
cannot wait until the hearing to do so. The student should see the two papers and have a
chance to rebut the charge. Moreover, Professor Holmes has demonstrated bias. He appears
to have made up his mind in advance. He has placed the burden on the student to disprove
the charges. And he probably feels obligated to support Watson’s original conclusion, since
Watson will be deciding his tenure case next year.
THE TAKINGS CLAUSE
Florence Dolan ran a plumbing store in Tigard, Oregon. She and her husband wanted to
enlarge it on land they already owned. But the city government said that they could expand
only if they dedicated some of their own land for use as a public bicycle path and for other
public use. Does the city have the right to make them do that? For an answer, we must look
to a different part of the Fifth Amendment.
The Takings Clause prohibits a state from taking private property for public use without
just compensation. A town wishing to build a new football field may boot you out of your
17409 U.S. 57, 93 S. Ct. 80, 1972 U.S. LEXIS 11 (1972).
18501 U.S. 1, 111 S. Ct. 2105, 1991 U.S. LEXIS 3317 (1991).
19See, for example, University of Texas Medical School at Houston v. Than, 901 S.W.2d 926, 1995 Tex.
LEXIS 105 (Tex. 1995).
124 U N I T 1 The Legal Environment
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house. But the town must compensate you. The government takes your land through the
power of eminent domain. Officials must notify you of their intentions and give you an
opportunity to oppose the project and to challenge the amount the town offers to pay. But
when the hearings are done, the town may write you a check and level your house, whether
you like it or not.
More controversial issues arise when a local government does not physically take the
property but passes regulations that restrict its use. Tigard is a city of 30,000 in Oregon. The
city developed a comprehensive land use plan for its downtown area in order to preserve
green space, to encourage transportation other than autos, and to reduce its flooding problems.
Under the plan, when a property owner sought permission to build in the downtown section, the
city could require some of her land to be used for public purposes. This has become a standard
method of land use planning throughout the nation. States have used it to preserve coastline,
urban green belts, and many environmental features.
When Florence Dolan applied for permission to expand, the city required that she
dedicate a 15-foot strip of her property to the city as a bicycle pathway and that she preserve,
as greenway, a portion of her land within a floodplain. She sued, and though she lost in the
Oregon courts, she won in the United States Supreme Court. The Court held that Tigard
City’s method of routinely forcing all owners to dedicate land to public use violated the
Takings Clause. The city was taking the land, even though title never changed hands.20
The Court did not outlaw all such requirements. What it required was that, before a
government may require an owner to dedicate land to a public use, it must show that this
owner’s proposed building requires this dedication of land. In other words, it is not enough for
Tigard to have a general plan, such as a bicycle pathway, and to make all owners participate in
it. Tigard must show that it needs Dolan’s land specifically for a bike path and greenway. This
argument will be much harder for local governments to demonstrate than merely showing a
city-wide plan. A related issue arose in the following controversial case. A city used eminent
domain to take property on behalf of private developers. Was this a valid public use?
The Kelo decision was controversial, and in response, some states passed statutes
prohibiting eminent domain for private development.
KELO V. CITY OF NEW LONDON, CONNECTICUT
545 U.S. 469
United States Supreme Court, 2005
C A S E S U M M A R Y
Facts: New London, Connecticut, was declining
economically. The city’s unemployment rate was double
that of the state generally, and the population was at its
lowest in 75 years. In response, state and local officials
targeted a section of the city, called Fort Trumbull, for
revitalization. Located on theThames River, Fort Trumbull
comprised 115 privately owned properties and 32 additional
acres of an abandoned naval facility. The development plan
included one section for a waterfront conference hotel and
stores; a second one for 80 private residences; and one for
research facilities.
The state bought most of the properties from willing
sellers. However, 9 owners of 15 properties refused to sell,
and filed suit. The owners claimed that the city was trying to
take land for private use, not public, in violation of theTakings
Clause. The case reached the United States Supreme Court.
Issue: Did the city’s plan violate the Takings Clause?
Decision: No, the plan was constitutional. Affirmed.
Reasoning: The Takings Clause allows for some trans-
fers of real property from one private party to another, so
20Dolan v. City of Tigard, 512 U.S. 374, 114 S. Ct. 2309, 1994 U.S. LEXIS 4826 (1994).
Eminent domain
The power of the government
to take private property for
public use.
CHAPTER 5 Constitutional Law 125
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SUBSTANTIVE DUE PROCESS
This doctrine is part of the Due Process Clause, but it is entirely different from procedural
due process and from government taking. During the first third of the twentieth century,
the Supreme Court frequently nullified state and federal laws, asserting that they interfered
with basic rights. For example, in a famous 1905 case, Lochner v. New York,21 the Supreme
Court invalidated a New York statute that had limited the number of hours that bakers
could work in a week. New York had passed the law to protect employee health. But the
Court declared that private parties had a basic constitutional right to contract. In this case,
the statute interfered with the rights of the employer and the baker to make any bargain
they wished. Over the next three decades, the Court struck down dozens of state and
federal laws that were aimed at working conditions, union rights, and social welfare gen-
erally. This was called substantive due process22 because the Court was looking at the
underlying rights being affected, such as the right to contract, not at any procedures.
Critics complained that the Court was interfering with the desires of the voting public
by nullifying laws that the justices personally disliked (judicial activism). During the Great
Depression, however, things changed. Beginning in 1934, the Court completely reversed
itself and began to uphold the types of laws it earlier had struck down.
The Supreme Court made an important substantive due process ruling in the case of
BMW v. Gore.23 A BMW dealership sold Gore a car that had sustained water damage. Instead
of telling him of the damage, they simply repainted the car and sold it as new.
In Chapter 6, we will examine two different types of cash awards that juries may make in
tort cases. For now, let’s call them “ordinary” and “punitive” damages. When plaintiffs win tort
cases, juries may always award ordinary damages to offset real, measureable losses. In addition,
juries are sometimes allowed to add to an award to further punish a defendant for bad behavior.
In theBMW case, the jury awardedGore $4,000 in ordinary damages as the difference in value
between a flawless new car and a water-damaged car. The jury then awarded a delighted Gore $4
million in punitive damages. In the end, the SupremeCourt decided that the punitive award was so
disproportionate to the harm actually caused that it violated substantive due process rights.
5-4d Fourteenth Amendment: Equal Protection Clause
Shannon Faulkner wanted to attend The Citadel, a state-supported military college in
South Carolina. She was a fine student who met every admission requirement that The
Citadel set except one: She was not a man. The Citadel argued that its long and distin-
guished history demanded that it remain all male. Faulkner responded that she was a citizen
long as the land will be used by the public. For example,
land may be taken to allow for the construction of a rail-
road, even if private railroad companies will be the pri-
mary beneficiaries of the transfer.
New London’s economic development plan aims to cre-
ate jobs and increase the city’s tax receipts. The Supreme
Court has not previously considered this type of public
use, but now determines that economic development is a
legitimate public purpose. New London did not violate the
Takings Clause.
Dissent by Justice O’Connor: Any public benefit in this
case would be incidental and secondary. Under themajority’s
opinion, the government can now take private property for
any purpose. This case will most likely benefit those with
inside access to government officials, at the expense of small
property owners.
21198 U.S. 45, 25 S. Ct. 539, 1905 U.S. LEXIS 1153 (1905).
22Be the first on your block to pronounce this word correctly. The accent goes on the first syllable:
substantive.
23517 U.S. 559 (1996).
Substantive due process
A form of due process that holds
that certain rights are so
fundamental that the government
may not eliminate them.
126 U N I T 1 The Legal Environment
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of the state and ought to receive the benefits that others got, including the right to a military
education. Could the school exclude her on the basis of gender?
The Fourteenth Amendment provides that “No State shall … deny to any person
within its jurisdiction the equal protection of the laws.” This is the Equal Protection Clause,
and it means that, generally speaking, governments must treat people equally. Unfair
classifications among people or corporations will not be permitted. A notorious example of
unfair classification would be race discrimination: Permitting only white children to attend a
public school violates the Equal Protection Clause.
Yet clearly, governments do make classifications every day. People with high incomes
pay a higher tax rate than those with low incomes; some corporations are permitted to
deal in securities, while others are not. To determine which classifications are constitution-
ally permissible, we need to know what is being classified. There are three major groups of
classifications. The outcome of a case can generally be predicted by knowing which group it
is in.
• Minimal Scrutiny: Economic and Social Relations. Government actions that classify
people or corporations on these bases are almost always upheld.
• Intermediate Scrutiny: Gender. Government classifications are sometimes upheld.
• Strict Scrutiny: Race, Ethnicity, and Fundamental Rights. Classifications based on
any of these are almost never upheld.
MINIMAL SCRUTINY: ECONOMIC AND SOCIAL REGULATION
Just as with the Due Process Clause, laws that regulate economic or social issues are
presumed valid. They will be upheld if they are rationally related to a legitimate goal. This
means a statute may classify corporations and/or people, and the classifications will be
upheld if they make any sense at all. The New York City Transit Authority excluded all
methadone users from any employment. The United States District Court concluded that
this practice violated the Equal Protection Clause by unfairly excluding all those who
were on methadone. The court noted that even those who tested free of any illegal drugs
and were seeking non-safety-sensitive jobs, such as clerks, were turned away. That
reasoning, said the district court, was irrational.
Not so, said the United States Supreme Court. The Court admitted that the policy
might not be the wisest. It would probably make more sense to test individually for illegal
drugs rather than automatically exclude methadone users. But, said the Court, it was not up
to the justices to choose the best policy. They were only to decide if the policy was rational.
Excluding methadone users related rationally to the safety of public transport and therefore
did not violate the Equal Protection Clause.24
INTERMEDIATE SCRUTINY: GENDER
Classifications based on sex must meet a tougher test than those resulting from economic or
social regulation. Such laws must substantially relate to important government objectives. Courts
have increasingly nullified government sex classifications as societal concern with gender
equality has grown.
At about the same time Shannon Faulkner began her campaign to enter The
Citadel, another woman sought admission to the Virginia Military Institute (VMI), an
all-male state school. The Supreme Court held that Virginia had violated the Equal
Protection Clause by excluding women from VMI. The Court ruled that gender-based
24New York City Transit Authority v. Beazer, 440 U.S. 568, 99 S. Ct. 1355, 1979 U.S. LEXIS 77 (1979).
Equal Protection Clause
A clause in the Fourteenth
Amendment that generally
requires the government to
treat people equally.
CHAPTER 5 Constitutional Law 127
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government discrimination requires an “exceedingly persuasive justification,” and that
Virginia had failed that standard of proof. The Citadel promptly opened its doors to
women as well.25
STRICT SCRUTINY: RACE, ETHNICITY, AND FUNDAMENTAL RIGHTS
Any government action that intentionally discriminates against racial or ethnic minorities,
or interferes with a fundamental right, is presumed invalid. In such cases, courts will look at
the statute or policy with strict scrutiny; that is, courts will examine it very closely to
determine whether there is compelling justification for it. The law will be upheld only if
it is necessary to promote a compelling state interest. Very few meet that test.
• Racial and Ethnic Minorities. Any government action that intentionally discriminates
on the basis of race, or ethnicity is presumed invalid. For example, in Palmore v.
Sidoti,26 the state had refused to give child custody to a mother because her new
spouse was racially different from the child. The practice was declared
unconstitutional. The state had made a racial classification, it was presumed
invalid, and the government had no compelling need to make such a ruling.
• Fundamental Rights. A government action interfering with a fundamental right also
receives strict scrutiny and will likely be declared void. For example, New York State
gave an employment preference to any veteran who had been a state resident when
he entered the military. Newcomers who were veterans were less likely to get jobs,
and therefore this statute interfered with the right to travel, a fundamental right. The
Supreme Court declared the law invalid.27
EXAM Strategy
Question: Megan is a freshman at her local public high school; her older sister Jenna
attends a nearby private high school. Both girls are angry because their schools
prohibit them from joining their respective wrestling teams, where only boys are
allowed. The two girls sue based on the U.S. Constitution. Discuss the relevant law
and predict the outcomes.
Strategy: One girl goes to private school and one to public school. Why does that
matter? Now ask what provision of the Constitution is involved, and what legal
standard it establishes.
Result: The Constitution offers protection from the government. A private high
school is not part of the government, and Jenna has no constitutional case. Megan’s
suit is based on the Equal Protection Clause. This is gender discrimination, mean-
ing that Megan’s school must convince the court that keeping girls off the team
substantially relates to an important government objective. The school will probably argue
that wrestling with stronger boys will be dangerous for girls. However, courts are
increasingly suspicious of any gender discrimination and are unlikely to find the
school’s argument persuasive.
25United States v. Virginia, 518 U.S. 515, 116 S. Ct. 2264, 1996 U.S. LEXIS 4259 (1996).
26466 U.S. 429, 104 S. Ct. 1879, 1984 U.S. LEXIS 69 (1984).
27Attorney General of New York v. Soto-Lopez, 476 U.S. 898, 106 S. Ct. 2317, 1986 U.S. LEXIS 59 (1986).
Fundamental rights
Rights so basic that any
governmental interference with
them is suspect and likely to be
unconstitutional.
128 U N I T 1 The Legal Environment
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Chapter Conclusion
The legal battle over power never stops. The obligation of a state to provide equal educa-
tional opportunity for both genders relates to whether Tigard, Oregon, may demand some of
Ms. Dolan’s store lot for public use. Both issues are governed by one amazing document.
That same Constitution determines what tax preferences are permissible and even whether
a state may require you to wear clothing. As social mores change in step with broad cultural
developments, as the membership of the Supreme Court changes, the balance of power
between federal government, state government, and citizens will continue to evolve. There
are no easy answers to these constitutional questions because there has never been a
democracy so large, so diverse, or so powerful.
EXAM REVIEW
1. CONSTITUTION The Constitution is a series of compromises about power.
(p. 111)
2. ARTICLES I, II, AND III Article I of the Constitution creates the Congress and
grants all legislative power to it. Article II establishes the office of President and
defines executive powers. Article III creates the Supreme Court and permits lower
federal courts; the article also outlines the powers of the federal judiciary. (p. 111)
3. COMMERCE CLAUSE Under the Commerce Clause, Congress may regulate
any activity that has a substantial effect on interstate commerce. (p. 112)
4. INTERSTATE COMMERCE A state may not regulate commerce in any way
that will interfere with interstate commerce. (p. 112)
Question: Maine exempted many charitable institutions from real estate taxes but
denied this benefit to a charity that primarily benefited out-of-state residents.
Camp Newfound was a Christian Science organization, and 95 percent of its
summer campers came from other states. Camp Newfound sued Maine. Discuss.
Strategy: The state was treating organizations differently depending on what
states their campers come from. This raised Commerce Clause issues. Did the
positive aspect or dormant aspect of that clause apply? The dormant aspect
applied. What does it state? Apply that standard to these facts. (See the “Result”
at the end of this section.)
5. SUPREMACY CLAUSE Under the Supremacy Clause, if there is a conflict
between federal and state statutes, the federal law preempts the field. Even without a
conflict, federal law preempts if Congress intended to exercise exclusive control. (p. 114)
6. PRESIDENTIAL POWERS The President’s key powers include making
agency appointments, proposing legislation, conducting foreign policy, and acting as
commander in chief of the armed forces. (p. 111)
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CHAPTER 5 Constitutional Law 129
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7. FEDERAL COURTS The federal courts adjudicate cases and also exercise
judicial review, which is the right to declare a statute or governmental action
unconstitutional and void. (pp. 115–117)
8. FREEDOM OF SPEECH Freedom of speech includes symbolic acts. Political
speech by both people and organizations is protected unless it is intended and likely
to create imminent lawless action. (pp. 118–122)
9. REGULATION OF SPEECH The government may regulate the time, place,
and manner of speech. (p. 120)
10. COMMERCIAL SPEECH Commercial speech that is false or misleading may
be outlawed; otherwise, regulations on this speech must be reasonable and directed
to a legitimate goal. (pp. 121–122)
Question: A federal statute prohibits the broadcasting of lottery advertisements,
except by stations that broadcast in states permitting lotteries. The purpose of the
statute is to support efforts of states that outlaw lotteries. Truth Broadcasting
operates a radio station in State A (a nonlottery state) but broadcasts primarily in
State B (a lottery state). Truth wants to advertise State A’s lottery but is barred by
the statute. Does the federal statute violate Truth’s constitutional rights?
Strategy: This case involves a particular kind of speech. What kind? What is the
rule about that kind of speech? (See the “Result” at the end of this section.)
11. PROCEDURAL DUE PROCESS Procedural due process is required whenever
the government attempts to take liberty or property. The amount of process that is
due depends upon the importance of the liberty or property threatened. (pp. 123–124)
Question: Fox’s Fine Furs claims that Ermine owes $68,000 for a mink coat on
which she has stopped making payments. Fox files a complaint and also asks the
court clerk to garnish Ermine’s wages. A garnishment is a court order to an
employer to withhold an employee’s wages, or a portion of them, and pay the
money into court so that there will be money for the plaintiff, if it wins. What
constitutional issue does Fox’s request for garnishment raise?
Strategy: Ermine is in danger of losing part of her income, which is property.
The Due Process Clause prohibits the government (the court) from taking life,
liberty, or property without due process. What process is Ermine entitled to? (See
the “Result” at the end of this section.)
12. TAKINGS CLAUSE The Takings Clause prohibits a state from taking private
property for public use without just compensation. (pp. 124–126)
13. SUBSTANTIVE DUE PROCESS A substantive due process analysis presumes
that any economic or social regulation is valid, and presumes invalid any law that
infringes upon a fundamental right. (p. 126)
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130 U N I T 1 The Legal Environment
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14. EQUAL PROTECTION CLAUSE The Equal Protection Clause generally
requires the government to treat people equally. Courts apply strict scrutiny in any
equal protection case involving race, ethnicity, or fundamental rights; intermediate
scrutiny to any case involving gender; and minimal scrutiny to an economic or social
regulation. (pp. 126–128)
4. Result: The dormant aspect holds that a state statute that discriminates against interstate
commerce is almost always invalid. Maine was subsidizing charities that served in-state
residents and penalizing those that attracted campers from elsewhere. The tax rules violated
the Commerce Clause and were void.28
10. Result: An advertisement is commercial speech. The government may regulate this speech
so long as the rules are reasonable and directed to a legitimate goal. The goal of supporting
nonlottery states is reasonable, and there is no violation of Truth’s free speech rights.29
11. Result: Ermine is entitled to notice of Fox’s claim and to a hearing before the court
garnishes her wages.30
MULTIPLE-CHOICE QUESTIONS
1. Greenville College, a public community college, has a policy of admitting only male
students. If the policy is challenged under the Fourteenth Amendment,
scrutiny will be applied.
(a) strict
(b) intermediate
(c) rational
(d) none of the above
2. You begin work at Everhappy Corp. at the beginning of November. On your second
day at work, you wear a political button on your overcoat, supporting your choice for
governor in the upcoming election. Your boss glances at it and says, “Get that stupid
thing out of this office or you’re history, chump.” Your boss violated
your First Amendment rights. After work, you put the button back on and start
walking home. You pass a police officer who blocks your path and says, “Take off that
stupid button or you’re going to jail, chump.” The officer violated your
First Amendment rights.
(a) has; has
(b) has; has not
(c) has not; has
(d) has not; has not
28Camps Newfound/Owatonna, Inc. v. Town of Harrison, Maine, 520 U.S. 564, 117 S. Ct. 1590 (1997).
29United States v. Edge Broadcasting, 509 U.S. 418, 113 S. Ct. 2696 (1993).
30Sniadach v. Family Finance Corp., 395 U.S. 337 (1969).
CHAPTER 5 Constitutional Law 131
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3. Which of the following statements accurately describes statutes that Congress and the
President may create?
(a) Statutes must be related to a power listed in Article I, section 8, of the Constitution.
(b) Statutes must not infringe on the liberties in the Bill of Rights.
(c) Both (a) and (b)
(d) None of the above
4. Which of the following is true of the origin of judicial review?
(a) It was created by Article II of the Constitution.
(b) It was created by Article III of the Constitution.
(c) It was created in the Marbury v. Madison case.
(d) It was created by the Fifth Amendment.
(e) It was created by the Fourteenth Amendment.
5. Consider Kelo v. City of New London, in which a city with a revitalization plan squared
off against property owners who did not wish to sell their property. The key
constitutional provision was the Takings Clause in the ____________ Amendment.
The Supreme Court decided the city ____________ use eminent domain and take the
property from the landowners.
(a) Fifth; could
(b) Fifth; could not
(c) Fourteenth; could
(d) Fourteenth; could not
ESSAY QUESTIONS
1. YOU BE THE JUDGE WRITING PROBLEM Scott Fane was a CPA licensed
to practice in New Jersey and Florida. He built his New Jersey practice by making
unsolicited phone calls to executives. When he moved to Florida, the Board of
Accountancy there prohibited him (and all CPAs) from personally soliciting new
business. Fane sued. Does the First Amendment force Florida to forgo foreclosing
Fane’s phoning? Argument for Fane: The Florida regulation violates the First
Amendment, which protects commercial speech. Fane was not saying anything false
or misleading, but was just trying to secure business. This is an unreasonable
regulation, designed to keep newcomers out of the marketplace and maintain steady
business and high prices for established CPAs. Argument for the Florida Board of
Accountancy: Commercial speech deserves—and gets—a lower level of protection
than other speech. This regulation is a reasonable method of ensuring that the level of
CPA work in our state remains high. CPAs who personally solicit clients are obviously
in need of business. They are more likely to bend legal and ethical rules to obtain
clients and keep them happy, and will lower the standards throughout the state.
2. President George H. W. Bush insisted that he had the power to send American troops
into combat in the Middle East, without congressional assent. Yet before authorizing
force in Operation Desert Storm, he secured congressional authorization. President Bill
Clinton stated that he was prepared to invade Haiti without a congressional vote. Yet he
bargained hard to avoid an invasion, and ultimately American troops entered without
the use of force. Why the seeming doubletalk by both Presidents?
132 U N I T 1 The Legal Environment
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3. In the landmark 1965 case of Griswold v. Connecticut, the Supreme Court examined a
Connecticut statute that made it a crime for any person to use contraception. The
majority declared the law an unconstitutional violation of the right of privacy. Justice
Black dissented, saying, “I do not to any extent whatever base my view that this
Connecticut law is constitutional on a belief that the law is wise or that its policy is a
good one. [It] is every bit as offensive to me as it is to the majority. [There is no
criticism by the majority of this law] to which I cannot subscribe—except their
conclusion that the evil qualities they see in the law make it unconstitutional.” What
legal doctrines are involved here? Why did Justice Black distinguish between his
personal views on the statute and the power of the Court to overturn it?
4. Gilleo opposed American participation in the war in the Persian Gulf. She displayed a
large sign on her front lawn that read, “Say No to War in the Persian Gulf, Call
Congress Now.” The city of Ladue prohibited signs on front lawns and Gilleo sued.
The city claimed that it was regulating “time, place, and manner.” Explain that
statement, and decide who should win.
5. David Lucas paid $975,000 for two residential lots on the Isle of Palms near
Charleston, South Carolina. He intended to build houses on them. Two years later,
the South Carolina legislature passed a statute that prohibited building seaward of a
certain line, and Lucas’s property fell in the prohibited zone. Lucas claimed that his
land was now useless and that South Carolina owed him its value. Explain his claim.
Should he win?
DISCUSSION QUESTIONS
1. Return to the opening scenario and the Citizens
United case. Is political advertising purchased by
corporations appropriate? Do you agree with the
five members of the Supreme Court who voted to
allow it, or with the four who dissented and would
have drawn distinctions between free speech by
individuals and organizations? Why?
2. Ethics Is political advertising by a nonprofit
political organization like Citizens United any
more or less appropriate than advertising by for-
profit corporations like the one described in the
opening scenario? If you were a board member in
the opening scenario, which (if any) of the three
ads would you vote to authorize?
3. Consider the “tea party” movement. Do you
believe that the federal government should be able
to create whatever laws it deems to be in the
country’s best interests, or do you believe that
individual states, like Florida and California,
should have more control over the laws within their
own borders?
4. This chapter is filled with examples of statutes that
have been struck down by the courts. A Texas law
banning flag burning was rejected by the Supreme
Court, as was a Louisiana death penalty statute.
The Affordable Healthcare Act was voided by
multiple lower court judges before the Supreme
Court ultimately upheld the law.
Do you like the fact that courts can void laws which
they determine to be in violation of the Constitution?
Or is it wrong for appointed judges to overrule “the
will of the majority,” as expressed by elected
members of Congress and state legislatures?
5. Gender discrimination currently receives
“intermediate” Fourteenth Amendment scrutiny.
Is this right? Should gender receive “strict”
scrutiny as does race? Why or why not?
CHAPTER 5 Constitutional Law 133
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CHAPTER6
TORTS AND
PRODUCT
LIABILITY
In a small Louisiana town, Don Mashburn ran a
restaurant called Maison de Mashburn. The New
Orleans States-Item newspaper reviewed his
eatery, and here is what the article said:
’Tain’t Creole, ’tain’t Cajun, ’tain’t French, ’tain’t
country American, ’tain’t good. I don’t know how
much real talent in cooking is hidden under the
mélangeofhideous sauceswhichmake this food and themenu
a travesty of pretentious amateurism, but I find it all quite
depressing. Put a yellow flour sauce on top of the duck, flame
it for drama, and serve it with some horrible multiflavored rice
in hollowed-out fruit and what have you got? A well-cooked
duck with an ugly sauce that tastes too sweet and thick and
makes you want to scrape off the glop to eat the plain duck.
[The stuffed eggplant was prepared by emptying] a shaker full
(more or less) of paprika on top of it. [One sauce created] trout à
la green plague [while another should have been called] yellow
death on duck.
Mashburn sued, claiming that the newspaper had committed libel, damaging his reputation
and hurting his business.1Trout à la green plague will be the first course on our menu of tort law.
Mashburn learned, as you will, why filing such a lawsuit is easier than winning it.
’Tain’t Creole, ’tain’t
Cajun, ’tain’t French,
’tain’t country American,
’tain’t good.
1Mashburn v. Collin, 355 So.2d 879 (La. 1977).
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The odd word “tort” is borrowed from the French, meaning “wrong.” And that is what it
means in law: a wrong. More precisely, a tort is a violation of a duty imposed by the civil
law. When a person breaks one of those duties and injures another, it is a tort. The injury
could be to a person or her property. Libel, which the restaurant owner in the opening
scenario alleged, is one example of a tort. A surgeon who removes the wrong kidney from a
patient commits a different kind of tort, called negligence. A business executive who
deliberately steals a client away from a competitor, interfering with a valid contract, commits
a tort called interference with a contract. A con artist who tricks you out of your money with
a phony offer to sell you a boat commits fraud, yet another tort.
Because tort law is so broad, it takes a while to understand its boundaries. To start with,
we must distinguish torts from two other areas of law: criminal law and contract law.
It is a crime to steal a car, to embezzle money from a bank, to sell cocaine. As discussed
in Chapter 1, society considers such behavior so threatening that the government itself will
prosecute the wrongdoer, whether or not the car owner or bank president wants the case to
go forward. A district attorney, who is paid by the government, will bring the case to court,
seeking to send the defendant to prison, fine him, or both. If there is a fine, the money goes
to the state, not to the victim.
In a tort case, it is up to the injured party to seek compensation. She must hire her own
lawyer, who will file a lawsuit. Her lawyer must convince the court that the defendant
breached some legal duty and ought to pay money damages to the plaintiff. The plaintiff
has no power to send the defendant to jail. Bear in mind that a defendant’s action might be
both a crime and a tort. A man who punches you in the face for no reason commits the tort of
battery. You may file a civil suit against him and will collect money damages if you can
prove your case. He has also committed a crime, and the state may prosecute, seeking to
imprison and fine him.
Differences between Contract, Tort, and Criminal Law
Type of Obligation Contract Tort Criminal Law
How the obligation
is created
The parties agree on
a contract, which
creates duties
for both.
The civil law imposes
duties of conduct on
all persons.
The criminal law
prohibits certain
conduct.
How the obligation
is enforced
Suit by plaintiff. Suit by plaintiff. Prosecution by
government.
Possible result Money damages for
plaintiff.
Money damages
for plaintiff.
Punishment for
defendant, including
prison and/or fine.
Example Raul contracts to sell
Deirdre 5,000 pairs
of sneakers at $50
per pair, but fails to
deliver them. Deirdre
buys the sneakers
elsewhere for $60
per pair and receives
$50,000, her extra
expense.
A newspaper falsely
accuses a private
citizen of being an
alcoholic. The plaintiff
sues and wins money
damages to
compensate for her
injured reputation.
Leo steals Kelly’s
car. The
government
prosecutes Leo for
grand theft, and the
judge sentences
him to two years in
prison. Kelly gets
nothing.
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Tort
A violation of a duty imposed by
the civil law.
CHAPTER 6 Torts and Product Liability 135
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A tort is also different from a contract dispute. A contract case is based on an agreement
two people have already made. For example, Deirdre claims that Raul promised to sell her
10,000 pairs of sneakers at a good price but has failed to deliver them. She files a contract
lawsuit. In a tort case, there is usually no “deal” between the parties. Don Mashburn had
never met the restaurant critic who attacked his restaurant and obviously had never made
any kind of contract. The plaintiff in a tort case claims that the law itself creates a duty that
the defendant has breached.
Tort law is divided into categories. In the first part of this chapter, we consider inten-
tional torts; that is, harm caused by a deliberate action. The newspaper columnist who
wrongly accuses someone of being a drunk has committed the intentional tort of libel. In
the last sections, we examine negligence and strict liability, which involve injuries and
losses caused by neglect and oversight rather than by deliberate conduct.
A final introductory point: When we speak of intentional torts, we do not necessa-
rily mean that the defendant intended to harm the plaintiff. If the defendant does
something deliberately and it ends up injuring somebody, she is probably liable even if
she meant no harm. For example, intentionally throwing a snowball at a friend is a
deliberate act. If the snowball permanently damages his eye, the harm is unintended,
but the defendant is liable for the intentional tort of battery because the act was
intentional.
We look first at the most common intentional torts and then at the most important
intentional torts that are related to business.
6-1 INTENTIONAL TORTS
6-1a Defamation
The First Amendment guarantees the right to free speech, a vital freedom that enables us to
protect other rights. But that freedom is not absolute.
The law of defamation concerns false statements that harm someone’s reputation.
Defamatory statements can be written or spoken. Written defamation is called libel. Suppose a
newspaper accuses a local retail store of programming its cash registers to overcharge customers
when the store has never done so. That is libel. Oral defamation is slander. If Professor
Wisdom, in class, refers to Sally Student as a drug dealer when she has never sold drugs, he
has slandered her. Exhibit 6.1 maps the tension in every defamation case—between an
individual’s right to protect his reputation and the public’s right to know.
There are four elements to a defamation case. An element is something that a plaintiff
must prove to win a lawsuit. The plaintiff in any kind of lawsuit must prove all of the
elements to prevail. The elements in a defamation case are:
• Defamatory statement. This is a statement likely to harm another person’s reputation.
Professor Wisdom’s accusation will clearly harm Sally’s reputation.
• Falseness. The statement must be false. If Sally Student actually sold marijuana to a
classmate, then Professor Wisdom has a defense to slander.
• Communicated. The statement must be communicated to at least one person other
than the plaintiff. If Wisdom speaks privately to Sally and accuses her of dealing drugs,
there is no slander.
Intentional torts
Harm caused by a deliberate
action.
Libel
Written defamation.
Slander
Oral defamation.
136 U N I T 1 The Legal Environment
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• Injury. In many slander cases, the plaintiff generally must show some injury.
Sally’s injury would be lower reputation in the school, embarrassment, and
humiliation. But in slander cases that involve false statements about sexual behavior,
crimes, contagious diseases, and professional abilities, the law is willing to assume
injury without requiring the plaintiff to prove it. Lies in these four categories amount
to slander per se.
Libel cases are treated like cases of slander per se, and courts award damages without
proof of injury.2
OPINION
Thus far, what we have seen is uncontroversial. If a television commentator refers to Frank
Landlord as a “vicious slumlord who rents uninhabitable units,” and Frank actually main-
tains his buildings perfectly, Frank will be compensated for the harm. But what if the
television commentator states a harsh opinion about Frank? Remember that the plaintiff
must demonstrate a “false” statement. Opinions generally cannot be proven true or false,
and so they do not usually amount to defamation.
Suppose that the television commentator says, “Frank Landlord certainly does less than
many rich people do for our community.” Is that defamation? Probably not. Who are the
“rich people”? How much do they do? How do we define “does less”? These vague
assertions indicate the statement is one of opinion. Even if Frank works hard feeding
homeless families, he will probably lose a defamation case.
A related defense involves cases where a supposed statement of fact clearly should not
be taken literally. Mr. Mashburn, who opened the chapter suing over his restaurant review,
lost his case. The court held that a reasonable reader would have understood the statements
to be opinion only. “A shaker full of paprika” and “yellow death on duck” were not to be
taken literally but were merely the author’s expression of his personal dislike.
PUBLIC PERSONALITIES
The rules of the game change for those who play in the open. Government officials and other
types of public figures such as actors and athletes receive less protection from defamation. In
the landmark case New York Times Co. v. Sullivan,3 the Supreme Court ruled that the free
exchange of information is vital in a democracy and is protected by the First Amendment to the
Constitution.
The rule from the New York Times case is that a public official or public figure can win a
defamation case only by proving actual malice by the defendant. Actual malice means that
the defendant knew the statement was false or acted with reckless disregard of the truth. If
the plaintiff merely shows that the defendant newspaper printed incorrect statements, even
very damaging ones, that will not suffice to win the suit. In the New York Times case, the
police chief of Birmingham, Alabama, claimed that the Times falsely accused him of racial
violence in his job. He lost because he could not prove that the Times had acted with actual
malice. If he had shown that the Times knew the accusation was false, he would have won.
Slander per se
Slander involving false
statements about sexual
behavior, crimes, contagious
diseases, and professional
abilities.
2When defamation by radio and television became possible, the courts chose to consider it libel,
analogizing it to newspapers because of the vast audience. This means that in broadcasting cases, a
plaintiff generally does not have to prove damages.
3376 U.S. 254, 84 S. Ct. 710, 1964 U.S. LEXIS 1655 (1964).
CHAPTER 6 Torts and Product Liability 137
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ONLINE DEFAMATION
Kenneth Zeran awoke one day to learn he had become notorious. An unidentified person
had posted a message on an AOL bulletin board advertising “Naughty Oklahoma T-Shirts.”
The shirts featured deeply offensive slogans relating to the 1995 bombing of a federal building
in Oklahoma City, in which hundreds of innocent people died. Those interested in purchasing
such a T-shirt were instructed to call “Ken” at Zeran’s home telephone number. In fact, Zeran
had nothing to do with the posting or the T-shirts. He was quickly inundated with phone
messages from furious callers, some of whom made death threats.
Zeran could not conveniently change his number because he ran his business from his
home. A radio talk show host in Oklahoma City angrily urged its listeners to call Zeran,
which they did. Before long, Zeran was receiving an abusive call every two minutes. He
sued AOL for defamation—and lost.
The court held that AOL was immune from a defamation suit based on a third-party
posting, based on the Communications Decency Act (CDA). Section 230 of the CDA
creates this immunity for any Internet service provider, the court declared, adding:
It would be impossible for service providers to screen each of their millions of postings for
possible problems. Faced with potential liability for each message republished by their services,
interactive computer service providers might choose to severely restrict the number and type of
messages posted. Congress considered the weight of the speech interests implicated and chose to
immunize service providers to avoid any such restrictive effect.4
PRIVILEGE
Defendants receive additional protection from defamation cases when it is important
for them to speak freely. Absolute privilege exists in courtrooms and legislative hearings.
Anyone speaking there, such as a witness in court, can say anything at all and never be sued
for defamation. (Deliberately false testimony would be perjury, but still not slander.)
Absolute
Privilege
Internet
Service
Provider
Public
Personality‘s
Reputation
s
Private
Citizen‘s
ReputationP
The Public‘s Need
to Exchange
Information
Private Right
to a Good
Reputation
Harder to Prove
Defamation
Easier to Prove
Defamation
Opinion
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EXHIB IT 6.1 Defamation cases show a tension between the public’s need for information and a citizen’s right to
protect his reputation.
4Zeran v. America Online, Inc., 129 F.3d 327, 1997 U.S. App. LEXIS 31791 (4th Cir. 1997).
Absolute privilege
A witness testifying in a court or
legislature may never be sued
for defamation.
138 U N I T 1 The Legal Environment
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6-1b False Imprisonment
False imprisonment is the intentional restraint of another person without reasonable cause
and without consent. Suppose that a bank teller becomes seriously ill and wants to go to the
doctor, but the bank will not permit her to leave until she makes a final tally of her accounts.
Against her wishes, company officials physically bar her from leaving the bank. That is false
imprisonment. The restraint was unreasonable because her accounts could have been verified
later.5
False imprisonment cases most commonly arise in retail stores, which sometimes detain
employees or customers for suspected theft. Most states now have statutes governing the
detention of suspected shoplifters. Generally, a store may detain a customer or worker for
alleged shoplifting provided there is a reasonable basis for the suspicion and the detention is
done reasonably. To detain a customer in the manager’s office for 20 minutes and question
him about where he got an item is lawful. To chain that customer to a display counter for
three hours and humiliate him in front of other customers is unreasonable and constitutes
false imprisonment.
6-1c Intentional Infliction of Emotional Distress
What should happen when a defendant’s conduct hurts a plaintiff emotionally but not
physically? Historically, not much did happen. Courts once refused to allow recovery,
assuming that if they awarded damages for mere emotional injury, they would be inviting
a floodgate of dubious claims. But gradually judges reexamined their thinking and reversed
this tendency. Today, most courts allow a plaintiff to recover for emotional injury that a
defendant intentionally caused. Some courts will also permit recovery when a defendant’s
negligent conduct caused the emotional injury.
The intentional infliction of emotional distress results from extreme and outrageous
conduct that causes serious emotional harm. A credit officer was struggling vainly to
locate Sheehan, who owed money on his car. The officer phoned Sheehan’s mother,
falsely identified herself as a hospital employee, and said she needed to find Sheehan
because his children had been in a serious auto accident. The mother provided
Sheehan’s whereabouts, which enabled the company to seize his car. But Sheehan
spent seven hours frantically trying to locate his supposedly injured children, who in
fact were fine. The credit company was liable for the intentional infliction of emotional
distress.6
By contrast, a muffler shop, trying to collect a debt from a customer, made six phone
calls over three months, using abusive language. The customer testified that this caused her
to be upset, to cry, and to have difficulty sleeping. The court ruled that the muffler shop’s
conduct was neither extreme nor outrageous.7
The following case arose in a setting that guarantees controversy—an abortion clinic.
5Kanner v. First National Bank of South Miami, 287 So.2d 715, 1974 Fla. App. LEXIS 8989 (Fla. Dist.
Ct. App. 1974).
6Ford Motor Credit Co. v. Sheehan, 373 So.2d 956, 1979 Fla. App. LEXIS 15416 (Fla. Dist. Ct.
App. 1979).
7Midas Muffler Shop v. Ellison, 133 Ariz. 194, 650 P.2d 496, 1982 Ariz. App. LEXIS 488 (Ariz. Ct.
App. 1982).
False imprisonment
Is the intentional restraint
of another person without
reasonable cause and without
consent.
Intentional infliction of
emotional distress
An intentional tort in which the
harm results from extreme and
outrageous conduct that
causes serious emotional
harm.
CHAPTER 6 Torts and Product Liability 139
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6-1d Additional Intentional Torts
Battery is an intentional touching of another person in a way that is unwanted or offensive.
There need be no intention to hurt the plaintiff. If the defendant intended to do the physical act,
and a reasonable plaintiff would be offended by it, battery has occurred.
Suppose an irate parent throws a chair at a referee during his daughter’s basketball
game, breaking the man’s jaw. It is irrelevant that the father did not intend to injure the
referee. But a parent who cheerfully slaps the winning coach on the back has not committed
battery because a reasonable coach would not be offended.
Assault occurs when a defendant does some act that makes a plaintiff fear an imminent
battery. It is assault even though the battery never occurs. Suppose Ms. Wilson shouts
“Think fast!” at her husband and hurls a toaster at him. He turns and sees it flying at him.
His fear of being struck is enough to win a case of assault, even if the toaster misses.
Fraud is injuring another person by deliberate deception. It is fraud to sell real estate
knowing that there is a large toxic waste deposit underground of which the buyer is ignorant. Fraud
is a tort that typically occurs during contract negotiation, and it is discussed inmore detail in Unit 2,
on contracts.
6-2 DAMAGES
6-2a Compensatory Damages
Mitchel Bien, who is deaf and mute, enters the George Grubbs Nissan dealership, where
folks sell cars aggressively. Very aggressively. Maturelli, a salesman, and Bien communicate
by writing messages back and forth. Maturelli takes Bien’s own car keys, and the two then
JANE DOE AND NANCY ROE V. LYNN MILLS
212 Mich. App. 73
Michigan Court of Appeals, 1995
C A S E S U M M A R Y
Facts: Late one night, an anti-abortion protestor named
Robert Thomas climbed into a dumpster located behind the
Women’s Advisory Center, an abortion clinic. He found docu-
ments indicating that the plaintiffs were soon to have abortions
at the clinic. Thomas gave the information to LynnMills. The
next day, Mills and Sister LoisMitoraj created signs, using the
women’s names, indicating that they were about to undergo
abortions and urging them not to “kill their babies.”
Doe and Roe (not their real names) sued, claiming
intentional infliction of emotional distress (as well as breach of
privacy, discussed later in this chapter). The trial court dis-
missed the lawsuit before trial, ruling that the defendants’
conduct was not extreme and outrageous. The plaintiffs
appealed.
Issue: Did the plaintiffs make a valid claim of intentional
infliction of emotional distress?
Decision: Yes. The plaintiffs made a valid claim of
intentional infliction of emotional distress.
Reasoning: A defendant is liable for the intentional
infliction of emotional distress only when his conduct is
outrageous in character, extreme in degree, and utterly
intolerable in a civilized community. A good test is
whether the average member of the community would
respond to the defendant’s conduct by exclaiming,
“Outrageous!”
These defendants had a constitutional right to protest
against abortions, but they had no such right to publicize
private matters. Their behavior here might well have
caused the average person to say, “Outrageous!” The
plaintiffs were entitled to a trial, so that a jury could decide
whether the defendants inflicted emotional distress.
Battery
An intentional touching of
another person in a way that is
harmful or offensive.
Assault
An act that makes a person
reasonably fear an imminent
battery.
Fraud
Injuring another person by
deliberate deception.
140 U N I T 1 The Legal Environment
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test drive a 300ZX. Bien says he does not want the car, but Maturelli escorts him back inside
and fills out a sales sheet. Bien repeatedly asks for his keys, but Maturelli only laughs,
pressuring him to buy the new car. Minutes pass. Hours pass. Bien becomes frantic, writing
a dozen notes, begging to leave, threatening to call the police. Maturelli mocks Bien and his
physical disabilities. Finally, after four hours, the customer escapes.
Bien sues for the intentional infliction of emotional distress. Two former salesmen from
Grubbs testify they have witnessed customers cry, yell, and curse as a result of the aggressive
tactics. Doctors state that the incident has traumatized Bien, dramatically reducing his con-
fidence and self-esteem and preventing his return to work even three years later.
The jury awards Bien damages. But how does a jury calculate the money? For that
matter, why should a jury even try? Money can never erase pain or undo a permanent injury.
The answer is simple: Money, however inexact, is often the only thing a court has to give.
A successful plaintiff generally receives compensatory damages, meaning an amount of
money that the court believes will restore him to the position he was in before the defendant’s
conduct caused injury. Here is how damages are calculated.
First, a plaintiff receives money for medical expenses that he has proven by producing bills
from doctors, hospitals, physical therapists, and psychotherapists. Bien receives all the money
he has paid. If a doctor testifies that he needs future treatment, Bien will offer evidence of how
much that will cost. The single recovery principle requires a court to settle the matter once and
for all, by awarding a lump sum for past and future expenses, if there will be any. A plaintiff may
not return in a year and say, “Oh, by the way, there are some new bills.”
Second, the defendants are liable for lost wages. The court takes the number of days ormonths
thatBienmissedworkandmultipliesthatbyhissalary. If Bienis
currently unable to work, a doctor estimates how many more
monthshewillmisswork,andthecourtaddsthat tohisdamages.
Third, a plaintiff is paid for pain and suffering. Bien
testifies about how traumatic the four hours were and how
the experience has affected his life. He may state that he now
fears shopping, suffers nightmares, and seldom socializes. To
bolster the case, a plaintiff uses expert testimony, such as the
psychiatrists who testified for Bien. Awards for pain and
suffering vary enormously, from a few dollars to many mil-
lions, depending on the injury and depending on the jury. In
some lawsuits, physical and psychological pain aremomentary
and insignificant; in other cases, the pain is the biggest part of
the verdict. In this case, the jury awarded Bien $573,815,
calculated as in the table that follows.8
Awards for future harm (such as future pain and suffering) involve the court making its
best estimate of the plaintiff’s hardship in the years to come. This is not an exact science. If
the judgment is reasonable, it will rarely be overturned. Ethel Flanzraich, aged 78, fell on
stairs that had been badly maintained. In addition to her medical expense, the court awarded
her $150,000 for future pain and suffering. The day after the court gave its award, Ms.
Flanzraich died of other causes. Did that mean her family must forfeit that money? No.
The award was reasonable when made and had to be paid.9
Bien becomes frantic,
writing a dozen notes,
begging to leave,
threatening to call the
police.
8The compensatory damages are described inGeorge GrubbsEnterprises v. Bien, 881S.W.2d 843, 1994Tex. App.
LEXIS 1870 (Tex. Ct. App. 1994). In addition to the compensatory damages described, the jury awarded $5
million in punitive damages. The Texas Supreme Court reversed the award of punitive damages, but not the
compensatory. Id., 900 S.W.2d 337, 1995 Tex. LEXIS 91 (Tex. 1995). The high court did not dispute the
appropriateness of punitivedamages, but reversedbecause the trial court failed to instruct the juryproperly as to
how it should determine the assets actually under the defendants’ control, an issue essential to punitive
damages but not compensatory.
9We looked at discovery issues from this case in Chapter 3. Stinton v. Robin’s Wood, 45 A.D.3d 203, 842
N.Y.S.2d 477 (N.Y.App.Div. 2007).
Compensatory damages
Money intended to restore a
plaintiff to the position he was in
before the injury.
Single recovery principle
Requires a court to settle the
matter once and for all, by
awarding a lump sum for past
and future expenses.
CHAPTER 6 Torts and Product Liability 141
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Past medical $ 70.00
Future medical 6,000.00
Past rehabilitation 3,205.00
Past lost earning capacity 112,910.00
Future lost earning capacity 34,650.00
Past physical symptoms and discomfort 50,000.00
Future physical symptoms and discomfort 50,000.00
Past emotional injury and mental anguish 101,980.00
Future emotional injury and mental anguish 200,000.00
Past loss of society and reduced ability to
socially interact with family, former fiancee,
and friends, and hearing (i.e., nondeaf) people
in general
10,000.00
Future loss of society and reduced ability to socially
interact with family, former fiancee, and friends,
and hearing people
5,000.00
TOTAL $573,815.00
6-2b Punitive Damages
Here we look at a different kind of award, one that is more controversial and potentially more
powerful: punitive damages. The purpose is not to compensate the plaintiff for harm, because
compensatory damages will have done that. Punitive damages are intended to punish the
defendant for conduct that is extreme and outrageous. Courts award these damages in relatively
few cases. The idea behind punitive damages is that certain behavior is so unacceptable that
society must make an example of it. A large award of money should deter the defendant from
repeating the mistake and others from ever making it. Some believe punitive damages
represent the law at its most avaricious, while others attribute to them great social benefit.
Although a jury has wide discretion in awarding punitive damages, the Supreme Court
has ruled that, if a verdict is unreasonable, it violates the Due Process clause of the
Constitution. Ira Gore purchased a new BMW automobile from an Alabama dealer and
then discovered that the car had been repainted. He sued. At trial, BMW acknowledged a
nationwide policy of not informing customers of predelivery repairs when the cost was less
than 3% of the retail price. The company had sold about 1,000 repainted cars nationwide.
The jury concluded that BMW had engaged in gross, malicious fraud and awarded Gore
$4,000 in compensatory damages and $4 million in punitive damages. The Alabama
Supreme Court reduced the award to $2 million, but the United States Supreme Court
ruled that even that amount was grossly excessive. The Court held that in awarding punitive
damages, a court must consider three “guideposts”:
• The reprehensibility of the defendant’s conduct;
• The ratio between the harm suffered and the award; and
• The difference between the punitive award and any civil penalties used in similar cases.
©
C
en
g
ag
e
Le
ar
n
in
g
Punitive damages
Damages that are intended
to punish the defendant for
conduct that is extreme and
outrageous.
142 U N I T 1 The Legal Environment
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The Court concluded that BMW had shown no evil intent and that Gore’s harm had
been purely economic (as opposed to physical). Further, the Court found the ratio of 500
to 1, between punitive and compensatory damages, to be excessive, although it offered no
definitive rule about a proper ratio. On remand, the Alabama Supreme Court reduced the
punitive damages award to $50,000.10
The U.S. Supreme Court gave additional guidance on punitive damages in the follow-
ing landmark case.
Landmark Case
Facts: While attempting
to pass several cars on a
two-lane road, Campbell
drove into oncoming
traffic. An innocent driver
swerved to avoid Camp-
bell and died in a collision
with a third driver. The
family of the deceased driver and the surviving third
driver both sued Campbell.
As Campbell’s insurer, State Farm represented him in
the lawsuit. It turned down an offer to settle the case for
$50,000, the limit of Campbell’s policy. The company had
nothing to gain by settling because even if Campbell lost
big at trial, State Farm’s liability was capped at $50,000.
A jury returned a judgment against Campbell for
$185,000. He was responsible for the $135,000 that
exceeded his policy limit. He argued with State Farm,
claiming that it should have settled the case. Eventually,
State Farm paid the entire $185,000, but Campbell still
sued the company, alleging fraud and intentional inflic-
tion of emotional distress.
His lawyers presented evidence that State Farm had
deliberately acted in its own best interests rather than his.
The jury was convinced, and in the end, awarded
$1 million in compensatory damages and $145 million in
punitive damages. State Farm appealed.
Issue: Did the punitive damages violate the Due Process
Clause?
Decision: Yes. A ratio of punitive to compensatory
damages of 145-to-1 was excessive, especially where the
plaintiff suffered limited harm.
Reasoning: The goal of
punitive damages is to
prevent and punish
wrongdoing. However,
the Due Process Clause
requires that people have
fair warning about what
conduct will be punished
and how severe the penalty will be. When punitive
damages are grossly excessive, they violate this provision
of the Constitution.
Punitive damages are reasonable only if they are pro-
portionate both to the amount of harm suffered by the
plaintiff and to the compensatory damages awarded. We
do not impose any precise limit on punitive damages
awards, because results will depend on the particular facts
of each case. However, we are skeptical of any awards in
which the ratio between punitive and compensatory
damages is greater than nine. Awards at this level are
unlikely to satisfy due process, while still achieving the
State’s goals of prevention and punishment. Double-digit
ratios could be possible, but only in cases of extreme harm.
The Campbells’ award had a triple-digit ratio of
145-to-1. That is, the lower court awarded the Campbells
$145 million in punitive damages and $1 million in com-
pensatory damages. What was the extent of their harm?
The Campbells suffered a year and a half of emotional
distress. They had no physical injuries or trauma. Their
economic damage was not significant either, since State
Farm paid the excess verdict. One million dollars was
adequate compensation for their stress and hurt feelings.
We reverse the judgment and remand this case to the
lower court.
10BMW of North America, Inc. v. Gore, 517 U.S. 559, 116 S. Ct. 1589, 1996 U.S. LEXIS 3390 (1996)
STATE FARM V. CAMPBELL
538 U.S. 408
Supreme Court of the United States (2003)
CHAPTER 6 Torts and Product Liability 143
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6-3 BUSINESS TORTS
In this section, we look at several intentional torts that occur almost exclusively in a commercial
setting: interference with a contract, interference with a prospective advantage, and the rights
to privacy and publicity. Note that several business torts are discussed elsewhere in the book:
• Patents, copyrights, and trademarks are discussed in Chapter 33, on intellectual
property.
• False advertising, discussed in part under the Lanham Act section (later in this
chapter), is considered more broadly in Chapter 31, on consumer law.
• Consumer issues are also covered in Chapter 31. The material in the present chapter
focuses not on consumer claims but on disputes between businesses.
6-3a Tortious Interference with Business Relations
Competition is the essence of business. Successful corporations compete aggressively, and the
law permits and expects them to. But there are times when healthy competition becomes
illegal interference. This is called tortious interference with business relations. It can take one
of two closely related forms—interference with a contract or interference with a prospective
advantage.
TORTIOUS INTERFERENCE WITH A CONTRACT
Tortious interference with a contract exists if the plaintiff can establish the following four
elements:
• There was a contract between the plaintiff and a third party;
• The defendant knew of the contract;
• The defendant improperly induced the third party to breach the contract or made
performance of the contract impossible; and
• There was injury to the plaintiff.
Because businesses routinely compete for customers, employees, and market share, it is
not always easy to identify tortious interference. There is nothing wrong with two companies
bidding against each other to buy a parcel of land, and nothing wrong with one corporation
doing everything possible to convince the seller to ignore all competitors. But once a company
has signed a contract to buy the land, it is improper to induce the seller to break the deal. The
most commonly disputed issues in these cases concern elements one and three: Was there a
contract between the plaintiff and another party? Did the defendant improperly induce a
party to breach it? Defendants will try to show that the plaintiff had no contract.
A defendant may also rely on the defense of justification; that is, a claim that special
circumstances made its conduct fair. To establish justification, a defendant must show that:
• It was acting to protect an existing economic interest, such as its own contract with
the third party;
• It was acting in the public interest, for example, by reporting to a government agency
that a corporation was overbilling for government services; or
• The existing contract could be terminated at will by either party, meaning that
although the plaintiff had a contract, the plaintiff had no long-term assurances
because the other side could end it at any time.
Tortious interference
with a contract
An intentional tort in which the
defendant improperly induced a
third party to breach a contract
with the plaintiff.
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Texaco v. Pennzoil One of the largest verdicts in the history of American law came in a
case of contract interference. Pennzoil made an unsolicited bid to buy 20 percent of Getty
Oil at $112.50 per share, and the Getty board approved the agreement. Before the lawyers
for both sides could complete the paperwork, Texaco appeared and offered Getty stock-
holders $128 per share for the entire company. Getty officers turned their attention to
Texaco, but Pennzoil sued, claiming tortious interference. Texaco replied that it had not
interfered because there was no binding contract.
The jury bought Pennzoil’s argument, and they bought it big: $7.53 billion in actual
damages, and $3 billion more in punitive damages. After appeals and frantic negotiations,
the two parties reached a settlement. Texaco agreed to pay Pennzoil $3 billion as settlement
for having wrongfully interfered with Pennzoil’s agreement to buy Getty.
TORTIOUS INTERFERENCE WITH A PROSPECTIVE ADVANTAGE
Interference with a prospective advantage is an awkward name for a tort that is simply a
variation on interference with a contract. The difference is that, for this tort, there need be no
contract; the plaintiff is claiming outside interference with an expected economic relationship.
Obviously, the plaintiff must show more than just the hope of a profit.
A plaintiff who has a definite and reasonable expectation of obtaining an economic
advantage may sue a corporation that maliciously interferes and prevents the relationship
from developing.
Suppose that Jump Co. and Block Co. both hope to purchase a professional basketball
team. The team’s owners reject the offer from Block. They informally agree to a price with
Jump but refuse to make a binding deal until Jump leases a stadium. Block owns the only
stadium in town and refuses to lease to Jump, meaning that Jump cannot buy the team.
Block has interfered with Jump’s prospective advantage.
6-3b Privacy and Publicity
We live in a world of dazzling technology, and it is easier than ever—and more profitable— to
spy on someone. Does the law protect us? What power do we have to limit the intrusion of
others into our lives and to prohibit them from commercially exploiting information about us?
INTRUSION
Intrusion into someone’s private life is a tort if a reasonable person would find it offensive.
Peeping through someone’s windows or wiretapping his telephone are obvious examples of
intrusion. In a famous case involving a “paparazzo” photographer and Jacqueline Kennedy
Onassis, the court found that the photographer had invaded her privacy by making a career
out of photographing her. He had bribed doormen to gain access to hotels and restaurants she
visited, had jumped out of bushes to photograph her young children, and had driven power
boats dangerously close to her. The court ordered him to stop.11 Nine years later, the paparazzo
was found in contempt of court for again taking photographs too close to Ms. Onassis. He
agreed to stop once and for all—in exchange for a suspended contempt sentence.
COMMERCIAL EXPLOITATION
The right to commercial exploitation prohibits the use of someone’s likeness or voice for
commercial purposes without permission. This business tort is the flip side of privacy and
covers the right to make money from publicity. For example, it would be illegal to run a
magazine ad showing Keira Knightley holding a can of soda without her permission. The ad
would imply that she endorses the product. Someone’s identity is her own, and it cannot be
used for commercial gain unless she permits it.
11Galella v. Onassis, 487 F. 2d 986.
Tortious interference with
a prospective advantage
Malicious interference with a
developing econimic
relationship.
Intrusion
A tort in which a reasonable
person would find the invasion
of her private life offensive.
CHAPTER 6 Torts and Product Liability 145
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Ford Motor Co. hired a singer to imitate Bette Midler’s version of a popular song. The
imitation was so good that most listeners were fooled into believing that Ms. Midler was
endorsing the product. That, ruled a court, violated her right to commercial exploitation.
6-4 NEGLIGENCE
Party time! A fraternity at the University of Arizona welcomed new members, and the
alcohol flowed freely. Several hundred people danced and shrieked and drank, and no one
checked for proof of age. A common occurrence—but one that ended tragically. A minor
student drove away, intoxicated, and slammed into another car. The other driver, utterly
innocent of wrongdoing, was gravely injured.
The drunken student was obviously liable, but his insurance did not cover the huge
medical bills. The injured man also sued the fraternity. Should that organization be legally
responsible? The question leads to other similar issues. Should a restaurant that serves an
intoxicated adult be liable for resulting harm? If you give a party, should you be responsible
for any damage caused by your guests?
These are moral questions—but very practical ones, as well. They are typical issues of
negligence law. In this contentious area, courts continually face one question: When someone
is injured, how far should responsibility extend?
We might call negligence the “unintentional” tort because it concerns harm that arises by
accident. A person, or perhaps an organization, does some act, neither intending nor expecting
to hurt anyone, yet someone is harmed. Should a court impose liability? The fraternity
members who gave the party never wanted—or thought—that an innocent man would suffer
terrible damage. But he did. Is it in society’s interest to hold the fraternity responsible?
Before we can answer this question, we need some background knowledge. Things go
wrong all the time, and society needs a means of analyzing negligence cases consistently
and fairly.
To win a negligence case, a plaintiff must prove five elements. Much of the remainder
of this chapter will examine them in detail. They are:
• Duty of Due Care. The defendant had a legal responsibility to the plaintiff.
• Breach. The defendant breached her duty of care or failed to meet her legal
obligations.
• Factual Cause. The defendant’s conduct actually caused the injury.
• Proximate Cause. It was foreseeable that conduct like the defendant’s might cause this
type of harm.
• Damages. The plaintiff has actually been hurt or has actually suffered a measureable loss.
To win a case, a plaintiff must prove all the elements listed above. If a defendant eliminates
only one item on the list, there is no liability.
6-4a Duty of Due Care
Each of us has a duty to behave as a reasonable person would under the circumstances.
If you are driving a car, you have a duty to all the other people near you to drive like a
reasonable person. If you drive while drunk, or send text messages while behind the wheel,
then you fail to live up to your duty of care.
But how far does your duty extend? Judges draw an imaginary line around the
defendant and say that she owes a duty to the people within the circle, but not to those
outside it. The test is generally “foreseeability.” If the defendant could have foreseen injury
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to a particular person, she has a duty to him. Suppose that one of your friends posts a YouTube
video of you texting behind the wheel and her father is so upset from watching it that he falls
down the stairs. You would not be liable for the father’s downfall because it was not foreseeable
that he would be harmed by your texting.
Let us apply these principles to the case described in the scenario that opened this
section.
In several circumstances, people have special duties to others. Three of them are
outlined below.
SPECIAL DUTY: LANDOWNERS
The common law applies special rules to a landowner for injuries occurring on her property.
In most states, the owner’s duty depends on the type of person injured.
Lowest Liability: Trespassing Adults A trespasser is anyone on another’s property
without consent. A landowner is liable to a trespasser only for intentionally injuring him or
for some other gross misconduct. The landowner has no liability to a trespasser for mere
negligence. Jake is not liable if a vagrant wanders onto his land and is burned by defective
electrical wires.
HERNANDEZ V. ARIZONA BOARD OF REGENTS
177 Ariz. 244, 866 P.2d 1330, 1994 Ariz.
LEXIS 6 Arizona Supreme Court, 1994
C A S E S U M M A R Y
Facts: At the University of Arizona, the Epsilon Epsilon
chapter of Delta Tau Delta fraternity gave a welcoming
party for new members. The fraternity’s officers knew
that the majority of its members were under the legal
drinking age, but they permitted everyone to consume
alcohol. John Rayner, who was under 21 years of age, left
the party. He drove negligently and caused a collision
with an auto driven by Ruben Hernandez. At the time
of the accident, Rayner’s blood alcohol level was 0.15,
exceeding the legal limit. The crash left Hernandez blind,
severely brain damaged, and quadriplegic.
Hernandez sued Rayner, who settled the case, based
on the amount of his insurance coverage. The victim also
sued the fraternity, its officers and national organization,
all fraternity members who contributed money to buy
alcohol, the university, and others. The trial court granted
summary judgment for all defendants, and the court of
appeals affirmed. Hernandez appealed to the Arizona
Supreme Court.
Issue: Did the fraternity and the other defendants have a
duty of due care to Hernandez?
Decision: The defendants did have a duty of due care to
Hernandez. Reversed and remanded.
Reasoning: Yes. Historically, Arizona and most states
have considered that consuming alcohol led to liability,
but not furnishing it. However, the common law also has
had a longstanding rule that a defendant could be liable
for supplying some object to a person who is likely to
endanger others. Giving a car to an intoxicated youth
would be an example of such behavior; the youth might
easily use the object (the car) to injure other people.
There is little difference between giving a car to an
intoxicated youth and giving alcohol to a young person
with a car. Both acts involve minors who, because of their
age and inexperience, are likely to endanger third parties.
Moreover, furnishing alcohol to a minor violates several
state statutes. As a result, most states have concluded that
a defendant who serves intoxicating drinks to a minor is
legally responsible for resulting harm to third parties.
Arizona now joins that majority. The defendants did have
a duty of due care to Hernandez and to the public in
general.
Trespasser
A person on another’s property
without consent.
CHAPTER 6 Torts and Product Liability 147
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Mid-level Liability: Trespassing Children The law makes exceptions when the
trespassers are children If there is some manmade thing on the land that may be reasonably
expected to attract children, the landowner is probably liable for any harm. Daphne lives next
door to a day-care center and builds a treehouse on her property. Unless she has fenced off
the dangerous area, she is probably liable if a small child wanders onto her property and
injures himself when he falls from the rope ladder to the treehouse.
Higher Liability: Licensee A licensee is anyone on the land for her own purposes but
with the owner’s permission. A social guest is a typical licensee. A licensee is entitled to a
warning of hidden dangers that the owner knows about. If Juliet invites Romeo for a late
supper on the balcony and fails to mention that the wooden railing is rotted, she is liable
when her hero plunges to the courtyard.
But Juliet is liable only for injuries caused by hidden dangers—she has no duty to warn
guests of obvious dangers. She need not say, “Romeo, oh Romeo, don’t place thy hand in
the toaster, Romeo.”
Highest Liability: Invitee An invitee is someone who has a right to be on the property
because it is a public place or a business open to the public. The owner has a duty of
reasonable care to an invitee. Perry is an invitee when he goes to the town beach. If riptides
have existed for years and the town fails to post a warning, it is liable if Perry drowns. Perry
is also an invitee when he goes to Dana’s coffee shop. Dana is liable if she ignores spilled
coffee that causes Perry to slip.
With social guests, you must have actual knowledge of some specific hidden danger to be
liable. Not so with invitees. You are liable even if you had no idea that something on your
property posed a hidden danger. Therefore, if you own a business, you must conduct inspec-
tions of your property on a regular basis to make sure that nothing is becoming dangerous.
The courts of some states have modified these distinctions, and a few have eliminated
them altogether. California, for example, requires “reasonable care” as to all people on the
owner’s property, regardless of how or why they got there. But most states still use the
classifications outlined above.
SPECIAL DUTY: PROFESSIONALS
A person at work has a heightened duty of care. While on the job, she must act as a reasonable
person in her profession. A taxi driver must drive as a reasonable taxi driver would. A heart
surgeon must perform bypass surgery with the care of a trained specialist in that field.
Two medical cases illustrate the reasonable person standard. A doctor prescribes a
powerful drug without asking his patient about other medicines she is currently taking.
The patient suffers a serious drug reaction from the combined medications. The physician is
liable for the harm. A reasonable doctor always checks current medicines before prescribing
new ones.
On the other hand, assume that a patient dies on the operating table in an emergency
room. The physician followed normal medical procedures at every step of the procedure and
acted with reasonable speed. In fact, the man had a fatal stroke. The surgeon is not liable. A
doctor must do a reasonable professional job, but she cannot guarantee a happy outcome.
SPECIAL DUTY: HIRING AND RETENTION
Employers also have special responsibilities.
In a recent one-year period, more than 1,000 homicides and 2 million attacks occurred
in the workplace. Companies must beware because they can be liable for hiring or retaining
violent employees. A mailroom clerk with a previous rape and robbery conviction followed a
secretary home after work and killed her. Even though the murder took place off the
company premises, the court held that the defendant would be liable if it knew or should
Licensee
A person on another’s land for
her own purposes but with the
owner’s permission.
Invitee
A person who has a right
to enter another’s property
because it is a public place or a
business open to the public.
148 U N I T 1 The Legal Environment
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have known of the mail clerk’s criminal history.12 In other cases, companies have been
found liable for failing to check an applicant’s driving record, contact personal references, or
search criminal records.
Courts have also found companies negligent for retaining dangerous workers. If an
employee threatens a coworker, the organization is not free to ignore the menacing conduct.
If the employee acts on his threats, the company may be liable.13
6-4b Breach of Duty
The second element of a plaintiff’s negligence case is breach of duty. If a legal duty of care
exists, then a plaintiff must show that the defendant did not meet it. Did the defendant act
as a reasonable person, or as a reasonable professional? Did she warn social guests of hidden
dangers she knew to exist in her apartment?
Normally, a plaintiff proves this part of a negligence case by convincing a jury that they
would not have behaved as the defendant did—indeed, that no reasonable person would.
NEGLIGENCE PER SE
In certain areas of life, courts are not free to decide what a “reasonable” person would have
done because the state legislature has made the decision for them. When a legislature sets a
minimum standard of care for a particular activity, in order to protect a certain group of
people, and a violation of the statute injures a member of that group, the defendant has
committed negligence per se. A plaintiff who can show negligence per se need not prove
breach of duty.
In Minnesota, the state legislature became alarmed about children sniffing glue, which
they could easily purchase in stores. The legislature passed a statute prohibiting the sale to a
minor of any glue containing toluene or benzene. About one month later, 14-year-old
Steven Zerby purchased Weldwood Contact Cement from the Coast-to-Coast Store in his
hometown. The glue contained toluene. Steven inhaled the glue and died from injury to his
central nervous system.
The store clerk had not realized that the glue was dangerous. Irrelevant: He was
negligent per se because he violated the statute. Perhaps a reasonable person would
have made the same error. Irrelevant. The legislature had passed the statute to protect
children, the sale of the glue violated the law, and a child was injured. The store was
automatically liable.
6-4c Causation
We have seen that a plaintiff must show that the defendant owed him a duty of care and that
the defendant breached the duty. To win, the plaintiff must also show that the defendant’s
breach of duty caused the plaintiff’s harm. Courts look at two separate causation issues: Was
the defendant’s behavior the factual cause of the harm? Was it the proximate cause?
FACTUAL CAUSE
If the defendant’s breach led to the ultimate harm, it is the factual cause. Suppose that
Dom’s Brake Shop tells a customer his brakes are now working fine, even though Dom
knows that is false. The customer drives out of the shop, cannot stop at a red light, and hits a
bicyclist crossing the intersection. Dom is liable to the cyclist. Dom’s unreasonable behavior
was the factual cause of the harm. Think of it as a row of dominoes. The first domino
(Dom’s behavior) knocked over the next one (failing brakes), which toppled the last one
(the cyclist’s injury).
12Gaines v. Monsanto, 655 S.W.2d 568, 1983 Mo. LEXIS 3439 (Mo. Ct. App. 1983).
13Yunker v. Honeywell, 496 N.W.2d 419, 1993 Minn. App. LEXIS 230 (Minn. Ct. App. 1993).
CHAPTER 6 Torts and Product Liability 149
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Suppose, alternatively, that just as the customer is exiting the repair shop, the cyclist
hits a pothole and tumbles off her cycle. Dom has breached his duty to his customer, but he
is not liable to the cyclist—she would have been hurt anyway. This is a row of dominoes
that veers off to the side, leaving the last domino (the cyclist’s injury) untouched. No factual
causation.
PROXIMATE CAUSE
For the defendant to be liable, the type of harm must have been reasonably foreseeable. In the
first example just discussed, Dom could easily foresee that bad brakes would cause an
automobile accident. He need not have foreseen exactlywhat happened. He did not know there
would be a cyclist nearby. What he could foresee was this general type of harm involving
defective brakes. Because the accident that occurred was of the type he could foresee, he is
liable.
By contrast, assume the collision of car and bicycle produces a loud crash. Two blocks
away, a pet pig, asleep on the window ledge of a twelfth-story apartment, is startled by the
noise, awakens with a start, and plunges to the sidewalk, killing a veterinarian who was
making a house call. If the vet’s family sues Dom, should it win? Dom’s negligence was the
factual cause: It led to the collision, which startled the pig, which flattened the vet. Most
courts would rule, though, that Dom is not liable. The type of harm is too bizarre. Dom
could not reasonably foresee such an extraordinary chain of events, and it would be unfair to
make him pay for it. See Exhibit 6.2. Another way of stating that Dom is not liable to the
vet’s family is by calling the falling pig a superseding cause. When one of the “dominoes” in
the row is entirely unforeseeable, courts will call that event a superseding cause, letting the
defendant off the hook.
=
=
=
=
=
== =
= =
= =
Superseding
cause
Pig to fall,
which causes
Death of
veterinarian
Factual
causation
but no
foreseeable
type of harm
Customer’s
brakes to
fail, which
causes
Customer’s
car to hit
cyclist
Factual
causation
and
foreseeable
type of harm
Cyclist hits
pothole
No factual
causation
Dom is not liable
to cyclist
Dom is liable
to cyclist
Dom is not liable
to veterinarian
Dom fails to
repair brakes,
which causes
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150 U N I T 1 The Legal Environment
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EXAM Strategy
Question: Jenny asked a neighbor, Tom, to water her flowers while she was on
vacation. For three days, Tom did this without incident, but on the fourth day, when
he touched the outside faucet, he received a violent electric shock that shot him
through the air, melted his sneakers and glasses, set his clothes on fire, and seriously
burned him. Tom sued, claiming that Jenny had caused his injuries by negligently
repairing a second-floor toilet. Water from the steady leak had flooded through the
walls, soaking wires and eventually causing the faucet to become electrified. You are
Jenny’s lawyer. Use one (and only one) element of negligence law to move for
summary judgment.
Strategy: The four elements of negligence we have examined thus far are duty to
this plaintiff, breach, factual cause, and proximate cause. Which element seems to be
most helpful to Jenny’s defense? Why?
Result: Jenny is entitled to summary judgment because this was not a foreseeable
type of injury. Even if she did a bad job of fixing the toilet, she could not reasonably
have anticipated that her poor workmanship could cause electrical injuries to
anyone.14
RES IPSA LOQUITUR
Normally, a plaintiff must prove factual cause and a foreseeable type of harm in order to
establish negligence. But in a few cases, a court may be willing to infer that the defendant
caused the harm under the doctrine of res ipsa loquitur (“the thing speaks for itself’).
Suppose a pedestrian is walking along a sidewalk when an air conditioning unit falls on his
head from a third-story window. The defendant, who owns the third-story apartment,
denies any wrongdoing, and it may be difficult or impossible for the plaintiff to prove why
the air conditioner fell. In such cases, many courts will apply res ipsa loquitur and declare
that the facts imply that the defendant’s negligence caused the accident. If a court uses this
doctrine, then the defendant must come forward with evidence establishing that it did not
cause the harm.
Because res ipsa loquitur dramatically shifts the burden of proof from plaintiff to
defendant, it applies only when (1) the defendant had exclusive control of the thing that
caused the harm, (2) the harm normally would not have occurred without negligence, and
(3) the plaintiff had no role in causing the harm. In the air conditioner example, most states
would apply the doctrine and force the defendant to prove that she did nothing wrong.
6-4d Damages
Finally, a plaintiff must prove that he has been injured or that he has had some kind of
measureable losses. In some cases, injury is obvious. For example, Ruben Hernandez
suffered grievous harm when struck by the drunk driver. But in other cases, injury is
unclear. The plaintiff must persuade the court that he has suffered harm that is genuine,
not speculative.
Some cases raise tough questions. Among the most vexing are suits involving future
harm. Exposure to toxins or trauma may lead to serious medical problems down the road— or
14Based on Hebert v. Enos, 60 Mass. App. Ct. 817, 806 N.E.2d 452 (Mass. Ct. App. 2004).
Res ipsa loquitur
The facts imply that the
defendant’s negligence caused
the accident.
CHAPTER 6 Torts and Product Liability 151
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it may not. A woman’s knee is damaged in an auto accident, causing severe pain for two
years. She is clearly entitled to compensation for her suffering. After two years, all pain may
cease for a decade—or forever. Yet there is also a chance that in 15 or 20 years, the trauma
will lead to painful arthritis. A court must decide today the full extent of present and future
damages; a plaintiff cannot return to court years later and demand compensation for newly
arisen ailments. The challenge to our courts is to weigh the possibilities and percentages of
future suffering and decide whether to compensate a plaintiff for something that might never
happen.
6-5 DEFENSES
6-5a Contributory and Comparative Negligence
Sixteen-year-old Michelle Wightman was out driving at night, with her friend Karrie Wieber in
the passenger seat. They came to a railroad crossing, where the mechanical arm had descended
and warning bells were sounding. They had been sounding for a long time. A Conrail train had
suffered mechanical problems and was stopped 200 feet from the crossing, where it had stalled
for roughly an hour. Michelle and Karrie saw several cars ahead of them go around the barrier
and cross the tracks. Michelle had to decide whether she would do the same.
Long before Michelle made her decision, the train’s engineer had seen the heavy Saturday
night traffic crossing the tracks and realized the danger. The conductor and brakeman also
understood the peril, but rather than posting a flagman, who could have stopped traffic when a
train approached, they walked to the far end of their train to repair the mechanical problem. A
police officer had come upon the scene, told his dispatcher to notify the train’s parent company
Conrail of the danger, and left.
Michelle decided to cross the tracks. She slowly followed the cars ahead of her. Seconds
later, both girls were dead. A freight train traveling at 60 miles per hour struck the car
broadside, killing both girls instantly.
Michelle’s mother sued Conrail for negligence. The company claimed that it was
Michelle’s foolish risk that led to her death. Who wins when both parties are partly
responsible? It depends on whether the state uses a legal theory called contributory
negligence. Under contributory negligence, if the plaintiff is even slightly negligent,
she recovers nothing. If Michelle’s death occurred in a contributory negligence state, and
the jury considered her even minimally responsible, her estate would receive no money.
Critics attacked this rule as unreasonable. A plaintiff who was 1 percent negligent could
not recover from a defendant who was 99 percent responsible. So most states threw out the
contributory negligence rule, replacing it with comparative negligence. In a comparative
negligence state, a plaintiff may generally recover even if she is partially responsible. The
jury will be asked to assess the relative negligence of the two parties.
Michelle died in Ohio, which is a comparative negligence state. The jury concluded
that reasonable compensatory damages were $1 million. It also concluded that Conrail was
60 percent responsible for the tragedy and Michelle 40 percent. See Exhibit 6.3. The girl’s
mother received $600,000 in compensatory damages.
Today, most but not all states have adopted some form of comparative negligence.
Critics claim that this principle rewards a careless plaintiff. If Michelle had obeyed the law,
she would still be alive. In response to this complaint, many comparative negligence states
do not permit a plaintiff to recover anything if he was more than 50 percent responsible for
his own injury.
152 U N I T 1 The Legal Environment
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In the Conrail case, the jury decided that the rail company was extraordinarily negligent.
Expert witnesses testified that similar tragedies occurred every year around the nation and the
company knew it. Conrail could easily have prevented the loss of life by posting a flagman on
the road. The jury awarded the estate $25 million in punitive damages. The trial judge reduced
the verdict by 40 percent to $15 million. The state supreme court affirmed the award.15
6-5b Assumption of the Risk
Good Guys, a restaurant, holds an ice-fishing contest on a frozen lake to raise money for
accident victims. Margie grabs a can full of worms and strolls to the middle of the lake to try
her luck, but slips on the ice and suffers a concussion. If she sues Good Guys, how will she
fare? She will fall a second time. Wherever there is an obvious hazard, a special rule applies.
Assumption of the risk: A person who voluntarily enters a situation that has an obvious
danger cannot complain if she is injured. Ice is slippery, and we all know it. If you venture
onto a frozen lake, any falls are your own tough luck.
However, the doctrine does not apply if someone is injured in a way that is not an
inherent part of the dangerous activity. NFL players assume substantial risks each time they
take the field, but some injuries fall outside the rule. In a game between the Jets and the
Dolphins, Jets assistant coach Sal Alosi, standing on the sideline, tripped Dolphins player
Nolan Carroll during a punt return. The trip was not a “normal” part of a football game, and
the “assumption of the risk” doctrine would not prevent Carroll from recovering damages.
The following case involves a lake, jet skis—and a great tragedy.
Responsibility
Plaintiff
recovers
zero
Plaintiff
recovers
$600,000
Defendant
is 60%
responsible
Recovery
Comparative
negligence state
Contributory
negligence state
Plaintiff is
40% responsible
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EXHIB IT 6 .3 Defendant’s negligence injures plaintiff, who suffers $1 million in
damages.
15Wightman v. Consolidated Rail Corporation, 86 Ohio St. 3d 431, 715 N.E.2d 546, 1999 Ohio LEXIS
2924 (Ohio 1999).
CHAPTER 6 Torts and Product Liability 153
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6-6 STRICT LIABILITY
Some activities are so naturally dangerous that the law places an especially high burden on anyone
who engages in them. A corporation that produces toxic waste can foresee dire consequences from
its business that a stationery store cannot. This higher burden is strict liability. There are two main
areas of business that incur strict liability: ultrahazardous activity and defective products.
TRUONG V. NGUYEN
67 Cal. Rptr.3d 675, 156 Cal.App.4th 865
California Court of Appeals, 2007
C A S E S U M M A R Y
Facts: On a warm California day, there were about 30
personal watercraft (jet skis) operating on Coyote Lake.
The weather was fair and visibility good. Anthony Nguyen
and Rachael Truong went for a ride on Anthony’s Polaris
watercraft. Cu VanNguyen and ChuongNguyen (neither of
whom were related to Anthony) were both riding a Yamaha
Waverunner. Both jet skis permitted a driver and passenger,
each seated. The two watercraft collided near the middle of
the lake. Rachael was killed, and the others were injured.
Rachael’s parents sued Anthony, Cu Van, and Chuong,
alleging that negligent operation of their watercraft caused
their daughter’s death. The court granted defendants’motion
for summary judgment, on the grounds that Rachel had
assumed the risk of riding on a jet ski. Her parents appealed,
arguing that jet skiing was not a sport and Rachael never
assumed any risk.
Issue: Does assumption of the risk apply to jet skiing?
Decision: Yes. Jet skiing is a sport and its participants
assume certain risks of injury.
Reasoning: A “sport” is an activity (1) that is done for
enjoyment or thrill, (2) requires physical skill, and (3) involves
challenges that create some risk of injury. When people
choose to participate in a sport, they assume that sport’s inher-
ent risks. The doctrine of assumption of the risk bars liability
when a participant suffers an injury that is “part of the game,”
even if conduct that caused the injury violates the rules
of the game.
For example, in baseball, a batter is not supposed
to carelessly throw the bat after getting a hit. However,
assumption of the risk recognizes that this activity is
part of the game—and a risk players assume when they
choose to play baseball. An umpire cannot sue a batter
when injured by a carelessly thrown bat. He can recover
only if the batter intentionally harmed him or engaged
in reckless conduct that was not reasonably or foresee-
ably part of the game. So, the umpire is justified in
complaining if the batter repeatedly whacked him with
the bat, because this conduct is not part of baseball as
we know it.
The question in this case was whether assumption of
the risk applied to jet skiing. Rachael’s parents contended
that assumption of risk did not apply, because jet skiing is
not a sport. But jet skiing fits into the definition of a sport.
It is done for enjoyment or thrill, not for transportation. It
involves skill and risk. Jet skiers race each other and jump
the wakes of other jet skis in an open-hulled vehicle. An
activity does not have to be a competitive or spectator
sport for assumption of risk to apply.
The plaintiffs also argued that Rachael did not
assume the risk as an active participant because she was
not driving the jet ski. However, a passenger on a personal
watercraft is enjoying the same thrills, taking on the same
challenges, and facing the same risks as the operator.
Rachael was an active participant who assumed the risks
inherent in jet skiing.
For these reasons, the summary judgment is affirmed.
Strict liability
A branch of tort law that
imposes a much higher level of
liability when harm results from
ultrahazardous acts or
defective products.
154 U N I T 1 The Legal Environment
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6-6a Ultrahazardous Activity
Ultrahazardous activities include using harmful chemicals, operating explosives, keeping
wild animals, bringing dangerous substances onto property, and a few similar activities
where the danger to the general public is especially great. A defendant engaging in an
ultrahazardous activity is almost always liable for any harm that results. Plaintiffs do not
have to prove duty or breach or foreseeable harm. Recall the deliberately bizarre case we
posed earlier of the pig falling from a window ledge and killing a veterinarian. Dom, the
mechanic whose negligence caused the car crash, could not be liable for the veterinarian’s
death because the plunging pig was a superseding cause.
But now imagine that the pig is jolted off the window ledge by a company engaged in
an ultrahazardous activity. Sam’s Blasting Co. sets off a perfectly lawful blast to clear ground
for a new building down the street. When the pig is startled and falls, the blasting company
is liable. Even if Sam took extraordinary care, it will do him no good at trial. The “reason-
able person” rule is irrelevant in a strict liability case.
Because “strict liability” translates into “defendant is liable,” parties in tort cases often
fight over whether the defendant was engaged in an ultrahazardous activity. If the court
rules that the activity was ultrahazardous, the plaintiff is assured of winning. If the court
rules that it was not ultrahazardous, the plaintiff must prove all elements of negligence.
The line is oftenhazy.A lawful fireworksdisplaydoesnot incur strict liability, but cropdusting
does. Cutting timber is generally not abnormally dangerous, but hauling logs might be. The
enormous diversity of business activities in our nation ensures continual disputes over this
important principle.
6-6b Product Liability
Defective products can also create strict liability. Most states have adopted the following model:
1. One who sells any product in a defective condition unreasonably dangerous to the
user or consumer or to his property is subject to liability for physical harm thereby
caused to the ultimate user or consumer, or to his property, if
a. the seller is engaged in the business of selling such a product, and
b. it is expected to and does reach the user or consumer without substantial change in
the condition in which it is sold.
2. The rule stated in Subsection (1) applies although
a. the seller has exercised all possible care in the preparation and sale of his product, and
b. the user or consumer has not bought the product from or entered into any contractual
relation with the seller.16
These are the key terms in subsection (1):
• Defective condition unreasonably dangerous to the user. The defendant is liable only
if the product is defective when it leaves his hands. There must be something wrong
with the goods. If they are reasonably safe and the buyer’s mishandling of the goods
causes the harm, there is no strict liability. If you attempt to open a soda bottle by
knocking the cap against a counter, and the glass shatters and cuts you, the
manufacturer owes nothing. A carving knife can produce a lethal wound, but
everyone knows that, and a sharp knife is not unreasonably dangerous. On the other
hand, prescription drugs may harm in ways that neither a layperson nor a doctor
would anticipate. The manufacturer must provide adequate warnings of any dangers that
are not apparent.
16Restatement (Second) of Torts Section 402A.
CHAPTER 6 Torts and Product Liability 155
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• In the business of selling. The seller is liable only if she normally sells this kind of
product. Suppose your roommate makes you a peanut butter sandwich and, while eating
it, you cut your mouth on a sliver of glass that was in the jar. The peanut butter
manufacturer faces strict liability, as does the grocery store where your roommate bought
the goods. But your roommate is not strictly liable because he is not in the food business.
• Reaches the user without substantial change. Obviously, if your roommate put the glass
in the peanut butter thinking it was funny, neither the manufacturer nor the store is liable.
And here are the important phrases in subsection (2).
• Has exercised all possible care. This is the heart of strict liability, which makes it
a potent claim for consumers. It is no defense that the seller used reasonable care. If the
product is dangerously defective and injures the user, the seller is liable even if
it took every precaution to design and manufacture the product safely. Suppose
the peanut butter jar did in fact contain a glass sliver when it left the factory. The
manufacturer proves that it uses extraordinary care in keeping foreign particles out of
the jars and thoroughly inspects each container before it is shipped. The evidence is
irrelevant. The manufacturer has shown that it was not negligent in packaging the food,
but reasonable care is irrelevant in strict liability cases.
• No contractual relation. When two parties contract, they are in privity. Privity only
exists between the user and the person from whom she actually bought the goods,
but in strict liability cases, privity is not required. Suppose the manufacturer that made
the peanut butter sold it to a distributor, which sold it to a wholesaler, which sold it to
a grocery store, which sold it to your roommate. You may sue the manufacturer,
distributor, wholesaler, and store, even though you had no privity with any of them.
CONTEMPORARY TRENDS
If the steering wheel on a brand new car falls off, and the driver is injured, that is a clear case
of defective manufacturing, and the company will be strictly liable. Those are the easy
cases. But defective design cases have been more contentious. Suppose a vaccine that
prevents serious childhood illnesses inevitably causes brain damage in a very small number
of children because of the nature of the drug. Is the manufacturer liable? What if a racing
sailboat, designed only for speed, is dangerously unstable in the hands of a less-experienced
sailor? Is the boat’s maker responsible for fatalities? Suppose an automobile made of light-
weight metal uses less fuel but exposes its occupants to more serious injuries in an accident.
How is a court to decide whether the design was defective? Often, these design cases also
involve issues of warnings: Did the drug designer diligently detail dangers to doctors?
Should a sailboat seller sell speedy sailboats solely to seasoned sailors?
Over the years, most courts have adopted one of two tests for design and warning cases.
The first is consumer expectation. Here, a court finds the manufacturer liable for defective
design if the product is less safe than a reasonable consumer would expect. If a smoke
detector has a 3 percent failure rate and the average consumer has no way of anticipating
that danger, effective cautions must be included, though the design may be defective anyway.
Many other states use a risk-utility test. Here, a court must weigh the benefits for society
against the dangers that the product poses. Principal factors in the risk-utility test include:
• The value of the product,
• The gravity, or seriousness, of the danger,
• The likelihood that such danger will occur,
• The mechanical feasibility of a safer alternative design, and
• The adverse consequences of an alternative design.
156 U N I T 1 The Legal Environment
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Chapter Conclusion
This chapter has been a potpourri of misdeeds, a bubbling cauldron of conduct best avoided.
Although tortious acts and their consequences are diverse, two generalities apply. First,
the boundaries are imprecise, the outcome of a particular case depending to a considerable
extent upon the factfinder who analyzes it. Second, the thoughtful executive and the careful
citizen, aware of the shifting standards and potentially vast liability, will strive to ensure that
his or her conduct never provides that factfinder an opportunity to give judgment.
EXAM REVIEW
1. TORT A tort is a violation of a duty imposed by the civil law. (p. 135)
Question: Keith is driving while intoxicated. He swerves into the wrong lane
and causes an accident, seriously injuring Caroline. Which statement is true?
(a) Caroline could sue Keith, who might be found guilty in her suit.
(b) Caroline and the state could start separate criminal cases against Keith.
(c) Caroline could sue Keith, and the state could prosecute Keith for drunk driving.
(d) The state could sue Keith but only with Caroline’s consent.
(e) The state could prosecute Keith and sue him at the same time, for drunk driving.
Strategy: What party prosecutes a criminal case? The government does, not the
injured party. What is the result in a criminal case? Guilt or innocence. What about
a tort lawsuit? The injured party brings a tort suit. The defendant may be found
liable but never guilty. (See the “Result” at the end of this section.)
2. DEFAMATION Defamation involves a defamatory statement that is false,
uttered to a third person, and causes an injury. Opinion and privilege are valid
defenses. (pp. 136–138)
Question: Benzaquin had a radio talk show. On the program, he complained
about an incident in which state trooper Fleming had stopped his car, apparently
for lack of a proper license plate and safety sticker. Benzaquin explained that the
license plate had been stolen and the sticker fallen onto the dashboard, but
Fleming refused to let him drive away. Benzaquin and two young grandsons had
to find other transportation. On the show, Benzaquin angrily recounted the
incident, then described Fleming and troopers generally: “We’re not paying them
to be dictators and Nazis”; “this man is an absolute barbarian, a lunkhead, a
meathead.” Fleming sued Benzaquin for defamation. Comment.
Strategy: Review the elements of defamation. Can these statements be proven
true or false? If not, what is the result? Look at the defenses. Does one apply?
(See the “Result” at the end of this section.)
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3. MALICE Public personalities can win a defamation suit only by proving actual
malice. (p. 137)
4. FALSE IMPRISONMENT False imprisonment is the intentional restraint
of another person without reasonable cause and without consent. (p. 139)
5. EMOTIONAL DISTRESS The intentional infliction of emotional distress involves
extreme and outrageous conduct that causes serious emotional harm. (p. 139)
6. ADDITIONAL INTENTIONAL TORTS Battery is an intentional touching of
another person in a way that is unwanted or offensive. Assault involves an act that
makes the plaintiff fear an imminent battery. Fraud is injuring another person by
intentional deception. (p. 140)
7. DAMAGES Compensatory damages are the normal remedy in a tort case. In
unusual cases, the court may award punitive damages, not to compensate the
plaintiff but to punish the defendant. (pp. 140–143)
8. TORTIOUS INTERFERENCE Tortious interference with business relations
involves the defendant harming an existing contract or a prospective relationship
that has a definite expectation of success. (pp. 144–145)
9. PRIVACY AND PUBLICITY The related torts of privacy and publicity involve
unreasonable intrusion into someone’s private life and unfair commercial exploitation
by using someone’s name, likeness, or voice without permission. (pp. 145–146)
10. NEGLIGENCE ELEMENTS The five elements of negligence are duty of due
care, breach, factual causation, proximate causation, and damage. (p. 146)
11. DUTY OF DUE CARE If the defendant could foresee that misconduct would
injure a particular person, he probably has a duty to her. Special duties exist for
people on the job, landowners, and employers. (pp. 146–149)
Question: A supervisor reprimanded an employee for eating in a restaurant when
he should have been at work. Later, the employee showed up at the supervisor’s
office and shot him. Although the employee previously had been violent,
management withheld this information from supervisory personnel. Is the
company liable for the supervisor’s injury?
Strategy: An employer must do a reasonable job of hiring and retaining employees.
(See the “Result” at the end of this section.)
12. BREACH OF DUTY A defendant breaches his duty of due care by failing to
meet his duty of care. (p. 149)
13. NEGLIGENCE PER SE If a legislature sets a minimum standard of care for
a particular activity in order to protect a certain group of people, and a violation of
the statute injures a member of that group, the defendant has committed negligence
per se. (p. 149)
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14. FACTUAL CAUSE If one event directly led to the ultimate harm, it is the factual
cause. (pp. 149–150)
15. PROXIMATE CAUSE For the defendant to be liable, the type of harm must
have been reasonably foreseeable. (p. 150)
16. DAMAGES The plaintiff must persuade the court that he has suffered a harm that
is genuine, not speculative. Damages for emotional distress, without a physical injury,
are awarded only in select cases. (pp. 151–152)
Question: Marko owned a cat and allowed it to roam freely outside. In the three
years he had owned the pet, the animal had never bitten anyone. The cat entered
Romi’s garage. When Romi attempted to move it outside, the cat bit her. Romi
underwent four surgeries, was fitted with a plastic finger joint, and spent more
than $39,000 in medical bills. She sued Marko, claiming both strict liability and
ordinary negligence. Assume that state law allows a domestic cat to roam freely.
Evaluate both of Romi’s claims.
Strategy: Negligence requires proof that the defendant breached a duty to the
plaintiff by behaving unreasonably, and that the resulting harm was foreseeable.
Was it? When would harm by a domestic cat be foreseeable? A defendant can be
strictly liable for keeping a wild animal. Apply that rule as well. (See the “Result”
at the end of this section.)
1. Result: (a) is wrong because a defendant cannot be found guilty in a civil suit.
(b) is wrong because a private party has no power to prosecute a criminal case.
(c) is correct.
(d) is wrong because the state will prosecute Keith, not sue him.
(e) is wrong for the same reason.
2. Result: The court ruled in favor of Benzaquin because a reasonable person
would understand the words to be opinion and ridicule. They are not statements
of fact because most of them could not be proven true or false. A statement like
“dictators and Nazis” is not taken literally by anyone.17
11. Result: This employer may have been liable for negligently hiring a previously
violent employee, and it certainly did an unreasonable job in retaining him
without advising his supervisor of the earlier violence. The assault was easily
foreseeable, and the employer is liable.18
17. Result: If Marko’s cat had bitten or attacked people in the past, this harm
was foreseeable and Marko is liable. If the cat had never done so, and state law
allows domestic animals to roam, Romi probably loses her suit for negligence.
Her strict liability case definitely fails: A housecat is not a wild animal.
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17Fleming v. Benzaquin, 390 Mass. 175, 454 N.E.2d 95 (1983).
18Caudle v. Betts, 512 So.2d 389 (La. 1987).
CHAPTER 6 Torts and Product Liability 159
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MULTIPLE-CHOICE QUESTIONS
1. Jane writes an article for a newspaper reporting that Ann was arrested for stealing a
car. The story is entirely false. Ann is not a public figure. Which of the following torts
has Jane committed?
(a) Ordinary slander
(b) Slander per se
(c) Libel
(d) None of the above
2. Refer back to Question 1. If Ann decides to sue, she have to
show evidence that she suffered an injury. If she ultimately wins her case, a
jury have the option to award punitive damages.
(a) will; will
(b) will; will not
(c) will not; will
(d) will not; will not
3. Sam sneaks up on Tom, hits him with a baseball bat, and knocks him unconscious.
Tom never saw Sam coming. He wakes up with a horrible headache. Which of the
following torts has Sam committed?
(a) Assault
(b) Battery
(c) Both (a) and (b)
(d) None of the above
4. Al runs a red light and hits Carol’s car. She later sues, claiming the following losses:
$10,000—car repairs
$10,000—medical expenses
$10,000—lost wages (she could not work for two months after the accident)
$10,000—pain and suffering
If the jury believes all of Carol’s evidence and she wins her case, how much will she
receive in compensatory damages?
(a) $40,000
(b) $30,000
(c) $20,000
(d) $10,000
(e) $0
5. Zack lives in a state that prohibits factory laborers from working more than 12 hours in
any 24-hour period. The state legislature passed the law to cut down on accidents
caused by fatigued workers.
Ignoring the law, Zack makes his factory employees put in 14-hour days. Eventually,
a worker at the end of a long shift makes a mistake and severely injures a coworker.
The injured worker sues Zack.
160 U N I T 1 The Legal Environment
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Which of the following terms will be most relevant to the case?
(a) Res ipsa loquitur
(b) Assumption of the risk
(c) Negligence per se
(d) Strict liability
ESSAY QUESTIONS
1. Caldwell was shopping in a K-Mart store, carrying a large purse. A security guard
observed her looking at various small items such as stain, hinges, and antenna wire.
On occasion, she bent down out of sight of the guard. The guard thought he saw
Caldwell put something in her purse. Caldwell removed her glasses from her purse
and returned them a few times. After she left, the guard approached her in the
parking lot and said that he believed she had store merchandise in her pocketbook,
but he could not say what he thought was put there. Caldwell opened the purse,
and the guard testified that he saw no K-Mart merchandise in it. The guard then
told Caldwell to return to the store with him. They walked around the store for
approximately 15 minutes, while the guard said six or seven times that he saw her put
something in her purse. Caldwell left the store after another store employee indicated
she could go. Caldwell sued. What kind of suit did she file, and what should the
outcome be?
2. Tata Consultancy of Bombay, India, is an international computer consulting
firm. It spends considerable time and effort recruiting the best personnel from
India’s leading technical schools. Tata employees sign an initial three-year
employment commitment, often work overseas, and agree to work for a specified
additional time when they return to India. Desai worked for Tata, but then he
quit and formed a competing company, which he called Syntel. His new
company contacted Tata employees by phone, offering higher salaries, bonuses,
and assistance in obtaining permanent resident visas in the United States if they
would come work for Syntel. At least 16 former Tata employees left their jobs
without completing their contractual obligations and went to work for Syntel.
Tata sued. What did it claim, and what should be the result?
3. YOU BE THE JUDGE WRITING PROBLEM Johnny Carson was for many
years the star of a well-known television show, The Tonight Show. For about 20 years,
he was introduced nightly on the show with the phrase, “Here’s Johnny!” A large
segment of the television watching public associated the phrase with Carson.
A Michigan corporation was in the business of renting and selling portable toilets.
The company chose the name “Here’s Johnny Portable Toilets,” and coupled the
company name with the marketing phrase, “The World’s Foremost Commodian.”
Carson sued, claiming that the company’s name and slogan violated his right to
commercial exploitation.
ARGUMENT FOR CARSON: The toilet company is deliberately taking
advantage of Johnny Carson’s good name. He worked hard for decades to build a
brilliant career and earn a reputation as a creative, funny, likable performer.
CHAPTER 6 Torts and Product Liability 161
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No company has the right to use his name, his picture, or anything else closely
identified with him, such as the phrase “Here’s Johnny.” The pun is personally
offensive and commercially unfair.
ARGUMENT FOR HERE’S JOHNNY PORTABLE TOILETS: Johnny
Carson doesn’t own his first name. It is available for anyone to use for any purpose.
Further, the popular term “john,” meaning toilet, has been around much longer than
Carson or even television. We are entitled to make any use of it we want. Our
corporate name is amusing to customers who have never heard of Carson, and we are
entitled to profit from our brand recognition.
4. At approximately 7:50 p.m, bells at the train station rang and red lights flashed,
signaling an express train’s approach. David Harris walked onto the tracks, ignoring a
yellow line painted on the platform instructing people to stand back. Two men
shouted to Harris, warning him to get off the tracks. The train’s engineer saw him too
late to stop the train, which was traveling at approximately 55 mph. The train struck
and killed Harris as it passed through the station. Harris’s widow sued the railroad,
arguing that the railroad’s negligence caused her husband’s death. Evaluate her
argument.
5. A new truck, manufactured by General Motors Corp. (GMC), stalled in rush hour
traffic on a busy interstate highway because of a defective alternator, which caused a
complete failure of the truck’s electrical system. The driver stood nearby and waved
traffic around his stalled truck. A panel truck approached the GMC truck, and
immediately behind the panel truck, Davis was driving a Volkswagen fastback.
Because of the panel truck, Davis was unable to see the stalled GMC truck. The
panel truck swerved out of the way of the GMC truck, and Davis drove straight into
it. The accident killed him. Davis’s widow sued GMC. GMC moved for summary
judgment, alleging (1) no duty to Davis, (2) no factual causation, and (3) no
foreseeable harm. Comment.
DISCUSSION QUESTIONS
1. You have most likely heard of the Liebeck v.
McDonalds case. Liebeck spilled hot McDonald’s
coffee in her lap and suffered third-degree burns.
At trial, evidence showed that her cup of coffee
was brewed at 190 degrees, and that, more
typically, a restaurant’s “hot coffee” is in the range
of 140 to 160 degrees. A jury awarded Liebeck
$160,000 in compensatory damages and $2.7
million in punitive damages. The judge reduced
the punitive award to $480,000, or three times the
compensatory award. Comment on the case and
whether the result was reasonable.
2. Celebrities often have problems with tabloids
and the paparazzi. It is difficult for public figures
to win libel lawsuits because they must show
actual malice. Intrusion lawsuits are also tricky,
and flocks of photographers often stalk
celebrities at all hours. Is this right? Should the
law change to offer more privacy to famous
people? Or is a loss of privacy just the price
of success?
3. Many retailers have policies that instruct
employees not to attempt to stop shoplifters. Some
store owners fear false imprisonment lawsuits and
possible injuries to workers more than losses
related to stolen merchandise. Are these “don’t be
a hero” policies reasonable? Would you put one in
place if you owned a retail store?
162 U N I T 1 The Legal Environment
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4. Imagine an undefeated high school football team
on which the average lineman weighs 300 pounds.
Also, imagine an 0–10 team on which the average
lineman weighs 170 pounds. The undefeated team
sets out to hit as hard as they can on every play and
to run up the score as much as possible. Before the
game is over, 11 players from the lesser team have
been carried off the field with significant injuries.
All injuries were the result of “clean hits”—none
of the plays resulted in a penalty. Even late in the
game, when the score is 70–0, the undefeated team
continues to deliver devastating hits that are far
beyond what would be required to tackle and
block. The assumption of the risk doctrine
exempts the undefeated team from liability. Is this
reasonable?
5. People who serve alcohol to others take a risk.
In some circumstances, they can be held legally
responsible for the actions of the people they
serve. Is this fair? Should an intoxicated person be
the only one liable if harm results? If not, in what
specific circumstances is it fair to stretch liablility
to other people?
CHAPTER 6 Torts and Product Liability 163
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CHAPTER7
CRIME
Crime can take us by surprise. Stacey tucks
her nine-year-old daughter, Beth, into bed.
Promising her husband, Mark, that she will
be home by 11:00 p.m., she jumps into her
car and heads back to Be Patient, Inc. She
plugs her iPhone into the player of her
$85,000 sedan and tries to relax by listening
to music. Be Patient is a healthcare organi-
zation that owns five geriatric hospitals. Most
of its patients use Medicare, and Stacey
supervises all billing to their largest client,
the federal government.
She parks in a well-lighted spot on the street and
walks to her building, failing to notice two men, collars
turned up, watching from a parked truck. Once in her
office, she goes straight to her computer and works on
billing issues. Tonight’s work goes more quickly than
she expected, thanks to new software she helped
develop. At 10:30 she emerges from the building with a
quick step and a light heart, walks to her car—and finds
it missing.
A major crime has occurred during the 90 minutes
Stacey was at her desk, but she will never report it to the
police. It is a crime that costs Americans countless dollars
each year, yet Stacey will not even mention it to friends
or family. Stacey is the criminal.
g
A major crime has
occurred during the
90 minutes Stacey was
at her desk, but she
will never report it to
the police.
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When we think of crime, we imagine the drug dealers and bank robbers endlessly portrayed
on television. We do not picture corporate executives sitting at polished desks. “Street
crimes” are indeed serious threats to our security and happiness. They deservedly receive
the attention of the public and the law. But when measured only in dollars, street crime takes
second place to white-collar crime, which costs society tens of billions of dollars annually.
The hypothetical about Stacey is based on many real cases and is used to illustrate that
crime does not always dress the way we expect. Her car was never stolen; it was simply towed.
Two parking bureau employees, watching from their truck, saw Stacey park illegally and did
their job. It is Stacey who committed a crime—Medicare fraud. Every month, she has billed
the government about $10 million for work that her company has not performed. Stacey’s
scheme was quick and profitable—and a distressingly common crime.
Crime, whether violent or white-collar, is detrimental to all society. It imposes a huge cost
on everyone. Just the fear of crime is expensive—homeowners buy alarm systems and
businesses hire security guards. But the anger and fear that crime engenders sometimes tempt
us to forget that not all accused people are guilty. Everyone suspected of a crime should have
the protections that you yourself would want in that situation. As the English jurist William
Blackstone said, “Better that ten guilty persons escape than that one innocent suffer.”
Thus, criminal law is a balancing act—between making society safe and protecting us
all from false accusations and unfair punishment.
This chapter has four parts:
1. The differences between a civil and criminal case;
2. Criminal procedure—the process by which criminals are accused, tried, and
sentenced;
3. Crimes that harm businesses;
4. Crimes committed by businesses.
7-1 THE DIFFERENCES BETWEEN A CIVIL
AND CRIMINAL CASE
Most of this book focuses on civil law, so we begin with a discussion of the differences
between a civil and criminal case.
Civil law involves the rights and liabilities that exist between private parties. As we
have seen, if one person claims that another has caused her a civil injury, she must file a
lawsuit and convince a court of her damages.
Criminal law is different. Conduct is criminal when society outlaws it. When a state
legislature or Congress concludes that certain behavior threatens public safety and welfare, it
passes a statute forbidding that behavior; in other words, declaring it criminal. Medicare fraud,
which Stacey committed, is a crime because Congress has outlawed it. Money laundering is a
crime because Congress concluded that it was a fundamental part of the drug trade and
prohibited it.
7-1a Prosecution
Suppose the police arrest Roger and accuse him of breaking into a store and stealing
50 computers. The owner of the store is the one harmed, and he has the right to sue the
thief in civil court to recover money damages. But only the government can prosecute a
Criminal procedure
The process by which criminals
are accused, tried, and
sentenced.
Criminal law
Prohibits and punishes conduct
that threatens public safety and
welfare.
CHAPTER 7 Crime 165
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crime and punish Roger by sending him to prison. The government may also impose a fine
on Roger, but it keeps the fine and does not share it with the victim. (However, the court
will sometimes order restitution, meaning that the defendant must reimburse the victim for
harm suffered.) The local prosecutor has total discretion in deciding whether to bring Roger
to trial on criminal charges.
7-1b Burden of Proof
In a civil case, the plaintiff must prove her case only by a preponderance of the evidence.1
But because the penalties for conviction in a criminal case are so serious, the government
must prove its case beyond a reasonable doubt. Also, the stigma of a criminal conviction
would stay with Roger forever, making it more difficult to obtain work and housing.
Therefore, in all criminal cases, if the jury has any significant doubt at all that Roger stole
the computers, it must acquit him.
7-1c Right to a Jury
The facts of a case are decided by a judge or jury. A criminal defendant has a right to a trial by
jury for any charge that could result in a sentence of six months or longer. The defendant may
demand a jury trial or may waive that right, in which case the judge will be the factfinder.
7-1d Felony/Misdemeanor
A felony is a serious crime, for which a defendant can be sentenced to one year or more in
prison. Murder, robbery, rape, drug dealing, money laundering, wire fraud, and embezzle-
ment are felonies. A misdemeanor is a less serious crime, often punishable by a year or less
in a county jail. Public drunkenness, driving without a license, and simple possession of a
single marijuana cigarette are considered misdemeanors in most states.
7-2 CRIMINAL PROCEDURE
The title of a criminal case is usually the government versus someone: The United States of
America v. Simpson or The State of Texas v. Simpson, for example. This name illustrates a
daunting thought—if you are Simpson, the vast power of the government is against you.
Because of the government’s great power and the severe penalties it can impose, criminal
procedure is designed to protect the accused and ensure that the trial is fair. Moreover, a
criminal defendant is often engaged in an uphill climb from the beginning because people
often assume that anyone accused of a crime must be guilty. Many of the protections for
those accused of a crime are found in the first 10 amendments to the United States
Constitution, known as the Bill of Rights.
7-2a Conduct Outlawed
Crimes are created by statute. The prosecution must demonstrate to the court that the
defendant’s conduct is indeed outlawed by a statute. Returning to Roger, the alleged
computer thief, the state charges that he stole computer equipment from a store, a crime
clearly defined by statute as larceny.
1See the earlier discussion in Chapter 3, on dispute resolution.
Restitution
A court order that a guilty
defendant reimburse the victim
for the harm suffered.
Beyond a reasonable
doubt
The very high burden of proof in
a criminal trial, demanding
much more certainty than
required in a civil trial.
Misdemeanor
A less serious crime, often
punishable by less than a year
in a county jail.
Felony
A serious crime, for which a
defendant can be sentenced to
one year or more in prison.
166 U N I T 1 The Legal Environment
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The Fifth and Fourteenth Amendments to the Constitution require that the language
of criminal statutes be clear and definite enough that (1) ordinary people can understand
what conduct is prohibited and (2) the police are discouraged from arbitrary and discrimi-
natory enforcement. Thus, for example, the Supreme Court ruled that a statute that
prohibited loitering was unconstitutionally vague because it did not clarify exactly what
behavior was prohibited and it tended to be enforced arbitrarily.2
7-2b State of Mind
VOLUNTARY ACT
A defendant is not guilty of a crime if she was forced to commit it. In other words, she is not
guilty if she acted under duress. However, the defendant bears the burden of proving by a
preponderance of the evidence that she did act under duress. In 1974, a terrorist group
kidnapped heiress Patricia Hearst from her apartment near the University of California at
Berkeley. After being tortured for two months, she participated in a bank robbery with the
group. Despite opportunities to escape, she stayed with the criminals until her capture by
the police a year later. The State of California put on her on trial for bank robbery. One
question for the jury was whether she had voluntarily participated in the crime. This was an
issue on which many people had strong opinions. Ultimately Hearst was convicted, sent to
prison, and then later pardoned.
ENTRAPMENT
When the government induces the defendant to break the law, the prosecution must prove
beyond a reasonable doubt that the defendant was predisposed to commit the crime. The
goal is to separate the cases where the defendant was innocent before the government
tempted him from those where the defendant was only too eager to break the law.
Kalchinian and Sherman met in the waiting room of a doctor’s office where they were
both being treated for drug addiction. After several more meetings, Kalchinian told Sherman
that the treatment was not working for him and he was desperate to buy drugs. Could
Sherman help him? Sherman repeatedly refused, but ultimately agreed to help end Kalchi-
nian’s suffering by providing him with drugs. Little did Sherman know that Kalchinian was a
police informant. Sherman sold drugs to Kalchinian a number of times. Kalchinian rewarded
this act of friendship by getting Sherman hooked again and then turning him in to the police.
A jury convicted Sherman of drug dealing, but the Supreme Court overturned the conviction
on the grounds that Sherman had been entrapped.3 The court felt there was no evidence that
Sherman was predisposed to commit the crime.
7-2c Gathering Evidence: The Fourth Amendment
If the police suspect that a crime has been committed, they will need to obtain evidence.
The Fourth Amendment to the Constitution prohibits the government from making illegal
searches and seizures of individuals, corporations, partnerships, and other organizations.
The goal of the Fourth Amendment is to protect the individual from the powerful state.
WARRANT
As a general rule, the police must obtain a warrant before conducting a search. A warrant is
written permission from a neutral official, such as a judge or magistrate, to conduct a search.4
The warrant must specify with reasonable certainty the place to be searched and the items
2Kolender v. Lawson, 461 U.S. 352 (S. Ct. 1983).
3Sherman v. United States, 356 U.S. 369 (S. Ct. 1958).
4A magistrate is a judge who tries minor criminal cases or undertakes primarily administrative
responsibilities.
Guilty
A judge or jury’s finding that a
defendant has committed a
crime.
CHAPTER 7 Crime 167
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to be seized. Thus, if the police say they have reason to believe that they will find bloody
clothes in the suspect’s car in his garage, they cannot also look through his house and
confiscate file folders.
If the police search without a warrant, they have, in most cases, violated the Fourth
Amendment. But even a search conducted with a warrant violates the Fourth Amendment if:
• There was no probable cause to issue the warrant;
• The warrant does not specify the place to be searched and the things sought; or
• The search extends beyond what is specified in the warrant.
PROBABLE CAUSE
The magistrate will issue a warrant only if there is probable cause. Probable cause means
that based on all the information presented, it is likely that evidence of a crime will be found
in the place to be searched. Often, the police base their applications for a warrant on data
provided by an informant. The magistrate will want evidence to support the informant’s
reliability. If it turns out that this informant has been wrong the last three times he gave
evidence to the police, the magistrate will probably refuse the request for a warrant.
SEARCHES WITHOUT A WARRANT
There are seven circumstances under which police may search without a warrant:
1. Plain View. Police may search if they see a machine gun, for example, sticking out
from under the front seat of a parked car.
2. Stop and Frisk. None of us wants to live in a world in which police can randomly
stop and frisk us on the street anytime they feel like it. The police do have the right
to stop and frisk, but only if they have a clear and specific reason to suspect that
criminal activity may be afoot and that the person may be armed and dangerous.5
3. Emergencies. If, for example, the police believe that evidence is about to be
destroyed, they can search.
4. Automobiles. If police have lawfully stopped a car and observe evidence of other
crimes in the car, such as burglary tools, they may search.
5. Lawful Arrest. Police may always search a suspect they have arrested. The goal is to
protect the officers and preserve evidence.
6. Consent. Anyone lawfully living in a dwelling can allow the police in to search
without a warrant. If your roommate gives the police permission to search your house,
that search is legal.
7. No Expectation of Privacy. The police have a right to search any area in which the
defendant does not have a reasonable expectation of privacy. For example,
Rolando Crowder was staying at his friend Bobo’s apartment. Hearing the police
in the hallway, he ran down to the basement. The police found Crowder in the
basement with drugs nearby. Crowder argued that the police should have obtained
a warrant, but the court ruled that Crowder had no expectation of privacy in
Bobo’s basement.6
Apart from these seven exceptions, a warrant is required.
5Terry v. Ohio, 392 U.S. 1 (S. Ct. 1968).
6Ohio v. Crowder, 2010 Ohio 3766; 2010 Ohio App. LEXIS 3210 (2010).
Probable cause
It is likely that evidence of crime
will be found in the place to be
searched.
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You Be the Judge
Facts: Wendy Northern
was hospitalized for a drug
overdose. When police
questioned her in the hos-
pital, she identified her
drug dealer as Antwaun
Smith. She then called
him to arrange for the purchase of crack cocaine at her house
that evening. When Smith arrived at her house, the police
arrested him, searched
him, and confiscated his
cell phone. When the
police looked at the phone
some time later, they
discovered call records
and phone numbers con-
firming that this phone had been used to speak with
Northern.
EXCLUSIONARY RULE
Under the exclusionary rule, evidence obtained illegally may not be used at trial. The Supreme
Court created the exclusionary rule to ensure that police conduct legal searches. The theory is
simple: If police know in advance that illegally obtained evidence cannot be used in court, they
will not be tempted to make improper searches. Is the exclusionary rule a good idea?
Opponents of the rule argue that a guilty person may go free because one police officer
bungled. They are outraged by cases like Coolidge v. New Hampshire.7 Pamela Mason, a 14-year-
old babysitter, was brutally murdered. Citizens of NewHampshire were furious, and the state’s
attorney general personally led the investigation. Police found strong evidence that Edward
Coolidge had done it. They took the evidence to the attorney general, who personally issued a
search warrant. A search of Coolidge’s car uncovered incriminating evidence, and he was found
guilty of murder and sentenced to life in prison. But the United States Supreme Court reversed
the conviction. The warrant had not been issued by a neutral magistrate. A law officer may not
lead an investigation and simultaneously decide what searches are permissible.
After the Supreme Court reversed Coolidge’s conviction, New Hampshire scheduled a
new trial, attempting to convict him with evidence lawfully obtained. Before the trial began,
Coolidge pleaded guilty to second degree murder. He was sentenced and remained in prison
until his release years later.
In fact, very few people do go free because of the exclusionary rule. One study showed
that evidence is actually excluded in only 1.3 percent of all prosecutions; and in about one-
half of those cases, the court convicted the defendant on other evidence. Only in 0.7 percent
of all prosecutions did the defendant go free after the evidence was suppressed.8
There are two exceptions to the exclusionary rule:
1. Inevitable Discovery. The inevitable discovery exception permits the use of evidence
that would inevitably have been discovered even without the illegal search. If an
informant was about to tell the police about Coolidge’s car, then the evidence found
there would have been admissible, so long as the court believed the testimony was true.
2. Good Faith Exception. Suppose the police use a search warrant believing it to be
proper, but it later proves to have been defective. Is the search therefore illegal? No,
so long as the police reasonably believed the warrant was valid, the search is legal.9
Should the exclusionary rule apply in the following case? You be the judge.
7403 U.S. 443, 91 S. Ct. 2022, 1971 U.S. LEXIS 25 (S. Ct. 1971).
8See the discussion in United States v. Leon (Justice Brennan, dissenting), 468 U.S. 897, 1985 U.S.
LEXIS 153 (S. Ct. 1984).
9Ibid.
OHIO V. SMITH
2009 Ohio 6426; 920 N.E.2d 949;
2009 Ohio Lexis 3496
Supreme Court of Ohio, 2009
Exclusionary rule
Evidence obtained illegally may
not be used at trial.
CHAPTER 7 Crime 169
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THE PATRIOT ACT
In response to the devastating attacks of September 11, 2001, Congress passed a sweeping
antiterrorist law known as the Patriot Act. The statute was designed to give law enforce-
ment officials greater power to investigate and prevent potential terrorist assaults. The bill
raced through Congress nearly unopposed. Proponents hailed it as a vital weapon for use
against continuing lethal threats. Opponents argued that the hastily passed law would not
provide serious benefits but did threaten the liberties of the very people it purported to
shield.
In an early legal test, a federal judge permitted the government to use secret evidence
in its effort to freeze the assets of Global Relief Foundation, a religious organization
suspected of terrorist activity. The group, which claimed to be purely humanitarian, asserted
that it could hardly defend itself against unseen evidence. Finding “acute national security
concerns,” the judge allowed the government to introduce the evidence in private, without
the foundation ever seeing it.10
The law also permitted the FBI to issue a national security letter (NSL) to commu-
nications firms such as Internet service providers (ISPs) and telephone companies. An NSL
typically demanded that the recipient furnish to the government its customer records,
without ever divulging to anyone what it had done. NSLs could be used to obtain access to
subscriber billing records, phone, financial, credit, and other information—even records of
books taken from libraries. However, an appeals court ruled that a secret NSL could be
issued only if the government first demonstrated to a court’s satisfaction that disclosure of
the NSL would risk serious harm.11
The police had neither a warrant nor Smith’s con-
sent to search the phone. Smith filed a motion request-
ing that the evidence from his cell phone be excluded
because it had been obtained without a warrant. After
the judge denied this motion, Smith was found guilty
and sentenced to 12 years in prison. The appeals court
upheld his conviction. He appealed to the Ohio
Supreme Court.
You Be the Judge: Was the search of Smith’s cell phone
legal? Should the evidence found on the phone be
excluded?
Argument for the Police: The police have the right to
search anyone they arrest. During a perfectly legal search,
they discovered Smith’s cell phone. Prior courts have
ruled that defendants have a low expectation of privacy
in address books and that police can search them without
a warrant. A cell phone is an electronic address book.
Therefore, the search of Smith and the subsequent search
of the contents of the phone were both legal. The evi-
dence was properly admitted in court.
Argument for Smith: Police have the right to search
someone they have arrested so that they can protect
themselves and prevent evidence from being destroyed.
A search of the cell phone’s contents was not neces-
sary to ensure officer safety, and there was no evidence
that the call records and phone numbers were in danger of
being destroyed. Once the police had the phone, they had
plenty of time to ensure that the data were preserved. In
addition, they might have been able to obtain Smith’s
phone records from his service provider.
The police were entitled to search Smith and discover
his cell phone. But they did not have the right to search the
phone without a warrant. Modern cell phones are much
more similar to a laptop than to an old-fashioned address
book—they have the ability to transmit large amounts of
personal data in various forms. Courts have ruled that defend-
ants have a high expectation of privacy in laptop computers
and that the police must obtain a warrant before searching
one. It would be a terrible precedent to declare that the
police could search cell phones without a warrant.
10Global Relief Found., Inc. v. O’Neill, 315 F.3d 748, 2002 U.S. App. LEXIS 27172 (7th Cir. 2002).
11Doe v. Mukasey, 549 F.3d 861, 2008 U.S. App. LEXIS 25193 (2d Cir. 2008).
170 U N I T 1 The Legal Environment
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EXAM Strategy
Question: Police bang down the door of Mary Beth’s apartment, enter without her
permission, and search the apartment. They had no warrant. When the officers
discover that she is smoking marijuana, they arrest her. What motion will the defense
lawyer make before trial? Please rule on the defendant’s motion. Are there any facts
that would make you change your ruling?
Strategy: The defendant’s motion is based on the police conduct. What was wrong
with that conduct, and what are the consequences?
Result: The defense lawyer will argue that the police violated the Fourth
Amendment because they lacked a warrant for the search. He will ask that the court
suppress the drug evidence. Ordinarily, the court would grant that motion unless
there was other evidence—for example, the police smelled marijuana from the
hallway, and Mary Beth would have smoked it all if the police had taken the time
to obtain a warrant.
7-2d The Case Begins
The trial is now ready to begin. But, the government may not be able to use all the evidence
it has gathered.
THE FIFTH AMENDMENT
The Fifth Amendment to the Constitution protects criminal defendants—both the innocent
and the guilty—in several ways.
Due Process Due process requires fundamental fairness at all stages of the case.
The basic elements of due process are discussed in Chapter 5, on constitutional law. In
the context of criminal law, due process sets additional limits. The requirement that the
prosecution disclose evidence favorable to the defendant is a due process rule. Similarly, if a
witness says that a tall white male robbed the liquor store, it would violate due process for
the police to place the male suspect in a lineup with four short women.
Self-Incrimination The Fifth Amendment bars the government from forcing any
person to provide evidence against himself. In other words, the police may not use mental
or physical coercion to force a confession or any other information out of someone. Society
does not want a government that engages in torture. Such abuse might occasionally catch a
criminal, but it would grievously injure innocent people and make all citizens fearful of the
government that is supposed to represent them. Also, coerced confessions are inherently
unreliable. The defendant may confess simply to end the torture. (The protection against
self-incrimination applies only to people; corporations and other organizations are not
protected and may be required to provide incriminating information.)
Exclusionary Rule (Again) If the police do force a confession, the exclusionary rule
prohibits the prosecution from using it or any information they obtain as a result of what the
defendant has said. (This secondary information is referred to as “the fruit of the poisonous
tree.”) For example, when the police illegally arrest Alice, she tells them that she has
bought drugs from Beau. The police go to Beau’s house, where they find drugs. He tells
them that Caitlyn is his dealer and, indeed, the police find drugs in Caitlyn’s bedroom.
None of this evidence—neither the confessions nor the drugs—is admissible in court
because it all stemmed from Alice’s illegal arrest.
Due process
Requires fundamental fairness
at all stages of the case.
CHAPTER 7 Crime 171
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The rationale is the same as for Fourth Amendment searches: Suppressing the evidence
means that police will not attempt to get it illegally. But remember that the confession is
void only if it results from custodial questioning. Suppose a policeman, investigating a bank
robbery, asks a pedestrian if he noticed anything peculiar. The pedestrian says, “You mean
after I robbed the bank?” Result? There was no custodial questioning, and the confession
may be used against him.
Miranda Rights The police cannot legally force a suspect to provide evidence against
himself. But sometimes, under forceful interrogation, he might forget his constitutional rights.
In the following landmark case, the Supreme Court established the requirement that police
remind suspects of their rights—with the very same warning that we have all heard so many
times on television shows.
Landmark Case
Facts: Ernesto Miranda
was a mentally ill, indigent
citizen of Mexico. The
Phoenix police arrested
him at his home and
brought him to a police
station, where a rape victim
identified him as her
assailant. The police did not
tell him that he had a right
to have a lawyer present during questioning. After two
hours of interrogation, Miranda signed a confession which
said that it had been made voluntarily.
At Miranda’s trial, the judge admitted this written
confession into evidence over the objection of defense
counsel. The officers testified that Miranda had also
made an oral confession during the interrogation. The
jury found Miranda guilty of kidnapping and rape. After
the Supreme Court of Arizona affirmed the conviction,
the U.S. Supreme Court agreed to hear his case.
Issues: Was Miranda’s confession admissible at trial? Should
his conviction be upheld?
Decision: Neither his written nor his oral confession was
admissible. His conviction was overturned.
Reasoning: To maintain a fair balance between state
power and individual rights, to respect human dignity,
our system of criminal justice demands that the govern-
ment seeking to punish an individual produce the
evidence against him by
its own independent
labors rather than by the
cruel, simple expedient of
compelling it from his
own mouth.
Therefore, once the
police take a suspect into
custody or otherwise dep-
rive him of his freedom,
they are required to protect his constitutional right to
avoid self-incrimination. To do so, they must warn him
that he has a right to remain silent, that any statement he
does make may be used as evidence against him, and that
he has a right to the presence of an attorney, either
retained or appoi-nted. If the police do not inform the
accused of these rights, then nothing he says or writes
can be admitted in court.
The defendant may waive these rights, provided the
waiver is made voluntarily, knowingly, and intelligently.
If, however, he indicates in any manner and at any stage
of the process that he does not want to be interrogated or
wishes to consult with an attorney before speaking, then
the police cannot question him. The mere fact that he
may have answered some questions or volunteered some
statements on his own does not deprive him of the right
to refrain from answering any further inquiries until he
has consulted with an attorney.
MIRANDA V. ARIZONA
384 U.S. 436; 1966 U.S. LEXIS 2817
Supreme Court of the United States,1966
C A S E S U M M A R Y
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7-2e Right to a Lawyer
As Miranda made clear, a criminal defendant has the right to a lawyer before being
interrogated by the police. The Sixth Amendment guarantees the right to a lawyer at all
important stages of the criminal process. Because of this right, the government must appoint
a lawyer to represent, free of charge, any defendant who cannot afford one.
7-2f After Arrest
INDICTMENT
Once the police provide the local prosecutor with evidence, he presents this evidence to a
grand jury and asks its members to indict the defendant. The grand jury is a group of ordinary
citizens, like a trial jury, but the grand jury holds hearings for several weeks at a time, on many
different cases. It is the grand jury’s job to determine whether there is probable cause that this
defendant committed the crime with which she is charged. At the hearing in front of the
grand jury, only the prosecutor presents evidence, not the defense attorney because it is
better for the defendant to save her evidence for the trial jury. After all, the defense attorney
may want to see what evidence the prosecution has before deciding how to present the case.
If the grand jury determines that there is probable cause, an indictment is issued. An
indictment is the government’s formal charge that the defendant has committed a crime and
must stand trial.
ARRAIGNMENT
At an arraignment, a clerk reads the formal charges of the indictment. The judge asks
whether the defendant has a lawyer. If she does not, the judge urges her to get one quickly.
If a defendant cannot afford a lawyer, the court will appoint one to represent her free of
charge. The judge now asks the lawyer how the defendant pleads to the charges. At this
stage, most defendants plead not guilty.
DISCOVERY
During the months before trial, both prosecution and defense will prepare the most
effective case possible. There is less formal discovery than in civil trials. The prosecution
is obligated to hand over any evidence favorable to the defense that the defense attorney
requests. The defense has a more limited obligation to inform the prosecution of its
evidence. In most states, for example, if the defense will be based on an alibi, counsel
must reveal the alibi to the government before trial.
PLEA BARGAINING
Sometime before trial, the two attorneys will meet to try to negotiate a plea bargain. A plea
bargain is an agreement between prosecution and defense that the defendant will plead
guilty to a reduced charge, and the prosecution will recommend to the judge a relatively
lenient sentence. In the federal court system, about 75 percent of all prosecutions end in a
plea bargain. In state court systems, the number is often higher. A judge need not accept the
bargain but usually does.
For example, astronaut Lisa Nowak drove across country dressed in a wig and trench
coat to attack fellow astronaut Colleen Shipman, whom she viewed as a romantic rival. After
Nowak’s arrest, police found in her car a BB gun, a knife, and surgical tubing, which was
thought to be evidence of her violent intent. Nowak was charged with attempted murder
and attempted kidnapping, but much of the evidence was thrown out of court under the
exclusionary rule because of police misconduct. Nowak ultimately pleaded guilty to battery
and burglary of a car. At that point, she had served two days in jail. She did not receive
further jail time, but she was required to complete 50 hours of community service and to
attend anger-management classes.
Grand jury
A group of ordinary citizens who
decides whether there is
probable cause the defendant
committed the crime with
which she is charged.
Indictment
The government’s formal
charge that the defendant has
committed a crime and must
stand trial.
Plea bargain
An agreement in which the
defendant pleads guilty to a
reduced charge, and the
prosecution recommends to
the judge a relatively lenient
sentence.
CHAPTER 7 Crime 173
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TRIAL AND APPEAL
When there is no plea bargain, the case must go to trial. The mechanics of a criminal trial are
similar to those for a civil trial, described in Chapter 3, on dispute resolution. It is the
prosecution’s job to convince the jury beyond a reasonable doubt that the defendant com-
mitted every element of the crime charged. The defense counsel will do everything possible
to win an acquittal. In federal courts, prosecutors obtain a conviction in about 80 percent of
cases; in state courts, the percentage is slightly lower. Convicted defendants have a right to
appeal, and again, the appellate process is similar to that described in Chapter 3.
DOUBLE JEOPARDY
The prohibition against double jeopardy means that a defendant may be prosecuted only once
for a particular criminal offense. The purpose is to prevent the government from destroying the
lives of innocent citizens with repetitive prosecutions. Imagine that Rod and Lucy are accused
of murdering a taxi driver. Rod is tried first and wins an acquittal. At Lucy’s trial, Rod testifies
that he is, indeed, the murderer. The jury acquits Lucy. The Double Jeopardy Clause prohibits
the state from retrying Rod again for the same offense, even though he has now confessed to it.
PUNISHMENT
The Eighth Amendment prohibits cruel and unusual punishment. The most dramatic issue
litigated under this clause is the death penalty. The Supreme Court has ruled that capital
punishment is not inherently unconstitutional. Most state statutes divide a capital case into
two parts, so that the jury first considers only guilt or innocence, and then, if the defendant
is found guilty, deliberates on the death penalty. As part of that final decision, the jury must
consider aggravating and mitigating circumstances that may make the ultimate penalty more
or less appropriate.12
As youmight expect from the term “cruel and unusual,” courts are generally unsympathetic
to such claims unless the punishment is truly outrageous. For example, Mickle pleaded guilty to
rape. The judge sentenced him to prison for five years and also ordered that he undergo a
vasectomy. The appeals court ruled that this sentence was cruel and unusual. Although the
operation in itself is not cruel (indeed, many men voluntarily undergo it), when imposed as
punishment, it is degrading and in that sense cruel. It is also an unusual punishment.13
In the following case, the Supreme Court was not moved to overturn a harsh punishment.
EWING V. CALIFORNIA
538 U.S. 11, 123 S. Ct. 1179, 155 L.Ed.2d 108
United States Supreme Court, 2003
C A S E S U M M A R Y
Facts: California passed a “three strikes” law, dramati-
cally increasing sentences for repeat offenders. A defend-
ant with two or more serious convictions, who was
convicted of a third felony, had to receive an indetermi-
nate sentence of life imprisonment. Such a sentence
required the defendant to actually serve a minimum of
25 years, and in some cases much more. Gary Ewing, on
parole from a nine-year prison term, stole three golf clubs
worth $399 each, and was prosecuted. Because he had
prior convictions, the crime, normally a misdemeanor,
12Gregg v. Georgia, 428 U.S. 153, 96 S. Ct. 2909, 1976 U.S. LEXIS 82 (S. Ct. 1976).
13Mickle v. Henrichs, 262 F. 687 (1918).
Double jeopardy
A criminal defendant may be
prosecuted only once for a
particular criminal offense.
174 U N I T 1 The Legal Environment
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Devil’s Advocate Are we really going to send Ewing to prison for a
minimum of 25 years—for shoplifting? It is true that
Ewing is a recidivist, and undoubtedly a state is entitled to punish chronic troublemakers
more harshly than first-time offenders. However, this still seems excessive. In California,
a first-time offense of “arson causing great bodily injury” incurs a maximum nine-year
sentence. A first-time offender convicted of voluntary manslaughter receives a sentence
of no more than 11 years. Only a first-time murderer receives a penalty equal to Ewing’s—
25 years to life. It is unfair to Ewing to equate his property crimes with a homicide, and
foolish for society to spend this much money locking him up.
The Eighth Amendment also outlaws excessive fines. Forfeiture is the most contro-
versial topic under this clause. Forfeiture is a civil law proceeding that is permitted by many
different criminal statutes. Once a court has convicted a defendant under certain criminal
statutes—such as a controlled substance law—the government may seek forfeiture of
property associated with the criminal act. How much property can the government take?
To determine if forfeiture is fair, courts generally look at three factors: whether the property
was used in committing the crime, whether it was purchased with proceeds from illegal acts,
and whether the punishment is disproportionate to the defendant’s wrongdoing. Neal
Brunk pleaded guilty to selling 2.5 ounces of marijuana, and the government promptly
sought forfeiture of his house on 90 acres, worth about $99,000. The court found that
forfeiture was legitimate because Brunk had used drug money to buy the land and then
sold narcotics from the property.14 By contrast, Hosep Bajakajian attempted to leave the
United States without reporting $375,000 cash to customs officials as the law requires.
was treated as a felony. Ewing was convicted and sen-
tenced to 25 years to life. He appealed, claiming that the
sentence violated the Eighth Amendment.
Issue: Did Ewing’s sentence violate the Eighth Amend-
ment?
Decision: No, the sentence did not violate the Eighth
Amendment. Affirmed.
Reasoning: States have a valid interest in deterring and
jailing habitual criminals. Nothing in the Eighth Amendment
prohibits theCalifornia legislature from choosing this method
of protecting the public. Recidivism is a serious public safety
concern nationwide. According to a recent report, 67 percent
of former inmates released from state prison were charged
with a serious new crime within three years. Property offend-
ers like Ewing were even likelier to commit a new crime
than those who served time for violent crimes.
Ewing had already been convicted of numerous mis-
demeanors and felonies, and he had served nine terms of
incarceration. He committed most of his crimes while on
parole or probation. His previous convictions included
serious crimes, such as robbery and residential burglary.
By imposing a three strikes sentence, the State is not
merely punishing the “triggering” offense. The State is
also deciding to treat more harshly someone whose
repeated criminal acts demonstrate that he is incapable
of conforming to the norms of society.
Unquestionably the sentence is a long one, and the
three strikes law has generated controversy. But criticism
of the statute should be directed to the State legislature.
Federal courts do not sit as a “super-legislature,” second-
guessing policy choices made by elected officials. The
three strikes law represents a rational legislative judg-
ment, entitled to judicial deference, that repeat offenders
who have committed serious crimes must be incapaci-
tated.
Ewing’s sentence of 25 years to life is not grossly
disproportionate and therefore does not violate the Eighth
Amendment.
14U.S. v. Brunk, 2001 U.S. App. LEXIS 7566 (4th Cir. 2001).
CHAPTER 7 Crime 175
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The government demanded forfeiture of the full sum, but the Supreme Court ruled that
seizure of the entire amount was grossly disproportionate to the minor crime of failing to
report cash movement.15
7-3 CRIMES THAT HARM BUSINESS
Businesses must deal with four major crimes: larceny, fraud, arson, and embezzlement.
7-3a Larceny
It is holiday season at the mall, the period of greatest profits—and the most crime. At the
Foot Forum, a teenager limps in wearing ragged sneakers and sneaks out wearing Super
Sneakers, valued at $145. Down the aisle at a home furnishing store, a man is so taken by a
$375 power saw that he takes it. Sweethearts swipe sweaters, pensioners pocket produce.
All are committing larceny.
Larceny is the trespassory taking of personal property with the intent to steal it.
“Trespassory taking” means that someone else originally has the property. The Super
Sneakers are personal property (not real estate), they were in the possession of the Foot
Forum, and the teenager deliberately left without paying, intending never to return the
goods. That is larceny. By contrast, suppose Fast Eddie
leaves Bloomingdale’s in New York, descends to the sub-
way system, and jumps over a turnstile without paying.
Larceny? No. He has “taken” a service—the train ride—
but not personal property.
Each year, about $10 billion in merchandise is stolen
from retail stores in the United States. Economists estimate
that 12 cents out of every dollar spent in retail stores covers
the cost of shoplifting. Some criminal experts believe that
drug addicts commit over half of all shoplifting to support
their habits. Stores have added electronic surveillance,
security patrols, and magnetic antitheft devices, but the
problem will not disappear.
7-3b Fraud
Robert Dorsey owned Bob’s Chrysler in Highland, Illinois. When he bought cars, the First
National Bank of Highland paid Chrysler, and Dorsey—supposedly—repaid the bank as he
sold the autos. Dorsey, though, began to suffer financial problems, and the bank suspected
he was selling cars without repaying his loans. A state investigator notified Dorsey that he
planned to review all dealership records. One week later, a fire engulfed the dealership. An
arson investigator discovered that an electric iron, connected to a timer, had been placed on
a pile of financial papers doused with accelerant.
The saddest part of this true story is that it is all too common. Some experts suggest
that 1 percent of corporate revenues are wasted on fraud alone. Dorsey was convicted and
imprisoned for committing two crimes that cost business billions of dollars annually—fraud
(for failing to repay the loans) and arson (for burning down the dealership).16
Fraud refers to various crimes, all of which have a common element: the deception of
another person for the purpose of obtaining money or property from him. Robert Dorsey’s
Economists estimate
that 12 cents out of every
dollar spent in retail
stores covers the cost of
shoplifting.
15U.S. v. Bajakajian, 524 U.S. 321, 118 S. Ct. 2028, 1998 U.S. LEXIS 4172 (S. Ct. 1998).
16United States v. Dorsey, 27 F.3d 285, 1994 U.S. App. LEXIS 15010 (7th Cir. 1994).
Larceny
The trespassory taking of
personal property with the
intent to steal it.
Fraud
Deception for the purpose of
obtaining money or property.
176 U N I T 1 The Legal Environment
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precise violation was bank fraud, a federal crime.17 It is bank fraud to use deceit to obtain
money, assets, securities, or other property under the control of any financial institution.
WIRE FRAUD AND MAIL FRAUD
Wire and mail fraud are additional federal crimes, involving the use of interstate mail,
telegram, telephone, radio, or television to obtain property by deceit.18 For example, if
Marsha makes an interstate phone call to sell land that she does not own, that is wire fraud.
THEFT OF HONEST SERVICES
Under traditional standards, a culprit could only be convicted of fraud if he had deceived the
victim to get something of value from her. But what if a CEO manipulates the financial
results of his company and otherwise misleads investors to keep the stock price high? He
has not committed fraud under this traditional definition because he did not personally
obtain money from the investors—they bought their stock either from other shareholders or
from the company.
To find a way to punish these wrongdoers, prosecutors looked to a federal statute that
prohibits the theft of honest services.19 Originally, this law was used to prosecute public
officials who took bribes or kickbacks. But then prosecutors began to apply it to employees
in the private sector as well. Prosecutors took the view that an employee violated this law if
she did not fully perform the job for which she was paid. Thus, the CEO could be charged
for not having done his job properly. But under this standard, the scope of the statute
became enormous. In theory, an employee who called in sick so that he could watch his
son’s play has violated this statute. The scope of the statute permitted enormous discretion
on the part of prosecutors.
The Supreme Court has stepped in to limit its scope. As the following case reveals, the
theft of honest services statute prohibits public and private employees from taking bribes or
kickbacks.
SKILLING V. UNITED STATES
130 S. Ct. 2896, 2010 U.S. LEXIS 5259
Supreme Court of the United States, 2010
Facts: Enron Corporation was an energy company in
Houston that hired a young Harvard Business School
graduate named Jeffrey Skilling to run one of its subsidi-
aries. Eleven years later, Skilling was promoted to presi-
dent and chief operating officer. At that time, only six
companies in the United States had higher revenues than
Enron. Ten months after Skilling’s promotion, Enron filed
for bankruptcy protection.
The company’s stock, which had been trading at $90
per share, became virtually worthless. A government inves-
tigation uncovered an elaborate conspiracy to prop up
Enron’s stock prices by overstating the company’s finances.
Skilling was convicted of violating the honest services
statute, sentenced to more than 24 years in prison, and
ordered to pay $45 million in restitution. Skilling appealed,
arguing that the honest services statute only applied to
bribery and kickback schemes. The Fifth Circuit affirmed
his conviction. The Supreme Court granted certiorari.
Issue: Did Skilling violate the honest services statute?
Decision: No, Skilling was not in violation.
Reasoning: The due process clause of the Constitution
provides that a criminal statute must define a violation so
1718 U.S.C. §1344.
1818 U.S.C. §§1341–1346.
1918 U.S.C. §1346.
CHAPTER 7 Crime 177
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Skilling had been found guilty of three crimes: honest services fraud, wire fraud, and
securities fraud. Although the Supreme Court ruled that Skilling had not violated the honest
services statute, they remanded the case to the appeals court to determine if the other two
convictionswere independent enough to stand on their ownwithout the honest services element.
If not, hewould have to be retried. The appeals court did uphold Skilling’s two other convictions.
INSURANCE FRAUD
Insurance fraud is another common crime. A Ford suddenly swerves in front of a Toyota, causing
it to brake hard. A Mercedes, unable to stop, slams into the Toyota, as the Ford races away.
Regrettable accident? No: a “swoop and squat” fraud scheme. The Ford and Toyota drivers
were working together, hoping to cause an accident with someone else. The “injured” Toyota
driver now goes to a third member of the fraud team—a dishonest doctor—who diagnoses
serious back and neck injuries and predicts long-term pain and disability. The driver files a claim
against the Mercedes’s driver, whose insurer may be forced to pay tens or even hundreds of
thousands of dollars for an accident that was no accident. Insurance companies investigate
countless cases like this each year, trying to distinguish the honest victim from the criminal.
EXAM Strategy
Question: Eric mails glossy brochures to 25,000 people, offering to sell them a
one-month time-share in a stylish apartment in Las Vegas. The brochure depicts
an imposing building, an opulent apartment, and spectacular pools. To reserve a
space, customers need only send in a $2,000 deposit. Three hundred people
respond, sending in the money. In fact, there is no such building. Eric, planning to
flee with the cash, is arrested and prosecuted. His sentence could be as long as 20
years. (1) With what crime is he charged? (2) Is this a felony or misdemeanor
prosecution? (3) Does Eric have a right to a jury trial? (4) What is the
government’s burden of proof?
Strategy: (1) Eric is deceiving people, and that should tell you the type of crime.
(2, 3) The potential 20-year sentence determines whether Eric’s crime is a misde-
meanor or felony, and whether or not he is entitled to a jury trial. (4) We know that
the government has the burden of proof in criminal prosecutions—but how much
evidence must it offer?
Result: Eric has committed fraud. A felony is one in which the sentence could be a
year or more. The potential penalty here is 20 years, so the crime is a felony. Eric has
a right to a jury, as does any defendant whose sentence could be six months or longer.
The prosecution must prove its case beyond a reasonable doubt, a much higher
burden than that in a civil case.
precisely that an ordinary person knows what activities are
illegal. Skilling argued that the honest services statute did
not meet this standard because it was too vague. It could
apply to a very wide range of behavior, including some
that is quite innocent.
Traditionally this statute was used against people who
took bribes or kickbacks. That is a clear standard everyone
can understand. Therefore, we hold that the honest services
statute is constitutional, but only when applied to someone
who has taken bribes or kickbacks.
The government did not allege that Skilling took
bribes to misstate Enron’s financials. The wrong-doing
was for his own benefit. Therefore, he was not in violation
of the honest services statute.
178 U N I T 1 The Legal Environment
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7-3c Arson
Robert Dorsey, the Chrysler dealer, committed a second serious crime. Arson is the
malicious use of fire or explosives to damage or destroy any real estate or personal property.
It is both a federal and a state crime. Dorsey used arson to conceal his bank fraud. Most
arsonists hope to collect on insurance policies. Every year thousands of buildings burn,
particularly in economically depressed neighborhoods, as owners try to make a quick kill or
extricate themselves from financial difficulties. Everyone who purchases insurance ends up
paying higher premiums because of this immorality.
7-3d Embezzlement
This crime also involves illegally obtaining property, but with one big difference: The culprit
begins with legal possession. Embezzlement is the fraudulent conversion of property already
in the defendant’s possession.
This is a story without romance: For 15 years, Kristy Watts worked part-time as a
bookkeeper for romance writer Danielle Steele, handling payroll and accounting. During
that time, Watts stole $768,000 despite earning a salary of $200,000 a year. Watts said that
she had been motivated by envy and jealousy. She was sentenced to three years in prison
and agreed to pay her former boss almost $1 million.
7-4 CRIMES COMMITTED BY BUSINESS
A corporation can be found guilty of a crime based on the conduct of any of its agents, who
include anyone undertaking work on behalf of the corporation. An agent can be a corporate
officer, an accountant hired to audit financial statements, a sales clerk, or almost any other
person performing a job at the company’s request.
If an agent commits a criminal act within the scope of his employment and with the
intent to benefit the corporation, the company is liable.20 This means that the agent himself
must first be guilty. If the agent is guilty, the corporation is, too.
Critics believe that the criminal law has gone too far. It is unfair, they argue, to impose
criminal liability on a corporation, and thus penalize the shareholders, unless high-ranking
officers were directly involved in the illegal conduct. The following case concerns a
corporation’s responsibility for a death caused by its employee.
COMMONWEALTH V. ANGELO TODESCA CORP.
446 Mass. 128, 842 N.E. 2d 930
Supreme Judicial Court of Massachusetts, 2006
C A S E S U M M A R Y
Facts: Brian Gauthier, an experienced truck driver,
worked for Todesca, a paving company. After about a year
driving a particular 10-wheel tri-axle dump truck, Gau-
thier noticed that its back-up alarm had stopped working.
When he reported this, the company mechanic realized
that the old alarm needed replacement. The mechanic
had none in stock, so the company instructed Gauthier
to drive the truck without the alarm.
About a month later, Gauthier and other Todesca
drivers were delivering asphalt to a work site on a highway
20New York Central & Hudson River R.R. Co. v. United States, 212 U.S. 481, 29 S. Ct. 304, 1909 U.S.
LEXIS 1832 (S. Ct. 1909). Note that what counts is the intention to benefit, not actual benefit. A
corporation will not escape liability by showing that the scheme failed.
Arson
The malicious use of fire
or explosives to damage
or destroy real estate or
personal property.
Embezzlement
The fraudulent conversion
of property already in the
defendant’s possession.
CHAPTER 7 Crime 179
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7-4a Selected Crimes Committed by Business
WORKPLACE CRIMES
The workplace can be dangerous. Working on an assembly line exposes factory employees
to fast-moving machinery. For a roofer, the first slip may be the last. The invisible radiation
in a nuclear power plant can be deadlier than a bullet. The most important statute regulat-
ing the workplace is the federal Occupational Safety and Health Act of 1970 (OSHA),21
which sets safety standards for many industries.22 May a state government go beyond
standards set by OSHA and use the criminal law to punish dangerous conditions? In People
v. O’Neill 23 courts of Illinois answered that question with a potent “yes,” permitting a
murder prosecution against corporate executives themselves.
Film Recovery Systems was an Illinois corporation in business to extract silver from
used X-ray film and then resell it. Steven O’Neill was president of Film Recovery, Charles
Kirschbaum was its plant manager, and Daniel Rodriguez the foreman. To extract the silver,
workers at Film Recovery soaked the X-ray film in large, open, bubbling vats that contained
sodium cyanide.
A worker named Stefan Golab became faint. He left the production area and walked to
the lunchroom, where workers found him trembling and foaming at the mouth. He lost
consciousness. Rushed to a hospital, he was pronounced dead on arrival. The medical
examiner determined that Golab died from acute cyanide poisoning caused by inhalation
of cyanide fumes in the plant.
at the entrance to a shopping mall. A police officer directed
the construction vehicles and the routine mall traffic. A
different driver asked the officer to “watch our backs” as
the trucks backed through the intersection. All of the
other trucks were equipped with back-up alarms. When
it was Gauthier’s turn to back up, he struck the police officer,
killing him.
The state charged the Todesca Corporation with
motor vehicle homicide, and the jury found the company
guilty. The trial judge imposed a fine—of $2,500. The
court of appeals reversed the conviction, and the prosecu-
tion appealed to the state’s highest court.
Issue: Could the company be found guilty of motor vehicle
homicide?
Decision: Yes, the company was guilty of motor vehicle
homicide.
Reasoning: The defendant maintains that a corporation
never can be criminally liable for motor vehicle homicide
because a corporation cannot “operate” a vehicle. We
disagree. A corporation can act only through its agents.
By the defendant’s reasoning, a corporation never could
be liable for any crime. A corporation can no more serve
alcohol to minors, or bribe government officials, than oper-
ate a vehicle negligently. Only human agents are capable
of these actions. Nevertheless, we consistently have held
that a corporation may be criminally liable for such acts
when performed by corporate employees, acting with-
in the scope of their employment and on behalf of the
corporation.
Gauthier’s truck was not equipped with a function-
ing back-up alarm, and he knew the alarm was missing.
The defendant had a written safety policy mandating
that all its trucks be equipped with such alarms. An
employee’s violation of his employer’s rules, intended
to protect the safety of third persons, is evidence of the
employee’s negligence, for which the employer may be
held liable.
Gauthier never informed the victim that his truck
did not have an alarm. The jury could have inferred that
the victim, a veteran police officer, knew that the defend-
ant routinely equipped its trucks with backup alarms.
The victim expected to hear a backup alarm and would
have, almost right in his ear, had the truck been properly
maintained.
Affirmed.
2129 U.S.C. §§651 et seq. (1982).
22See Chapter 26 on employment law.
2323194 Ill. App. 3d 79, 550 N.E.2d 1090, 1990 Ill. App. LEXIS 65 (Ill. App. Ct. 1990).
180 U N I T 1 The Legal Environment
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Illinois indicted Film Recovery and several of its managers for murder. The indictment
charged that O’Neill and Kirschbaum committed murder by failing to disclose to Golab that
he was working with cyanide and other potentially lethal substances and by failing to provide
him with appropriate and necessary safety equipment.
The case was tried to a judge without a jury. Workers testified that O’Neill, Kirsch-
baum, and other managers never told them they were using cyanide or that the fumes they
inhaled could be harmful; that management made no effort to ventilate the factory; that
Film Recovery gave the workers no goggles or protective clothing; that the chemicals they
worked with burned their skin; that breathing was difficult in the plant because of strong,
foul orders; and that workers suffered frequent dizziness, nausea, and vomiting.
The trial judge found O’Neill, Kirschbaum, and others guilty of murder. Illinois defines
murder as performing an act that the defendant knows will create a strong probability of death
in the victim, and the judge found they had done that. He found Film Recovery guilty of
involuntary manslaughter. Involuntary manslaughter is recklessly performing an act that
causes death. He sentenced O’Neill, Kirschbaum, and Rodriguez to 25 years in prison.
The defendants appealed, contending that the verdicts were inconsistent. They argued,
and the Illinois Court of Appeals agreed, that the judge had made contradictory findings.
Murder required the specific intent of knowing there was a strong probability of death, whereas
the manslaughter conviction required reckless conduct. The appeals court reversed the
convictions and remanded for a new trial.
Moments before the new trial was to start, O’Neill, Kirschbaum, and Rodriguez all
pleaded guilty to involuntary manslaughter. They received sentences of three years, two
years, and four months, respectively.
HIRING ILLEGAL WORKERS
Employers are required to verify their workers’ eligibility for employment in the United
States. It is illegal to knowingly employ unauthorized workers. Within three days of hiring a
worker, the employer must complete an I-9 form, which lists the items that can be used as
documentation of eligibility. The government has the right to arrest illegal employees, and
it can also bring charges against the business that hired them.
RICO
The Racketeer Influenced and Corrupt Organizations Act (RICO) is one of the most
powerful and controversial statutes ever written.24 Congress passed the law primarily to
prevent gangsters from taking money they earned illegally and investing it in legitimate
businesses. But RICO has expanded far beyond the original intentions of Congress and is
now used more often against ordinary businesses than against organized criminals. Some
regard this wide application as a tremendous advance in law enforcement, but others view it
as an oppressive weapon used to club ethical companies into settlements they should never
have to make.
What is a violation of this law? RICO prohibits using two or more racketeering acts to
accomplish any of these goals: (1) investing in or acquiring legitimate businesses with
criminal money; (2) maintaining or acquiring businesses through criminal activity; or (3)
operating businesses through criminal activity.
What does that mean in English? It is a two-step process to prove that a person or an
organization has violated RICO.
2418 U.S.C. §§1961–1968.
Racketeer Influenced and
Corrupt Organizations Act
(RICO)
A powerful federal statute,
originally aimed at organized
crime, now used in many
criminal prosecutions and civil
lawsuits.
CHAPTER 7 Crime 181
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1. The prosecutor must show that the defendant committed two or more racketeering
acts, which are any of a long list of specified crimes: embezzlement, arson, mail fraud,
wire fraud, and so forth. Thus, if a gangster ordered a building torched in January and
then burned a second building in October, that would be two racketeering acts. If a
stockbroker told two customers that Bronx Gold Mines was a promising stock, when
she knew that it was worthless, that would be two racketeering acts.
2. The prosecutor must then show that the defendant used these racketeering acts to
accomplish one of the three purposes listed above. If the gangster committed two
arsons and then used the insurance payments to buy a dry cleaning business, that
would violate RICO. If the stockbroker gave fraudulent advice and used the
commissions to buy advertising for her firm, that would also violate RICO.
The government may prosecute both individuals and organizations for violating
RICO. For example, the government prosecuted financier Michael Milken for manipulat-
ing stock prices. It also threatened to prosecute his employer, Drexel Burnham Lambert.
If the government proves its case, the defendant can be hit with large fines and a prison
sentence of up to 20 years. RICO also permits the government to seek forfeiture of the
defendant’s property. A court may order a convicted defendant to hand over any property
or money used in the criminal acts or derived from them. Courts often freeze a defendant’s
assets once charges are brought to ensure that he will not hide the assets. If all his assets
are frozen, he will have a hard time paying his defense lawyer, so a freeze often
encourages a defendant to plea bargain on a lesser charge. Both Milken and Drexel
entered into plea agreements with the government, rather than face a freeze on their
assets, or in Milken’s case, a long prison sentence.
In addition to criminal penalties, RICO also creates civil law liabilities. The govern-
ment, organizations, and individuals all have the right to file civil lawsuits, seeking
damages and, if necessary, injunctions. For example, a physician sued State Farm Insur-
ance, alleging that the company had hired doctors to produce false medical reports that the
company used to cut off claims by injured policy holders. As a result of these fake reports,
the company refused to pay the plaintiff for legitimate services he performed on the policy
holders. RICO is powerful (and for defendants, frightening) in part because a civil plaintiff
can recover treble damages; that is, a judgment for three times the harm actually suffered,
as well as attorney’s fees.
MONEY LAUNDERING
Money laundering consists of taking the proceeds of certain criminal acts and either (1)
using the money to promote crime, or (2) attempting to conceal the source of the money.25
Money laundering is an important part of major criminal enterprises. Successful
criminals earn enormous sums, which they must filter back into the flow of commerce
so that their crimes go undetected. Laundering is an essential part of the corrosive traffic
in drugs. Profits, all in cash, may mount so swiftly that dealers struggle to use the money
without attracting the government’s attention. For example, Colombian drug cartels set up
a sophisticated system in which they shipped money to countries such as Dubai that do
not keep records on cash transactions. This money was then transferred to the U.S.
disguised as offshore loans. Prosecution by the U.S. government led to the demise of
some of the banks involved.
But drug money is not the only or even major component of so-called flight capital.
Criminals also try to hide the vast sums they earn from arms dealing and tax evasion. Some
of this money is used to support terrorist organizations.
2518 U.S.C. §§1956 et seq.
Money laundering
Using the proceeds of criminal
acts and either promoting
crime or concealing the source
of the money.
Racketeering acts
Any of a long list of specified
crimes, such as embezzlement,
arson, mail fraud, wire fraud,
and so forth.
182 U N I T 1 The Legal Environment
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EXAM Strategy
Question: Explain the difference between embezzlement and money laundering.
Give an example of each.
Strategy: Both crimes involve money illegally obtained, but they are very different.
As to embezzlement, how did the criminal obtain the funds? In a laundering case, to
what use is the criminal trying to put the cash?
Result: Embezzlement refers to fraudulently taking money that is already in the
defendant’s possession. For example, if a financial advisor, lawfully entrusted with his
client’s funds for investing, uses some of the cash to buy himself a luxurious yacht, he
has embezzled the client’s money. Money laundering consists of taking illegally
obtained money and either using the funds to promote additional crimes or attempting
to conceal the source of the cash. Thus, an arms dealer might launder money so that he
can use it to finance a terrorist organization.
OTHER CRIMES
Additional crimes that affect business appear elsewhere in the text. Antitrust violations,
in which a corporation fixes prices, can lead to criminal prosecutions. Securities fraud is
a crime and can lead to severe prison sentences. (See Chapter 30, on securities and
antitrust.)
7-4b Punishing a Corporation
FINES
The most common punishment for a corporation is a fine, as demonstrated in the Todesca
case. This makes sense in that the purpose of a business is to earn a profit, and a fine,
theoretically, hurts. But most fines are modest by the present standards of corporate wealth.
In the Todesca prosecution, does a $2,500 fine force corporate leaders to be more cautious,
or does it teach them that cutting corners makes economic sense, because the penalties will
be a tolerable cost of doing business?
Sometimes the fines are stiffer. British Petroleum (BP) was found guilty of two serious
environmental violations. In Alaska, the company’s failure to inspect and clean pipelines
caused 200,000 gallons of crude oil to spill onto the tundra. In Texas, the company’s failure
to follow standard procedures for ensuring safe refineries caused a catastrophic explosion
that killed 15 people and injured 170 more. The total fine for both criminal violations was
$62 million.26 Is that enough to change BP’s practices? Evidently not. In the spring of 2010,
a BP well called Deepwater Horizon exploded, killing 11 workers and releasing into the
Gulf of Mexico the largest marine oil spill ever. The Deepwater rig had violated many
safety requirements.
COMPLIANCE PROGRAMS
The Federal Sentencing Guidelines are the detailed rules that judges must follow when
sentencing defendants convicted in federal court of crimes. The guidelines instruct judges
to determine whether, at the time of the crime, the corporation had in place a serious
26Source: http://epa.gov/
Federal Sentencing
Guidelines
The detailed rules that judges
must follow when sentencing
defendants convicted of crimes
in federal court.
CHAPTER 7 Crime 183
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compliance program; that is, a plan to prevent and detect criminal conduct at all levels of the
company. A company that can point to a detailed, functioning compliance program may
benefit from a dramatic reduction in the fine or other punishment meted out. Indeed, a
tough compliance program may even convince federal investigators to curtail an investiga-
tion and to limit any prosecution to those directly involved, rather than attempting to get a
conviction against high-ranking officers or the company itself.
For a compliance plan to be deemed effective:
• The program must be reasonably capable of reducing the prospect of criminal conduct.
• Specific, high-level officers must be responsible for overseeing the program.
• The company must not place in charge any officers it knows or should have known,
from past experience, are likely to engage in illegal conduct.
• The company must effectively communicate the program to all employees and agents.
• The company must ensure compliance by monitoring employees in a position to
cheat and by promptly disciplining any who break the law.
Chapter Conclusion
Crime has an enormous impact on business. Companies are victims of crimes, and sometimes
they also commit criminal actions. Successful business leaders are ever-vigilant to protect
their company from those who wish to harm it, whether from the inside or the outside.
EXAM REVIEW
1. BURDEN OF PROOF In all prosecutions, the government must prove its case
beyond a reasonable doubt. (p. 166)
Question: Arnie owns a two-family house in a poor section of the city. A fire
breaks out, destroying the building and causing $150,000 damage to an adjacent
store. The state charges Arnie with arson. Simultaneously, Vickie, the store owner,
sues Arnie for the damage to her property. Both cases are tried to juries, and the
two juries hear identical evidence of Arnie’s actions. But the criminal jury acquits
Arnie, while the civil jury awards Vickie $150,000. How did that happen?
Strategy: The opposite outcomes are probably due to the different burdens of
proof in a civil and criminal case. Make sure you know that distinction. (See the
“Result” at the end of this section.)
2. RIGHT TO A JURY A criminal defendant has a right to a trial by jury for any
charge that could result in a sentence of six months or longer. (p. 166)
3. DURESS A defendant is not guilty of a crime if she committed it under duress.
However, the defendant bears the burden of proving by a preponderance of the
evidence that she acted under duress. (p. 167)
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Compliance program
A plan to prevent and detect
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the company.
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4. ENTRAPMENT When the government induces the defendant to break the law,
the prosecution must prove beyond a reasonable doubt that the defendant was
predisposed to commit the crime. (p. 167)
5. FOURTH AMENDMENT The Fourth Amendment to the Constitution
prohibits the government from making illegal searches and seizures of individuals,
corporations, partnerships, and other organizations. (pp. 167–171)
6. WARRANT As a general rule, the police must obtain a warrant before conducting
a search, but there are seven circumstances under which the police may search
without a warrant. (pp. 167–168)
7. THE EXCLUSIONARY RULE Under the exclusionary rule, a prosecutor may
not use evidence obtained illegally. (p. 169)
8. FIFTH AMENDMENT The Fifth Amendment requires due process in all
criminal procedures and prohibits double jeopardy and self-incrimination.
(pp. 167 and 171)
9. SIXTH AMENDMENT The Sixth Amendment guarantees criminal defendants
the right to a lawyer. (p. 173)
10. EIGHTH AMENDMENT The Eighth Amendment prohibits excessive fines and
cruel and unusual punishments. (p. 174)
11. LARCENY Larceny is the trespassory taking of personal property with the intent
to steal. (p. 176)
12. FRAUD Fraud refers to a variety of crimes, all of which involve the deception of
another person for the purpose of obtaining money or property. (pp. 176–178)
Question: Chuck is a DJ on a radio station. A music company offers to pay him
every time he plays one of its songs. Soon enough, Chuck is earning $10,000 a
week in these extra payments, and his listeners love the music. In Chuck’s view,
this is a win-win situation. Is Chuck right?
Strategy: This is not traditional fraud because Chuck is not getting money from the
people he is cheating—his listeners. Indeed, they are happy. Is there another type
of fraud that applies in this situation? (See the “Result” at the end of this section.)
13. ARSON Arson is the malicious use of fire or explosives to damage or destroy real
estate or personal property. (p. 179)
14. EMBEZZLEMENT Embezzlement is the fraudulent conversion of property
already in the defendant’s possession. (p. 179)
15. CORPORATE LIABILITY If a company’s agent commits a criminal act within the
scope of her employment and with the intent to benefit the corporation, the company
is liable. (p. 179)
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CHAPTER 7 Crime 185
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16. RICO RICO prohibits using two or more racketeering acts to invest in legitimate
business or carry on certain other criminal acts. RICO permits civil lawsuits as well as
criminal prosecutions. (pp. 181–182)
Question: Cheryl is a bank teller. She figures out a way to steal $99.99 per day in
cash without getting caught. She takes the money daily for eight months and
invests it in a catering business she is starting with Floyd, another teller. When
Floyd learns what she is doing, he tries it, but is caught in his first attempt. He and
Cheryl are both prosecuted.
(a) Both are guilty only of larceny.
(b) Both are guilty of larceny and violating RICO.
(c) Both are guilty of embezzlement; Cheryl is also guilty of violating RICO.
(d) Both are guilty of embezzlement and violating RICO.
Strategy: You need to know the difference between larceny and embezzlement.
What is it? Once you have that figured out, focus on RICO. The government must
prove two things: First, that the defendant committed crimes more than once—
how many times? Second, that the defendant used the criminal proceeds for a
specific purpose—what? (See the “Result” at the end of this section.)
17. MONEY LAUNDERING Money laundering consists of taking profits from a
criminal act and either using them to promote crime or attempting to conceal their
source. (p. 182)
1. Result: The plaintiff offered enough proof to convince a jury by a preponderance of the
evidence that Arnie had damaged her store. However that same evidence, offered in a
criminal prosecution, was not enough to persuade the jury beyond a reasonable doubt that
Arnie had lit the fire.
12. Result: Chuck has committed a theft of honest services because he has taken a bribe.
16. Result: Cheryl and Floyd both committed embezzlement, which refers to fraudulently
taking money that was properly in their possession. Floyd did it once, but a RICO conviction
requires two or more racketeering acts—Floyd has not violated RICO. Cheryl embezzled
dozens of times and invested the money in a legitimate business. She is guilty of embez-
zlement and RICO; the correct answer is (c).
MULTIPLE-CHOICE QUESTIONS
1. In a criminal case, which statement is true?
(a) The prosecution must prove the government’s case by a preponderance of the
evidence.
(b) The criminal defendant is entitled to a lawyer even if she cannot afford to pay for
it herself.
(c) The police are never allowed to question the accused without a lawyer present.
(d) All federal crimes are felonies.
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2. The police are not required to obtain a warrant before conducting a search if:
(a) a reliable informant has told them they will find evidence of a crime in a
particular location.
(b) they have a warrant for part of a property and another section of the property is in
plain view.
(c) they see someone on the street who could possibly have committed a criminal act.
(d) someone living on the property has consented to the search.
3. Under the exclusionary rule, which statement is true?
(a) Evidence must be excluded from trial if the search warrant is defective, even if
the police believed at the time of the search that it was valid.
(b) The prosecution cannot use any evidence the police found at the site of the
illegal search, but it can use any evidence the police discover elsewhere as a
result of the illegal search.
(c) Any statements a defendant makes after arrest are inadmissible if the police do
not read him his Miranda rights.
(d) If a conviction is overturned because of the exclusionary rule, the prosecution is
not allowed to retry the defendant.
4. Benry asks his girlfriend, Alina, to drive his car to the repair shop. She drives his car
all right—to Las Vegas, where she hits the slots. Alina has committed:
(a) fraud.
(b) embezzlement.
(c) larceny.
(d) a RICO violation.
5. Which of the following elements is required for a RICO conviction?
(a) Investment in a legitimate business
(b) Two or more criminal acts
(c) Maintaining or acquiring businesses through criminal activity
(d) Operating a business through criminal activity
ESSAY QUESTIONS
1. YOU BE THE JUDGE WRITING PROBLEM An undercover drug informant
learned from a mutual friend that Philip Friedman “knew where to get marijuana.”
The informant asked Friedman three times to get him some marijuana, and Friedman
agreed after the third request. Shortly thereafter, Friedman sold the informant a small
amount of the drug. The informant later offered to sell Friedman three pounds of
marijuana. They negotiated the price and then made the sale. Friedman was tried
for trafficking in drugs. He argued entrapment. Was Friedman entrapped?
Argument for Friedman: The undercover agent had to ask three times before
Friedman sold him a small amount of drugs. A real drug dealer, predisposed to
commit the crime, leaps at an opportunity to sell. If the government spends time
and money luring innocent people into the commission of crimes, all of us are the
losers. Argument for the Government: Government officials suspected Friedman
CHAPTER 7 Crime 187
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of being a sophisticated drug dealer, and they were right. When he had a chance
to buy three pounds, a quantity only a dealer would purchase, he not only did so,
but he bargained with skill, showing a working knowledge of the business.
Friedman was not entrapped—he was caught.
2. Conley owned video poker machines. Although they are outlawed in Pennsylvania,
he placed them in bars and clubs. He used profits from the machines to buy more
machines. Is he guilty of money laundering?
3. Karin made illegal firearm purchases at a gun show. At her trial, she alleged
that she had committed this crime because her boyfriend had threatened to
harm her and her two daughters if she did not. Her lawyer asked the judge
to instruct the jury that the prosecution had an obligation to prove beyond a
reasonable doubt that Karin had acted freely. Instead, the judge told the jury
that Karin had the burden of proving duress by a preponderance of the evidence.
Who is correct?
4. An informant bought drugs from Dorian. The police obtained a search warrant
to search Dorian’s house. But before they acted on the warrant, they sent the
informant back to try again. This time, Dorian said he did not have any drugs.
The police then acted on the warrant and searched his house. Did the police
have probable cause?
5. Shawn was caught stealing letters from mailboxes. After pleading guilty, he was
sentenced to two months in prison and three years supervised release. One of the
supervised release conditions required him to stand outside a post office for eight
hours wearing a signboard stating, “I stole mail. This is my punishment.” He
appealed this requirement on the grounds that it constituted cruel and unusual
punishment. Do you agree?
DISCUSSION QUESTIONS
1. Under British law, a police officer must now say the
following to a suspect placed under arrest: “You do
not have to say anything. But if you do not mention
now something which you later use in your defense,
the court may decide that your failure to mention it
now strengthens the case against you. A record will
be made of anything you say and it may be given in
evidence if you are brought to trial.” What is the
goal of this British law? What does a police officer in
the United States have to say, and what difference
does it make at the time of an arrest? Which
approach is better?
2. Ethics You are a prosecutor who thinks it is
possible that Naonka, in her role as CEO of a
brokerage firm, has stolen money from her
customers, many of whom are not well off. If you
charge her and her company with RICO violations,
you know that she is likely to plea bargain because
otherwise her assets and those of the company may
be frozen by the court. As part of the plea bargain,
you might be able to get her to disclose evidence
about other people who might have taken part in
this criminal activity. But you do not have any hard
evidence at this point. Would such an indictment
be ethical? Do the ends justify the means? Is it
worth it to harm Naonka for the chance of
protecting thousands of innocent investors?
3. Van is brought to the police station for questioning
about a shooting at a mall. The police read him his
Miranda rights. For the rest of the three-hour
interrogation, he remains silent except for a few
one-word responses. Has he waived his right to
remain silent? Can those few words be used
against him in court?
188 U N I T 1 The Legal Environment
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4. Police arrested Hank on a warrant issued in a
neighboring county. When they searched him, the
police found drugs and a gun. Only later did the
police discover that when they had used the
warrant, it was not valid because it had been
recalled months earlier. The notice of recall had
not been entered into the database. Should the
evidence of drugs and a gun be suppressed under
the exclusionary rule?
5. Andy was arrested for driving under the influence
of alcohol (DUI). He had already been convicted
of another driving offense. The court in the first
offense was notified of this later DUI charge and
took that information into consideration when
determining Andy’s sentence. Did the state
violate Andy’s protection against double jeopardy
when it subsequently tried and convicted him for
the DUI offense?
CHAPTER 7 Crime 189
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CHAPTER8
INTERNATIONAL
LAW
The month after Anfernee graduates from
business school, he opens a clothing store. Sales
are brisk, but Anfernee is making little profit
because his American-made clothes are
expensive. Then an Asian company offers to
sell him identical merchandise for 45 percent
less than the American suppliers charge.
Anfernee is elated, but quickly begins to
wonder: Why is the new price so low? The sales
representative expects Anfernee to sell no clothes except his. Is that legal? He also requests
a $50,000 cash “commission” to smooth the export process in his country. That sounds
suspicious, too. The questions multiply. Will the
contract be written in English or a foreign language?
Must Anfernee pay in dollars or some other currency?
The foreign company wants a letter of credit. What does
that mean? What law will govern the agreement? If the
clothes are defective, how will disputes be resolved—
and where?
Transnational business grows with breathtaking
speed. The United States now exports more than
$1 trillion worth of goods and services. Leading exports include industrial machinery,
computers, aircraft, agricultural products, electronic equipment, and chemicals. Anfernee
should put this lesson under his cap: The world is now one vast economy, and deals can
cross borders quickly.
The world is now one
vast economy, and deals
can cross borders quickly.
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8-1 TRADE REGULATION: THE
BIG PICTURE
Nations regulate international trade in many ways. In this section, we look at export and
import controls that affect trade out of and into the United States. Exporting is shipping
goods or services out of a country. The United States, with its huge farms, is the world’s
largest exporter of agricultural products. Importing is shipping goods and services into a
country. The United States suffers trade deficits every year because the value of its imports
exceeds that of its exports, as the following table demonstrates.
Rank Country
Exports (in
billions of
U.S. dollars)
Imports (in
billions of
U.S. dollars)
Total, All Countries 1,278 1,912
1 Canada 249 277
2 China 92 365
3 Mexico 163 230
8-1a Export Controls
You and a friend open an electronics business, intending to purchase goods in this country
for sale abroad. A representative of Interlex stops in to see you. Interlex is a Latin American
electronics company, and the firm wants you to help it acquire a certain kind of infrared
dome, that helps helicopters identify nearby aircraft. You find a Pennsylvania company that
manufactures the domes, and you realize that you can buy and sell them to Interlex for a
handsome profit. Any reason not to? As a matter of fact, there is.
All nations limit what may be exported. In the United States, several statutes do this.
The Export Administration Act of 19851 is one. This statute balances the need for free
trade, which is essential in a capitalist society, with important requirements of national
security. The statute permits the federal government to restrict exports if they endanger
national security, harm foreign policy goals, or drain scarce materials.
The Secretary of Commerce makes a Controlled Commodities List of those items that
meet any of these criteria. No one may export any commodity on the list without a license.
A second major limitation comes from the Arms Export Control Act.2 This statute
permits the President to create a second list of controlled goods, all related to military
weaponry. Again, no person may export any listed item without a license.
The AECA will prohibit you from exporting the infrared domes. They are used in the
guidance system of one of the most sophisticated weapons in the American defense arsenal.
Foreign governments have attempted to obtain the equipment through official channels,
but the federal government has placed the domes on the list of restricted military items.
When one U.S. citizen sent such goods overseas, he was convicted and imprisoned.3
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150 U.S.C. §2402 (1994).
222 U.S.C. §2778 (1994).
3United States v. Tsai, 954 F.2d 155, 1992 U.S. App. LEXIS 601 (3d Cir. 1992).
Exporting
Shipping goods or services out
of a country.
Importing
Shipping goods or services into
a country.
CHAPTER 8 International Law 191
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You Be the Judge
Facts: Isotoner imports
gloves for sale in the Uni-
ted States. The United
States imposes a higher
tariff on “men’s” leather
gloves than it does on
gloves manufactured “for
other persons.” Isotoner argued that this difference violated
the Constitution’s Equal Protection Clause and amounted
to illegal gender discrimination. The lower court dismissed
the complaint, and Isotoner appealed.
Issue: Did higher tariff
rates for men’s gloves amount
to illegal gender discrimina-
tion?
Argument for Isotoner:
Because the Constitution
requires equal protection
under the law, the government must treat people the same.
In this instance, the government treats men worse than
women—with the result that men will have to pay more for
gloves. This is unacceptable. Surely this court would not
TOTES-ISOTONER CO. V.
UNITED STATES
594 F.3d 1346
United States Court of Appeals for the Federal Circuit, 2010
8-1b Import Controls
TARIFFS
Tariffs are the most widespread method of limiting what may be imported into a nation. A
tariff is a tax imposed on goods when they enter a country. Tariffs are also called duties.
Nations use tariffs primarily to protect their domestic industries. Because the company
importing the goods must pay this duty, the importer’s costs increase, making the merchan-
dise more expensive for consumers. This renders domestic products more attractive. High
tariffs unquestionably help local industry, but they may harm local buyers. Consumers often
benefit from zero tariffs because the unfettered competition drives down prices.
Tariffs change frequently and vary widely from one country to another. For manufac-
tured goods, the United States imposes an average tariff of less than 4 percent, about the
same as that in the European Union. However, some major trading partners around the
world set tariffs of 10 percent to 30 percent for identical items, with those duties generally
being highest in developing countries. Foodstuffs show even greater diversity. For agricul-
tural products, average tariffs are about 25 percent in North America, but over 100 percent in
South Asia. As we will see later in the chapter, regional trade treaties have changed the tariff
landscape. The majority of all U.S. products entering Mexico are duty free. Almost all trade
between Canada and the United States is done with zero tariffs, which is partly why the two
nations do more bilateral commerce than any others in the world.
Classification The U.S. Customs Service4 imposes tariffs at the point of entry into the
United States. A customs official inspects the merchandise as it arrives and classifies it, in
other words, decides precisely what the goods are. This decision is critical because tariffs
can vary greatly depending on the classification. Disputes at this stage typically involve an
importer claiming that the Customs Service has imposed the wrong classification. Companies
will often go to great lengths to convince a court to lower tariffs on their products.
In the following case, Isotoner claimed that a tariff violated the Constitution. Did the
company make a sensible argument? You be the judge.
4The Customs Service is part of the United States Customs and Border Protection, which is itself a
division of the Department of Homeland Security.
Tariff
A tax imposed on goods when
they enter a country.
192 U N I T 1 The Legal Environment
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Valuation After classifying the imported goods, customs officials impose the appropriate
duty ad valorem, meaning “according to the value of the goods.” In other words, the service
must determine the value of the merchandise before it can tax a percentage of that value.
This step can be equally contentious, since goods will have different prices at each stage of
manufacturing and delivery. The question is supposed to be settled by the transaction value
of the goods, meaning the price actually paid for the merchandise when sold for export to
the United States (plus shipping and other minor costs). But there is often room for debate,
so importers and their agents try to negotiate the most favorable valuation.
DUTIES FOR DUMPING AND SUBSIDIZING
Dumping means selling merchandise at one price in the domestic market and at a cheaper,
unfair price in an international market. Suppose a Singapore company, CelMaker, makes
cellular telephones for $20 per unit and sells them in the United States for $12 each, vastly
undercutting domestic American competitors. CelMaker may be willing to suffer short-term
losses in order to bankrupt competitors. Once it has gained control of that market, it will
raise its prices, more than compensating for its initial losses. And CelMaker may get help
from its home government. Suppose the Singapore government prohibits foreign cellular
phones from entering Singapore. CelMaker may sell its phones for $75 at home, earning
such high profits that it can afford the temporary losses in America.
In the United States, the Commerce Department investigates suspected dumping. If
the department concludes that the foreign company is selling items at less than fair value,
and that this harms an American industry, it will impose a dumping duty that is sufficiently
high to put the foreign goods back on fair footing with domestic products.
Subsidized goods are also unfair. Suppose the Singapore government permits CelMaker
to pay no taxes for 10 years. This enormous benefit will enable the company to produce
cheap phones and undersell competitors. Again, the United States imposes a tariff on
subsidized goods, called countervailing duties. If CelMaker sells phones for $15 that would
cost an unsubsidized competitor $21 to make, it will pay a $6 countervailing duty on every
phone entering the United States.
8-1c Treaties
Recall from Chapter 1 that the President makes treaties with foreign nations. To take effect,
treaties must then be approved by at least two-thirds of the United States Senate. This
section will examine three significant trade agreements.
GENERAL AGREEMENT ON TARIFFS AND TRADE (GATT)
What is GATT? The greatest boon to American commerce in a century—or perhaps it is the
worst assault on the American economy in 200 years. It depends on whom you ask. Let’s
start where everyone agrees.
GATT is the General Agreement on Tariffs and Trade. This massive international
treaty has been negotiated on and off since the 1940s as nations have sought to eliminate
allow a special tax on yarmulkes, or higher tariffs linked to
race. Distinctions that disfavor an entire group of people
cannot stand.
Argument for the United States: To be in violation of
the Equal Protection Clause, the government must intend
to discriminate. That is not the case here. Tariff rates
are set for a variety of reasons. Men’s and women’s
gloves may be made by different companies, in different
countries, with different impacts on American industry.
Surely the government has the discretion to set different
tariff rates for gloves or any other kind of imported
goods.
Ad valorem
Customs officials impose duties
“according to the value of the
goods.”
Dumping
Selling merchandise at one
price in the domestic market
and at a cheaper, unfair price in
an international market.
Subsidized goods
Goods that benefit from
government financial
assistance, which artificially
lower their price.
GATT
The General Agreement on
Tariffs and Trade.
Countervailing duties
Duties imposed on subsidized
imports.
CHAPTER 8 International Law 193
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trade barriers and bolster commerce. GATT has already had a considerable effect. In 1947,
the worldwide average tariff on industrial goods was about 40 percent. Now it is about
4 percent. The world’s economies have exploded over the past six decades. Leading
supporters of GATT suggest that its lower tariffs vastly increase world trade. The United
States is one of the biggest beneficiaries because for decades this country has imposed lower
duties than most other nations. A typical American family’s annual income has increased
due to the more vigorous domestic economy, and at the same time, many goods are less
expensive because they enter with low duties.
But opponents claim that the United States now competes against nations with unlim-
ited pools of exploited labor. These countries dominate labor-intensive industries such as
textiles, clothing, and manufacturing, and are steadily taking jobs from millions of American
workers. Because domestic job losses come in low-end employment, those put out of work
are precisely those least able to find a new job.
GATT created theWorld Trade Organization (WTO) to stimulate international commerce
and resolve trade disputes. TheWTO is empowered to hear arguments from any signatory nation
about tariff violations or nontariff barriers. This international “court”may order compliance from
any nation violating GATT and may penalize countries by imposing trade sanctions.
Here is how the WTO decides a trade dispute. Suppose that the United States believes
that Brazil is unfairly restricting trade. The United States uses the WTO offices to request a
consultation with Brazil’s trade representative. In the majority of cases, these discussions lead
to a satisfactory settlement. If the consultation does not resolve the problem, the United States
asks the WTO’s Dispute Settlement Body (DSB) to form a panel, which consists of three
nations uninvolved in the dispute. After the panel hears testimony and arguments from both
countries, it releases its report. The DSB generally approves the report, unless either nation
appeals. If there is an appeal, the WTO Appellate Body hears the dispute and generally makes
the final decision, subject to approval by the entire WTO. No single nation has the power to
block final decisions. If a country refuses to comply with the WTO’s ruling, affected nations
may retaliate by imposing punitive tariffs. The following case forced the WTO to weigh the
merits of two important, competing goals: environmental protection and trade growth.
UNITED STATES—IMPORT PROHIBITION OF CERTAIN
SHRIMP AND SHRIMP PRODUCTS
AB-1998-4
WTO Appellate Body, 1998
C A S E S U M M A R Y
Facts: Sea turtles are migratory animals that live
throughout the world. The United States recognizes the
animals as an endangered species. Studies showed that
the greatest threat to the turtles, around the world, came
from shrimp fishermen inadvertently catching the animals
in their nets. The U.S. government responded by requir-
ing any importers to certify that shrimp entering the
country had been caught using Turtle Excluder Devices
(TEDs), which keep the animals out of the nets.
India, Pakistan, Malaysia, and Thailand filed com-
plaints with the WTO, claiming that the United States
had no right to impose its environmental concerns on
world trade. The United States argued that Article XX
of the WTO Agreement permitted trade restrictions based
on environmental concerns. Article XX states in part:
Nothing in this Agreement shall be construed to prevent the
adoption or enforcement by any Member of measures: …
(b) necessary to protect human, animal or plant life
or health; … (g) relating to the conservation of exhaus-
tible natural resources if such measures are made
effective in conjunction with restrictions on domestic
production or consumption;
The Dispute Settlement Body declared that the United
States had no right to impose its policies on shrimp importers,
and the United States appealed.
World Trade Organization
(WTO)
Organization created by GATT
to stimulate international
commerce and resolve trade
disputes.
194 U N I T 1 The Legal Environment
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Environmental groups attacked the ruling, declaring that the WTO paid lip service to
the environment but ensured further killing of an important endangered species. Trade
supporters applauded it. In addition to the trade versus environment tension, there is a
second conflict: rich versus poor. Critics of the shrimp regulations claim that it is unseemly
for a wealthy nation to punish subsistence fishermen because of environmental concerns.
Their opponents argue that we all share this planet, and long-term growth for each of us
depends upon living in harmony with limited resources and fragile ecosystems. Which of
the competing goals is more important to you?
Ethics Child labor is a wrenching issue. The practice exists to some degree
in all countries and is common throughout the developing world. The
International Labor Organization estimates that more than 250 million children under the
age of 14 work full or part time. As the world generally becomes more prosperous, this
ugly problem has actually increased. Children in developing countries typically work in
agriculture and domestic work, but many toil in mines and factories.
The rug industry illustrates the international nature of this tragedy. In the 1970s, the
Shah of Iran banned child labor in rug factories, but many manufacturers simply packed up
and moved to southern Asia. Today, tens of millions of children, some as young as four, toil
in rug workrooms, seven days a week, 12 hours a day. Child labor raises compelling moral
questions—and economic ones as well. In 1997, Congress passed a statute prohibiting the
import of goods created by forced or indentured child labor. The first suit under the new law
targeted the carpet factories of southern Asia and sought an outright ban on most rugs
from that area. Is this statute humane legislation or cultural imperialism dressed as a
nontariff barrier? Should the voters of this country or the WTO decide the issue? In
answering such difficult questions, we must bear in mind that child labor is truly universal.
The United Farm Workers union estimates that 800,000 underage children help their
migrant parents harvest U.S. crops.
Our response to such a troubling moral issue need not take the form of a statute or
lawsuit. Duke University is one of the most popular names in sports apparel, and the school
sells millions of dollars worth of T-shirts, sweatshirts, jackets, caps, and other sportswear
bearing its logo. In response to the troubling issue of child labor, Duke adopted a code of
conduct that prohibits its manufacturers from using forced or child labor and requires all of
the firms to pay a minimum wage, permit union organizing, and maintain a safe workplace.
The university plans to monitor the companies producing its apparel and terminate the
contract for any firm that violates its rules.
Issue: Did the WTO Agreement permit the United States to
impose environmental restrictions on shrimp importers?
Decision: No. The restrictions discriminated against
other WTO Members.
Reasoning: To protect sea turtles, the United States
required that its domestic, commercial shrimp trawl ves-
sels use TEDs. Protecting the environment is a legitimate
and noble objective. The United States, like all other
Members of the WTO, has the right to adopt strict stan-
dards for its citizens.
However, the United States does not have the right
to arbitrarily impose its own standards on other WTO
Member nations. The United States was requiring for-
eign countries to adopt the same regulatory program for
their shrimp trawl vessels as it had for its own without
taking into consideration the different conditions that
may occur in other countries.
If the United States’ primary objective was to save sea
turtles, it should have persuaded other Members to sign
an environmental treaty for their protection. Instead, it
tried to achieve this goal in a backdoor manner.
Although the United States’ policy served a legiti-
mate environmental objective, its application constituted
arbitrary and unjustifiable discrimination between Mem-
bers of the WTO.
CHAPTER 8 International Law 195
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REGIONAL AGREEMENTS: NAFTA AND THE EUROPEAN UNION
In 1993, the United States, Canada, and Mexico signed the North American Free Trade
Agreement (NAFTA). The principal goal was to eliminate almost all trade barriers between
the three nations. Like GATT, this treaty has been controversial. Unquestionably, trade
between the three nations has increased enormously. Mexico now exports more goods to
the United States than do Germany, Britain, and Korea combined. Opponents of the treaty
argue that NAFTA costs the United States jobs and lowers the living standards of American
workers by forcing them to compete with low-paid labor. For example, Swingline Staplers
closed a factory in Queens, New York, after 75 years of operation and moved to Mexico.
Instead of paying its American workers $11.58 per hour, Swingline decided to pay Mexican
workers 50 cents an hour to do the same job.
Proponents contend that although some jobs are lost, many others are gained, especially
in fields with a bright future, such as high technology. They claim that as new jobs
invigorate the Mexican economy, consumers there will be able to afford American goods
for the first time, providing an enormous new market.
EXAM Strategy
Question: California producers of sea salt protest to the American government that
they cannot compete with the same product imported from China. How do the
California producers want the United States government to respond? May the U.S.
government legally oblige?
Strategy: Domestic producers who cannot compete with foreign competition
typically ask their government to impose higher tariffs on the imported goods.
However, the whole point of GATT, and the WTO, is to avoid trade wars. There are
two instances in which the U.S. government is free to levy increased duties on the
Chinese goods. What are they?
Result: When a company dumps goods, it sells them overseas at an artificially low
price, generally to destroy competition and gain a foothold. That is illegal, and the
domestic (U.S.) government may impose dumping duties to protect local producers.
Subsidized goods—those supported by the foreign company’s government—are also
illegal. If the United States government can demonstrate illegal subsidies, it will
impose countervailing duties designed to give all producers an equal chance.
Twenty-eight countries belong to the European Union (EU), including Great Britain,
Germany, France, Italy, and Spain, as well as Latvia and Slovakia.
The EU is one of the world’s most powerful associations, with a population of nearly
half a billion people. Its sophisticated legal system sets EU-wide standards for tariffs,
dumping, subsidies, antitrust, transportation, and many other issues. The first goals of the
EU were to eliminate trade barriers between member nations, establish common tariffs
with respect to external countries, permit the free movement of citizens across its borders,
and coordinate its agricultural and fishing policies for the collective good. The EU has
largely achieved these goals. Seventeen of the EU countries have adopted a common
currency, the euro. Participating countries comprise what is known as the eurozone.
Following the recent global financial crisis, the future of the euro was called into question,
as the the debts of the weaker member nations burdened the eurozone’s financial
stability.
North American Free
Trade Agreement (NAFTA)
A treaty eliminating almost all
trade barriers, tariff and
nontariff, between the United
States, Canada, and Mexico.
Euro
The common currency of most
EU countries.
196 U N I T 1 The Legal Environment
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8-2 INTERNATIONAL SALES AGREEMENTS
Overseas markets offer tremendous growth potential. Foreign customers have an astonishing
desire for some kinds of American goods and services.
Cowboy boots are hot in France. Imagine that you own and operate Big Heel, Inc., a
small Texas company that makes superb boots. You realize that France could be a bonanza.
What should you consider as you proceed? Several things.
8-2a The Sales Contract
Le Pied d’Or, a new, fast-growing French chain of shoe stores, is interested in buying
10,000 pairs of your boots at about $300 per pair. You are wise enough to know that you
must have a written contract—$3 million is a lot of money for Big Heel.
WHAT LAW GOVERNS?
Potentially, three conflicting laws could govern your boot contract: Texas law, French law,
and an international treaty. Each is different, and it is therefore essential to negotiate which
law will control.
Texas lawyers are familiar with the Texas law and will generally prefer that it govern.
French law is obviously different, and French lawyers and business executives are naturally
partial to it. How to compromise? Perhaps by using a neutral law.
TheUnited Nations Convention on Contracts for the International Sale of Goods (CISG)
is the result of 50 years of work by various international groups, all seeking to create a uniform,
international law on this important subject. The United States and most of its principal trading
partners have adopted this important treaty.
The CISG applies automatically to any contract for the sale of goods between two
parties from different countries if each operates in a country that is a signatory. (Goods are
moveable objects like boots.) France and the United States have both signed. Thus, the
CISG automatically applies to the Big Heel–Pied d’Or deal unless the parties specifically opt
out. If the parties want to be governed by other law, their contract must state very clearly
that they exclude the CISG and elect, for example, French law.
CHOICE OF FORUM
The parties must decide not only what law governs, but also where disagreements will be
resolved. This can be a significant part of a contract, because the French and American legal
systems are dramatically different. In a French civil lawsuit, generally neither side is entitled
to depose the other or to obtain interrogatories or even documents. This is in sharp contrast
to the American system, where such discovery methods dominate litigation. American
lawyers, accustomed to discovery to prepare a case and advance settlement talks, are
sometimes frankly unnerved by the French system. Similarly, French lawyers are dismayed
at the idea of spending two years taking depositions, exchanging paper, and arguing
motions, all at great expense. At trial, the contrasts grow. In a French civil trial, there is
generally no right to a jury. The rules of evidence are more flexible (and unpredictable),
neither side employs its own expert witnesses, and the parties themselves never appear as
witnesses.
CHOICE OF LANGUAGE AND CURRENCY
The parties must select a language for the contract and a currency for payment. Language
counts because legal terms seldom translate literally. Currency is vital because the exchange
rate may alter between the signing and payment. Suppose the Argentine peso falls
Signatory
A nation that signs a treaty.
CISG
United Nations treaty governing
the international sale of goods.
CHAPTER 8 International Law 197
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30 percent against the dollar in one week. An Argentine company that contracted on Monday
to pay $1 million for U.S. aircraft engines will suddenly have to pay 30 percent more in pesos
to meet its contractual obligations. To avoid such calamities, companies engaged in international
commerce often purchase from currency dealers a guarantee to obtain the needed currency
at a future date for a guaranteed price. Assuming that Big Heel insists on being paid in U.S.
dollars, Pied d’Or could obtain a quote from a currency dealer as to the present cost
of obtaining $3 million at the time the boots are to be delivered. Pied d’Or might pay a
5 percent premium for this guarantee, but it will have insured itself against disastrous
currency swings.
Choices Made The parties agree that the contract price will be paid in U.S. dollars.
Pied d’Or is unfamiliar with U.S. law and absolutely refuses to make a deal unless either
French law or the CISG governs. Your lawyer, Susan Fisher, recommends accepting the
CISG, provided that the contract is written in English and that any disputes will be
resolved in Texas courts. Pied d’Or balks at this, but Fisher presses hard, and ultimately
those are the terms agreed upon. Fisher is delighted with the arrangement, pointing out
that the CISG provisions can all be taken into account as the contract is written, and that
by using Texas courts to settle any dispute, Big Heel has an advantage in terms of
familiarity and location.
LETTER OF CREDIT
Because Pied d’Or is new and fast growing, you are not sure it will be able to foot the
bill. Pied d’Or provides a letter of reference from its bank, La Banque Bouffon, but this
is a small bank and it is unfamiliar to you. You need greater assurance of payment, and
your lawyer recommends that payment be made by letter of credit. Here is how the
letter will work.
Big Heel demands that the contract include a provision requiring payment by con-
firmed, irrevocable letter of credit. Le Pied d’Or agrees. The French company now contacts
its bank, La Banque Bouffon, and instructs Bouffon to issue a letter of credit to Big Heel.
The letter of credit is a promise by the bank itself to pay Big Heel if Big Heel presents
certain documents. Banque Bouffon, of course, expects to be repaid by Pied d’Or. The
bank is in a good position to assess Pied d’Or’s creditworthiness since it is local and can
do any investigating it wants before issuing the credit. It may also insist that Pied d’Or
give Bouffon a mortgage on property, or that Pied d’Or deposit money in a separate
Bouffon account. Pied d’Or is the account party on the letter of credit, and Big Heel is the
beneficiary.
But at Big Heel, you are still not entirely satisfied. You feel that a bank is unlikely to
default on its promises, but still, you do not know anything about Bouffon. That is why you
have required a confirmed letter of credit. Bouffon will forward its letter of credit to Big
Heel’s own bank, Wells Fargo. Wells Fargo examines the letter and then confirms the letter.
This is Wells Fargo’s own legal guarantee that it will pay Big Heel. Wells Fargo will do this
only if it knows, through international banking contacts, that Bouffon is a sound and
trustworthy bank. The risk has now been spread to two banks, and at Big Heel, you are
finally confident of payment.
You get busy, make excellent boots, and pack them. When they are ready, you truck
them to Galveston, where they are taken alongside a ship, Le Fond de la Mer. Your agent
presents the goods to the ship’s officials, along with customs documents that describe the
goods. Le Fond de la Mer’s officer in turn issues your agent a negotiable bill of lading. This
document describes exactly the goods received—their quantity, color, quality, and anything
else important.
You now take the negotiable bill of lading to Wells Fargo. You also present to Wells Fargo
a draft, which is simply a formal order to Wells Fargo to pay, based on the letter of credit.
Letter of credit
A commercial device used to
guarantee payment in
international trade.
Beneficiary
Party that will be paid by the
issuing bank pursuant to a
letter of credit.
Negotiable bill of lading
A document of title that
describes the goods received
by the common carrier.
Draft
A formal order to pay.
Account party
Party that applies for the letter
of credit from its bank.
198 U N I T 1 The Legal Environment
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Wells Fargo will look closely at the bill of lading, which must specify precisely the goods
described in the letter of credit. Why so cautious? Because the bank is dealing only in paper.
It never sees the boots. Wells Fargo is exchanging $3 million of its own money based on
instructions in the letter of credit. The bank should pay only if the bill of lading indicates that
Le Fond de la Mer received exactly what is described in the letter of credit. Wells Fargo will
decide whether the bill of lading is conforming or nonconforming. If the terms of both docu-
ments are identical, the bill of lading is conforming and Wells Fargo must pay. If the terms
vary, the bill of lading is nonconforming and Wells Fargo will deny payment. Thus, if the bill
of lading indicated 9,000 pairs of boots and 1,000 pairs of sneakers, it is nonconforming and
Big Heel would get no money.
Wells Fargo concludes that the documents are conforming, so it issues a check to Big
Heel for $3 million. In return, you endorse the bill of lading and other documents over to
Wells Fargo, which endorses the same documents and sends them to Banque Bouffon.
Bouffon makes the same minute inspection and then writes a check to Wells Fargo. Bouffon
then demands payment from Le Pied d’Or. Pied d’Or pays its bank, receiving in exchange
the bill of lading and customs documents. Note that payment in all stages is now complete,
though the boots are still rolling on the high seas. Finally, when the boots arrive in Le
Havre, Pied d’Or trucks roll up to the wharf and, using the bill of lading and customs
documents, collect the boots. See Exhibit 8.1.
Le Fond de la Mer
Big
Heel
(Beneficiary)
Wells
Fargo
Le Pied D‘Or
(Account Party)
Banque
Bouffon
Endorses
N.B.O.L.
to
Wells Fargo
7Issues
check to
Big Heel Confirms
L.O.C.
Delivers
goods
Issues
N.B.O.L.
Endorses
N.B.O.L.
to Bouffon
Issues
L.O.C.
13
Issues
check to
Wells Fargo
Endorses
N.B.O.L.
to Le Pied
D‘Or and
demands
payment
Pays
Bouffon
and
receives
N.B.O.L.
Instructs
Bouffon
to issue
L.O.C.
Ships
goods
Exchanges
N.B.O.L.
for goods
3
12
10
6
8 9
1 11
2
4
5
©
C
en
g
ag
e
Le
ar
n
in
g
EXHIB IT 8 .1 A Typical International Letter of Credit Transaction for the Sale of Goods
CHAPTER 8 International Law 199
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EXAM Strategy
Question: In an international contract for the sale of goods, Seller is to be paid by a
confirmed irrevocable letter of credit. Buyer claims that the goods are defective and
threatens to sue. If the parties are going to end up in court anyway, why bother with a
letter of credit?
Strategy: A confirmed letter of credit is unique because the seller is assured of
payment as soon as it presents a proper bill of lading to the appropriate local bank—
regardless of the quality of the goods. Seller would much rather defend this lawsuit
against Buyer than sue for its money in foreign courts.
Result: There may be a lawsuit, but Seller is not worried. It is Buyer who must sue,
probably in Seller’s home country. Buyer now risks substantial time and cash for an
uncertain outcome. When the parties discuss a settlement, as surely they will, Seller is
holding a big advantage—the cash.
CENTRIFUGAL CASTING MACHINE CO., INC. V.
AMERICAN BANK & TRUST CO.
966 F.2d 1348, 1992 U.S. App. LEXIS 13089
United States Court of Appeals for the Tenth Circuit, 1992
C A S E S U M M A R Y
Facts: Centrifugal Casting Machine Co. (CCM) entered
into a contract with the State Machinery Trading Co.
(SMTC), an agency of the Iraqi government. CCM agreed
to manufacture cast-iron pipe plant equipment for a total
price of $27 million. The contract specified payment of
the full amount by confirmed irrevocable letter of credit.
The Central Bank of Iraq then issued the letter, on behalf
of SMTC (the “account party”) to be paid to CCM (the
“beneficiary”). The Banca Nazionale del Lavoro (BNL)
confirmed the letter.
Following Iraq’s invasion of Kuwait on August 2, 1990,
President George H. W. Bush issued two executive orders
blocking the transfer of property in the United States in
which Iraq held any interest. In other words, no one could
use, buy, or sell any Iraqi property or cash. When CCM
attempted to draw upon the letter of credit, the United
States government intervened. The government claimed
that like all Iraqi money in the United States, this money
was frozen by the executive order. The United States
District Court rejected the government’s claim, and the
government appealed.
Issue: Was CCM entitled to be paid pursuant to the letter of
credit?
Decision: Yes, CCM was entitled to payment. Affirmed.
Reasoning: The United States claimed that it froze
Iraqi assets to punish international aggression. That is a
legitimate foreign policy argument. However, no court has
the power to rewrite basic principles of international trade.
A letter of credit has unique value for two reasons.
First, the bank that issues the letter is substituting its
credit for that of the buyer. Because the bank is promising
to pay with its own funds, the seller is confident of
receiving its money.
Second, the bank’s obligation to pay on the letter of
credit is entirely separate from the underlying bargain
between buyer and seller. The bank must pay even if
the seller has breached the contract or the buyer has
gone bankrupt. The money in this case came from the
bank that issued the letter; the government may not
seize it. Any other ruling would undermine all letters of
credit.
200 U N I T 1 The Legal Environment
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8-3 INTERNATIONAL TRADE ISSUES
Assume that Ambux is an American communications corporation that decides to invest in a
growing overseas market. The president of Ambux is particularly interested in building
telephone systems in the former republics of the Soviet Union, reasoning that these
economies offer great opportunity for growth. She hires a consultant to advise her on the
most important issues concerning possible investment in Uzbekistan and other former
Soviet republics. The consultant presents several related issues:
• Repatriation of profits
• Expropriation
• Sovereign immunity
• Act of State doctrine
• The Foreign Corrupt Practices Act (FCPA)
• Extraterritoriality
8-3a Repatriation of Profits
Repatriation of profits occurs when an investing company pulls its earnings out of a foreign
country and takes them back home. If Ambux builds a telephone system in Uzbekistan,
it will plan to make money and then repatriate the profit to its headquarters in the United
States. But Ambux must not assume an automatic right to do so. Many countries impose
a much higher tax on repatriated profits than on normal income in order to keep the
money in domestic commerce. Others bar repatriation altogether. Developing countries in
particular want the money to “stay home.” Thus, before
Ambux invests anywhere, it must ensure that it can repatri-
ate profits or live with any limitations the foreign country
might impose.
Fortunately, investing in Uzbekistan is relatively secure.
Uzbekistan and the United States have signed a trade treaty
guaranteeing unlimited repatriation for American investors.
This treaty should suffice. But Ambux might still feel
cautious. Uzbekistan is a relatively new nation, and the
mechanisms for actually getting the money out of Uzbekistan
banks may be slow or faulty. The solution is to get a written
agreement from the Minister of Commerce explicitly
permitting Ambux to repatriate all profits and providing a
clear mechanism to do it through the local banks.
8-3b Expropriation
Many nations, both developed and developing, nationalize property, meaning that they
declare the national government to be the new owner. For example, during the 1940s and
1950s, Great Britain nationalized its coal, steel, and other heavy industries. The state
assumed ownership and paid compensation to the previous owners. In the United States,
nationalization is rare, but local governments often take land by eminent domain, to be used
for roads or other public works. As we have seen, the United States Constitution requires
that the owners be fairly compensated.
When a government takes property owned by foreign investors, it is called expropriation.
The U.S. government historically has acknowledged that the expropriation of American
Many countries impose
a much higher tax on
normal income in order
to keep the money in
domestic commerce.
Nationalize
Action in which a government
assumes ownership of
property.
Expropriation
The government’s seizure of
property owned by foreign
investors.
Repatriation of profits
The act of bringing profits
earned in a foreign country
back to a company’s home
country.
CHAPTER 8 International Law 201
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interests is legal, provided the host government pays the owners promptly and fully, in dollars.
But if compensation is inadequate or long delayed, or made in a local currency that is hard to
exchange, the taking is a confiscation.
The courts of almost all nations agree that confiscation is illegal. But it can be difficult or
impossible to prevent because courts of a host country may be partial to their own government.
SOVEREIGN IMMUNITY
Sovereign immunity holds that the courts of one nation lack the jurisdiction (power) to hear
suits against foreign governments. Most nations respect this principle. In the United States, the
Foreign Sovereign Immunities Act (FSIA) states that American courts generally cannot entertain
suits against foreign governments.5 This is a difficult hurdle for a company to overcome when
seeking compensation for foreign expropriation, but there are three possible exceptions.
Waiver A lawsuit is permitted against a foreign country that waives its immunity, that is,
voluntarily gives up this protection. Suppose the Czech government wishes to buy fighter
planes from an American manufacturer. The manufacturer might insist on a waiver in the
sales contract, and the Czech Republic might be willing to grant one to get the weapons it
desires. If the planes land safely but the checks bounce, the manufacturer may sue.
Commercial Activity A plaintiff in the United States can sue a foreign country
engaged in commercial, but not political, activity. Suppose the government of Iceland hires
an American ecology-consulting firm to help its fishermen replenish depleted fishing grounds.
Since fishing is a for-profit activity, the contract is commercial, and if Iceland refuses to pay, the
company may sue in American courts.
Violation of International Law A plaintiff in this country may sue a foreign govern-
ment that has confiscated property in violation of international law, provided that the
property either ends up in the United States or is involved in commercial activity that
affects someone in the United States. Suppose a foreign government confiscates a visiting
American ship, with no claim of right, and begins to use it for shipping goods for profit.
Later, the ship carries some American produce. The taking was illegal, and it now affects
American commerce. The original owner may sue.
INVESTMENT INSURANCE
Companies eager to do business abroad but anxious about expropriation should consider
publicly funded insurance. In 1971, Congress established the Overseas Private Investment
Corporation (OPIC) to insure U.S. investors against overseas losses due to political violence
and expropriation. OPIC insurance is available to investors at relatively low rates for invest-
ment in almost any country.
Should Ambux investigate OPIC insurance before investing in Uzbekistan? Absolutely.
While the Uzbekistan government has the best of intentions with respect to foreign
investment, the nation is young and the government has no track record. A government
can change course quickly. Why take unnecessary risks?
8-3c Foreign Corrupt Practices Act
The Foreign Corrupt Practices Act (FCPA)6 makes it illegal for an American businessperson
to give “anything of value” to any foreign official in order to influence an official decision.
It is sad but true that in many countries, bribery is routine and widely accepted. When
Congress investigated foreign bribes to see how common they were, more than 450 U.S.
companies admitted paying hundreds of millions of dollars in bribes to foreign officials.
Confiscation
The government takes property
without fair payment.
528 U.S.C. Sec. §330, §332(a), §39(f) and §§60–6.
615 U.S.C. §§78 et seq.
Foreign Sovereign
Immunities Act (FSIA)
A statute providing that
American courts generally
cannot entertain suits against
foreign governments.
Foreign Corrupt
Practices Act
A statute that illegalizes bribes
to foreign officials by U.S.
individuals or businesses.
202 U N I T 1 The Legal Environment
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Legislators concluded that such massive payments distorted competition among American
companies for foreign contracts, interfered with the free market system, and undermined
confidence everywhere in our way of doing business. In response, Congress passed the FCPA.
American executives have long complained that the FCPA puts their companies at a
competitive disadvantage. Of the more than 200 nations in the world, very few aggressively
prevent their nationals from bribing foreign officials. (In some countries, a bribe paid to a
foreign official may even be treated as a tax deduction!) Others argue that the United States
should not try to affect the way other countries do business by creating laws that apply
outside its own borders.
The FCPA has two principal requirements:
• Bribes. The statute makes it illegal for U.S. companies and citizens to bribe foreign
officials to influence a governmental decision. The statute prohibits giving anything
of value and also bars using third parties as a conduit for such payments. Interestingly,
the bribe need not be actually paid. A promise to pay bribes violates the Act. Also, the
bribe need not be successful. If an American company makes an unauthorized
payment but never gains any benefit, the company has still violated the law.
• Recordkeeping. All publicly traded companies—whether they engage in international
trade or not—must keep detailed records that prevent hiding or disguising bribes.
These records must be available for inspection by U.S. officials.
Not all payments violate the FCPA. A grease or facilitating payment is legal. Grease
payments are common in many foreign countries to obtain a permit, process governmental
papers, or obtain utility service. For example, the cost of a permit to occupy an office building
might be $100, but the government clerk suggests that you will receive the permit faster
(within this lifetime) if you pay $150, one-third of which he will pocket. Such small payments
are legal. You cannot bribe the high-level decision makers who award contracts in the first
place. But, once a contract has been secured, you may often bribe lower-level government
workers to encourage them to speed things along.
Further, a payment does not violate the FCPA if it was legal under the written laws of
the country in which it was made. Since few countries establish written codes permitting
officials to receive bribes, this defense is unlikely to help many Americans who hand out
gifts.
Punishments can be severe. A company may face large fines and the loss of profits
earned as a result of illegal bribes. In 2011, Johnson & Johnson agreed to pay $77 million to
settle an FCPA action. In addition to financial penalties, individuals who violate the FCPA
can face up to five years in prison.
The following case is a classic example of bribery. Not much loyalty within Owl
Securities. Why is that? What does it teach us?
UNITED STATES V. KING
351 F.3d 859
Eighth Circuit Court of Appeals, 2003
C A S E S U M M A R Y
Facts: Owl Securities and Investments, Ltd., hoped to
develop a large port in Limon, Costa Rica. The project
included docks, housing, recreational facilities, an airport,
and more. Richard King was one of Owl’s largest inves-
tors, and Stephen Kingsley its CEO. The government
charged King with attempting to pay a $1 million bribe
(also known as a “kiss payment” or “toll” or “closing
cost”) to senior Costa Rican officials to obtain land and
CHAPTER 8 International Law 203
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Ethics What’s wrong with bribery, anyway? Many businesspeople think it is
relatively harmless—just a cost of doing business, like New York City’s high
taxes or Germany’s high labor costs. Corruption is not a victimless crime. Poor people in
poor countries are the losers when officials are on the take; corruption means that good
projects are squeezed out by bad ones. And corruption can reduce a country’s entire
administration to a state of decay. Honest officials give up. Bribes grow ever bigger and
more ubiquitous. The trough becomes less well stocked; the snouts plunge deeper.
Worldwide about $400 billion is lost each year to corruption in government procurement.
The anticorruption czar in Mexico estimated that bribes reduce Mexico’s gross domestic
product annually by 9.5 percent. This sum is twice the country’s education budget.7
other concessions needed for the project. At trial, several
of Owl’s officers, including Kingsley, testified against
King. A jury convicted King of violating the FCPA. He
received a 30-month sentence and a fine of $60,000.
He appealed.
Issue: Did King violate the FCPA?
Decision: Yes. Taped conversations proved that King
knowingly violated the FCPA.
Reasoning: The FCPA prohibits making an offer, pay-
ment, promise to pay, or authorization of the payment of
anything of value to any foreign official for purposes of
influencing an official act or decision. There was ample
evidence to prove King’s knowledge and authorization of
the proposed payment to the Costa Rican officials.
For example, the following taped exchanges are just a
small sample of what the jury heard.
Kingsley: Yeah, what, um, what Pablo had said, was why just
pay, pay off the current politicians. Pay off the future ones.
King: That’s right. Because we’re gonna have to work with
them anyway.
Kingsley: And so what he was saying was double, you
know, give them more money. Buy the opposition. If you
buy the current party and the opposition, then it doesn’t
matter who’s in because there’s only two parties.
King: The thing that really worries me is that, uh, if the
Justice Department gets a hold of. Finds out how many
people we’ve been paying off down there. Uh, or even if
they don’t. Are we gonna have to spend the rest of our lives
paying off these petty politicians to keep them out of our
hair? I can just see us, every, every day some politician on
our doorstep down there wanting a hand out for this or that
… . Think we could pay the top people enough, that the
rest of the people won’t bother us any. That’s what I’m
hoping this million dollars does. I’m hoping it pays enough
top people …
[A later recording:]
Kingsley: Now Pablo’s continued to talk to the politicians.
They know about the toll, closing costs call it what you will.
King: Does everybody agree to what we talked about recently?
Kingsley: Yeah, a million into escrow for the toll.
King: And then we get the property … ?
Kingsley: Um hum. Yeah now let me I’ll, I’ll, I’ll come on to
that because I’ll explain how we work through that. Uh,
essentially once the politicians see the money in escrow,
they’ll move. That’s what it comes down to. Pablo’s gonna
send a list, an e-mail with a list of politicians already paid off
and the ones he’s gonna pay off.
King: Isn’t that awfully dangerous?
Based on this evidence, King’s conviction was affirmed.
7
“Who Will Listen to Mr. Clean?”The Economist, August 2, 1997, p. 52.
204 U N I T 1 The Legal Environment
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You Be the Judge
Facts: Boston Scientific
(BSC) was an American
company that manufac-
tured medical equipment.
The company had its head-
quarters in Massachusetts
but did business around
the world through foreign subsidiaries. One of the company’s
subsidiaries was Boston Scientific Argentina (BSA), and it
was there that Ruben Carnero began working. His employ-
ment contract stated he would work at BSA’s headquarters in
Buenos Aires and be paid in pesos. Argentine law was to
govern the contract. Four
years later, Carnero took
an assignment to work as
country manager for a dif-
ferent BSC subsidiary,
Boston Scientific Do Brasil
(BSB). Carnero frequently
traveled to Massachusetts to meet with company executives,
but he did most of his work in South America.
About a year later, BSB fired Carnero, and BSA
soon did the same. Carnero claimed that the companies
terminated him in retaliation for his reporting to BSC
EXAM Strategy
Question: Splash is a California corporation that develops resorts. Lawrence, a
Splash executive, is hoping to land a $700 million contract with a developing country
in Southeast Asia. He seeks your advice. “I own a beach house in Australia, worth
about $2 million. If I give it to a certain government official in the Asian country, I
know that will close the resort deal. If I don’t, someone else will, and my company
loses out. Do you think that’s wrong? Should I do it?” Please advise him.
Strategy: Lawrence has phrased his question in terms of ethics, but there is more
involved. What law governs his proposed conduct? Is Lawrence legally safe, given
that the land is foreign and the contract will be signed overseas?
Result: If Lawrence gives anything of value (such as a house) to secure a
government contract, he has violated the FCPA. It makes no difference where the
property is located or the deal signed. He could go to jail, and his company could be
harshly penalized. Ethically, his gift would exacerbate corruption in a developing
nation and mean that the agreement was determined by a bribe, not the merits of
Splash. Other companies might do a superior job employing local workers,
constructing an enduring resort, and protecting the environment, all for less money.
8-3d Extraterritoriality
TheUnited States has many statutes designed to protect employees, such as those that prohibit
discrimination on race, religion, gender, and so forth. Do these laws apply overseas? This is an
issue of extraterritoriality—the power of one nation to impose its laws in other countries.8
Many American companies do business through international subsidiaries— foreign compa-
nies that they control. The subsidiary may be incorporated in a nation that denies workers the
protection they would receive in the United States. What should happen when an employee
of a foreign subsidiary argues that his rights under an American statute have been violated?
You make the call.
8Extraterritoriality can also refer to exemption from local laws. For example, ambassadors are generally
exempt from the law of the nation in which they serve.
CARNERO V. BOSTON
SCIENTIFIC CORPORATION
433 F.3d 1
First Circuit Court of Appeals, 2006
Extraterritoriality
The power of one nation to
impose its laws in other
countries.
CHAPTER 8 International Law 205
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Chapter Conclusion
Overseas investment, like sales abroad, offers potentially great rewards but significant
pitfalls. A working knowledge of international law is essential to any entrepreneur or
executive seriously considering foreign commerce. Issues such as choice of law, repatriation
of profits, and expropriation can mean the difference between profit and loss. As the WTO
lowers barriers, international trade will only increase, and your awareness of these principles
will grow still more valuable.
executives that the Argentine and Brazilian subsidiaries
inflated sales figures and engaged in other accounting
fraud. Carnero filed suit in Massachusetts, alleging that
his firing violated an American statute, the Sarbanes-
Oxley Act of 2002 (SOX).
Congress passed that law in response to the massive
fraud cases involving Enron, Arthur Andersen, and others.
The law was passed primarily to protect investors, but
included a “whistleblower” provision. That section was
designed to guard employees who informed superiors or
investigating officials of fraud within the company. The
law allows injured employees reinstatement and back pay.
BSC argued that SOX did not apply overseas and the
District Court agreed, dismissing the case. Carnero
appealed.
Issue: Did SOX protect a whistleblower employed overseas
by a subsidiary of an American company?
Argument for Carnero: Congress passed SOX because
the American people were appalled by the massive fraud
in major corporations, and the resulting harm to employees,
investors, the community, and the economy. The whistle-
blower protection is designed to encourage honest employ-
ees to come forward and report wrongdoing—an act that no
employee wants to do, and one which has historically led to
termination. Mr. Carnero knew his report would be poorly
received, but believed he had an ethical obligation to
protect his company. For that effort, he was fired, and
now Boston Scientific attempts to avoid liability using the
technicality of corporate hierarchy.
Yes, Mr. Carnero was employed by BSB and BSA. But
both of those companies are owned and operated by Boston
Scientific. It is the larger company, with headquarters in the
United States, which calls the shots. That is why executives
in Massachusetts frequently asked Mr. Carnero to report to
them—and why he brought them his unhappy news.
A whistleblower deserves gratitude and a pay raise.
Mr. Carnero may well have saved his employer from
massive losses and public disgrace. Would Boston Scien-
tific like to wind up as Enron did—the company in bank-
ruptcy court, its executives in prison? If Boston Scientific
is too petty to acknowledge Mr. Carnero’s contribution,
the company should at least honor the purpose and intent
of SOX by protecting his job.
Argument for Boston Scientific: First, we do not
know whether there have been any accounting irregula-
rities or not. Second, the fact that Mr. Carnero is
employed by companies incorporated in Argentina and
Brazil is more than a technicality. He is asking an Amer-
ican court to go into two foreign countries—sovereign
nations with good ties to the United States—and investi-
gate accounting and employment practices of companies
incorporated and operating there. The very idea is offen-
sive. No nation can afford to treat its allies and trading
partners with such contempt.
If the United States can impose its whistleblowing
law in foreign countries, may those nations impose their
rules and values here? Suppose that a country forbids
women to do certain work. May companies in those
nations direct American subsidiaries to reject all female
job applicants? Neither the citizens nor courts of this
country would tolerate such interference for a moment.
Mr. Carnero’s idea is also impractical. How would an
American court determine why he was fired? Must the
trial judge here subpoena Brazilian witnesses and demand
documentary evidence from that country?
Finally, the SOX law does not apply overseas because
Congress never said it did. The legislators—well aware
that American corporations operate subsidiaries abroad—
made no mention of those companies when they passed
this statute.
206 U N I T 1 The Legal Environment
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EXAM REVIEW
1. EXPORT RESTRICTIONS Several statutes restrict exports from the United
States that would harm national security, foreign policy, or certain other goals. (p. 191)
2. TARIFFS A tariff is a tax imposed on goods entering a country. The Customs
Service classifies goods when they enter the United States and imposes appropriate
tariffs. (pp. 192–193)
Question: Sports Graphics, Inc. imports “Chill” brand coolers from Taiwan.
Chill coolers have an outer shell of vinyl, with handles and pockets, and an inner
layer of insulation. In one lawsuit, the issue was whether “Chill” coolers were
“luggage” or “articles used for preparing, serving, or storing food or beverages,” as
Sports Graphics claimed. Who was the other party to the dispute, why did the two
sides care about this, and what arguments did they make?
Strategy: The Customs Service (the other party) classifies goods and then
imposes an appropriate ad valorem tax. What is at stake, of course, is money. (See
the “Result” at the end of this section.)
3. DUMPED AND SUBSIDIZED IMPORTS Most countries, including the
United States, impose duties for goods that have been dumped (sold at an unfairly
low price in the international market) and for subsidized goods (those benefiting from
government financial assistance in the country of origin). (p. 193)
4. GATT The General Agreement on Tariffs and Trade (GATT) is lowering the
average duties worldwide. Proponents see it as a boon to trade; opponents see it as a
threat to workers. (pp. 193–195)
5. WTO GATT created the WTO, which resolves disputes between signatories to the
treaty. (pp. 194–195)
Question: In a recent WTO case, several nations claimed that American laws
concerning shrimp fishing were unfair and illegal. The case demonstrated a
conflict between two important values. What were the values? In your view, which
is more important? Who won and why?
Strategy: Make sure you understand the Shrimp Products case in the text. (See
the “Result” at the end of this section.)
6. CISG A sales agreement between an American company and a foreign company
may be governed by American law, by the law of the foreign country, or by the CISG.
(p. 197)
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CHAPTER 8 International Law 207
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7. LETTERS OF CREDIT A confirmed, irrevocable letter of credit is an
important means of facilitating international sales contracts, because the seller is
assured of payment by a local bank so long as it delivers the specified goods.
(pp. 198–200)
Question: Flyby Knight (FK) contracts to sell 12 helicopters to Air Nigeria for
$8 million each. Payment is to be made by letter of credit, issued by the Bank of
Nigeria, confirmed by Citibank in New York, and due when the confirming bank
receives a bill of lading indicating all helicopters are on board ship, ready for sailing to
Nigeria. FK loads the aircraft on board ship, and the next day delivers the bill of lading
to Citibank. The same day, Air Nigeria informs FK that its inspectors onboard ship
have discovered serious flaws in the rotator blades and the fuel lines. Air Nigeria states
it will neither accept nor pay for the helicopters. Is FK entitled to its $96 million?
(a) FK is entitled to no money.
(b) FK is entitled to no money provided Air Nigeria can prove the helicopters are
defective.
(c) Air Nigeria is obligated to pay FK the full price.
(d) Bank of Nigeria is obligated to pay FK the full price.
(e) Citibank is obligated to pay FK the full price.
Strategy: Payment is to be made by confirmed letter of credit. Ask yourself what that
means. In such a case, the confirming bank is obligated to pay the seller when the bank
receives a bill of lading indicating that conforming goods have been delivered. What
about the fact that the goods seem defective? That is irrelevant. It is precisely to avoid
long-distance arguments over such problems that sellers insist on these letters. (See
the “Result” at the end of this section.)
8. REPATRIATION A foreign government may restrict repatriation of profits.
(p. 201)
9. EXPROPRIATION Expropriation refers to a government taking property owned
by foreign investors. U.S. courts regard this as lawful, provided the country pays the
American owner promptly and fully in dollars. (pp. 201–202)
10. SOVEREIGN IMMUNITY Sovereign immunity means that, in general,
American courts lack jurisdiction to hear suits against foreign governments unless the
foreign nation has waived immunity, is engaging in commercial activity, or has
violated international law. (p. 202)
11. FOREIGN CORRUPT PRACTICES ACT (FCPA) The FCPA makes it
illegal for an American businessperson to bribe foreign officials. (pp. 202–204)
12. EXTRATERRITORIALITY The principle that refers to the power of one nation
to impose its laws in other ountries. (pp. 205–206)
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208 U N I T 1 The Legal Environment
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2. Result: Customs evidently claimed the goods were luggage, with a higher tariff
than food storage articles. Customs argued that the handles and portability made the
articles luggage. But Sports Graphics prevailed, convincing the court that the primary
purpose of the containers was the storage of food. The lawsuit reduced the company’s
tariff from 20 percent to 3.4 percent.
5. Result: Small nations sued, claiming that American regulations made it difficult or
impossible for them to fish, devastating their economic growth. The United States
argued that vital environmental concerns mandated such rules. The WTO found in favor
of the small nations, ruling that before the United States imposed its environmental
standards on other countries, it must engage in multinational negotiations, seeking an
acceptable compromise. Environmentalists argued that the decision was short-sighted,
and contributed to the destruction of an endangered species. Supporters of the decision
responded that long-term environmental concerns sound patronizing and hollow to
people with empty stomachs.
7. Result: When Citibank receives the bill of lading, indicating delivery of the helicopters,
it is obligated to pay. The correct answer is (e).
MULTIPLE-CHOICE QUESTIONS
1. A letter of credit is issued by a _______________.
(a) buyer
(b) seller
(c) shipping company
(d) bank
2. Tariffs are a tax on _______________. Treaties like NAFTA seek to
_______________ tariffs.
(a) imports; increase
(b) imports; decrease
(c) exports; increase
(d) exports; decrease
3. The President negotiates a defense agreement with a foreign government. To take
effect, the agreement must be ratified by which of the following?
(a) Two-thirds of the House of Representatives
(b) Two-thirds of the Senate
(c) The Supreme Court
(d) (a) and (b)
(e) (a), (b), and (c)
CHAPTER 8 International Law 209
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4. Lynn owns a small printing company in Nevada. She makes a contract with a
company in France to print custom children’s books and ship them to France. The
contract does not say anything about which body of law will be used to resolve
any disputes that arise. If there is a conflict, which body of law will actually be
applied to the case?
(a) Nevada law
(b) French law
(c) The CISG
(d) None of the above
5. Countervailing duties are imposed when _______________.
(a) dumping occurs
(b) goods are unreasonably subsidized
(c) Both (a) and (b)
(d) None of the above
ESSAY QUESTIONS
1. Arnold Mandel exported certain high-technology electronic equipment. Later, he
was in court arguing that the equipment he shipped should not have been on the
Department of Commerce’s Commodity Control List. What items may be on that list,
and why does Mandel care?
2. YOU BE THE JUDGE WRITING PROBLEM Continental Illinois National
Bank issued an irrevocable letter of credit on behalf of Bill’s Coal Co. for $805,000,
with the Allied Fidelity Insurance Co. as beneficiary. Bill’s Coal Co. then went
bankrupt. Allied then presented to Continental documents that were complete and
conformed to the letter of credit. Continental refused to pay. Since Bill’s Coal was
bankrupt, there was no way Continental would collect once it had paid on the letter.
Allied filed suit. Who should win? Argument for Allied Fidelity: An irrevocable letter
of credit serves one purpose: to assure the seller that it will be paid if it performs
the contract. Allied has met its obligation. The company furnished documents
demonstrating compliance with the agreement. Continental must pay. Continental’s
duty to pay is an independent obligation, unrelated to the status of Bill’s Coal. The
bank issued this letter knowing the rules of the game and expecting to make a profit.
It is time for Continental to honor its word. Argument for Continental Bank: In this
transaction, the bank was merely a middleman, helping to facilitate payment of a
contract. Allied has fulfilled its obligations under the contract, and we understand the
company’s desire to be paid. Regrettably, Bill’s Coal is bankrupt. No one is going to
be paid on this deal. Allied should have researched Bill’s financial status more
thoroughly before entering into the agreement. While we sympathize with Allied’s
dilemma, it has only itself to blame and cannot expect the bank to act as some sort of
insurance company for a deal gone awry.
3. Jean-François, a French wine exporter, sues Bobby Joe, a Texas importer, claiming
that Bobby Joe owes him $2 million for wine. Jean-François takes the witness stand to
describe how the contract was created. Where is the trial taking place?
210 U N I T 1 The Legal Environment
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4. The Kyrgyz Republic is one of the new nations that broke away from the old Soviet
Union. In September 1994, the government of Kyrgyzstan made two independent
announcements; (1) It was abolishing all taxes on repatriation; and (2) the government
was resigning and would shortly be replaced. Explain the significance of these
announcements for an American company considering a major investment in
Kyrgyzstan.
5. The Instituto de Auxilios y Viviendas is a government agency of the Dominican
Republic. Dr. Marion Fernandez, the general administrator of the Instituto and
Secretary of the Republic, sought a loan for the Instituto. She requested that Charles
Meadows, an American citizen, secure the Instituto a bank loan of $12 million. If he
obtained a loan on favorable terms, he would receive a fee of $240,000. Meadows
secured a loan on satisfactory terms, which the Instituto accepted. He then sought his
fee, but the Instituto and the Dominican government refused to pay. He sued the
government in United States District Court. The Dominican government claimed
immunity. Comment.
DISCUSSION QUESTIONS
1. The United States consistently imports much more
than it exports. The annual gap is consistently several
hundred billion dollars. Does this concern you? If so,
what should be done about it? If not, why not?
2. Does the FCPA seem sensible? Is fighting
corruption the right thing to do, or does the statute
place American companies at an unacceptable
competitive disadvantage?
3. Generally speaking, should the United States pass
laws that seek to control behavior outside its
borders? Or, when in Rome, should our companies
and subsidiaries be allowed to do as the
Romans do?
4. Do you favor free trade agreements like NAFTA?
Do you believe that free trade benefits everyone in
the long run, or are you more concerned that
American jobs may be lost?
5. Imagine that you read an article that reports the
maker of your favorite brand of clothing uses child
labor in its overseas factories. Being realistic, would
you avoid buying that kind of clothing in the
future? Why or why not?
CHAPTER 8 International Law 211
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UNIT2
Contracts
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

CHAPTER9
INTRODUCTION
TO CONTRACTS
Chris always knew that he would propose to his
girlfriend Alissa at Chez Luc, a ritzy, reservations-
only restaurant. When it came time to pop the
question, Chris went on Chez Luc’s website to
reserve a special table. But the website would not
grant him a seating time unless he agreed not to
use his cell phone at the restaurant. Chris clicked
on “I agree” and was issued a booking at his
waterfront table of choice.
After Alissa’s exuberant “yes” during the appetizer,
the newly-engaged couple could not contain their
excitement. With their iPhones, Chris and Alissa took
pictures of themselves, which they immediately posted
on Facebook. They each called their parents from the
table to share the good news … only to be stopped in
their tracks by the angry maître d’, who asked the
couple to leave the dining room for breaching their
contract with the restaurant.
The website would not
grant him a seating time
unless he agreed not to
use his cell phone at the
restaurant.
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We make promises and agreements all the time—from the casual “I will call you later” to the
more formal employment contracts. Some agreements are in writing; some are not. Some we
can negotiate; some we cannot. One of the aims of contract law is to sort those agreements that
are “worthy” of legal enforcement from those that are not. How do we know if an agreement is
“worthy”? The answer might surprise you. Most people assume that contracts must always be
long, unintelligible documents written by lawyers, or that they are necessarily hefty agreements
of great financial significance.
In reality, contract law is based on the notion that you are the best judge of your own
welfare. This means that you have the freedom to enter into relationships and agree to the
rules that will govern them. However, this freedom is not limitless: The law imposes certain
formalities. Your agreements must meet seven requirements, which we will analyze in detail
in upcoming chapters.
Contract law is a story of freedom and power, rules and relationships—with drama to
spare. It is important to study this story to avoid your own contract drama. Let’s start with an
introduction to contracts.
9-1 CONTRACTS
9-1a Elements of a Contract
A contract is merely a legally enforceable agreement. People regularly make promises, but
only some of them are enforceable. For a contract to be enforceable, seven key character-
istics must be present. We will study this “checklist” at length in the next several chapters.
• Offer. All contracts begin when a person or a company proposes a deal. It might
involve buying something, selling something, doing a job, or anything else. But only
proposals made in certain ways amount to a legally recognized offer.
• Acceptance. Once a party receives an offer, he must respond to it in a certain way. We
will examine the requirements of both offers and acceptances in the next chapter.
• Consideration. There has to be bargaining that leads to an exchange between the
parties. Contracts cannot be a one-way street; both sides must receive some
measureable benefit.
• Legality. The contract must be for a lawful purpose. Courts will not enforce
agreements to sell cocaine, for example.
• Capacity. The parties must be adults of sound mind.
• Consent. Certain kinds of trickery and force can prevent the formation of a contract.
• Writing. While verbal agreements often amount to contracts, some types of contracts
must be in writing to be enforceable.
9-1b Other Important Issues
Oncewehaveexamined theessential parts of contracts, theunitwill turn to other important issues:
• Third-Party Interests. If Jerome and Tara have a contract, and if the deal falls apart,
can Kevin sue to enforce the agreement? It depends.
• Performance and Discharge. If a party fully accomplishes what the contract requires,
his duties are discharged. But what if his obligations are performed poorly, or not at all?
• Remedies. A court will award money or other relief to a party injured by a breach of
contract.
Offer
Acceptance
Contracts Checklist
Legality
Capacity
Consent
Writing
Consideration
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CHAPTER 9 Introduction to Contracts 215
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Let’s apply these principles to the opening scenario.
Is the “contract” between Chris and Chez Luc legally binding? Can Chez Luc kick out—
or even sue—Chris for using his cell phone? In deciding this issue, a judge would consider
whether the parties intentionally made an agreement, which included a valid offer and
acceptance. The restaurant’s website set forth its terms, to which Chris agreed by clicking
“I agree”—so there is no question there. A judge would then carefully examine whether the
parties exchanged something of value that proved that they both meant to be bound by this
agreement. And there was. The restaurant gave up a coveted reservation time in exchange for
Chris’s promise to stay away from his phone. A judge would also verify that the parties were
adults of sound mind and that the subject matter of the contract was legal. Assuming Chris
was of legal age (and we certainly hope he was, since he was getting engaged), the agreement
was valid and enforceable. Whether kicking out a newly-engaged couple is good business
practice for a restaurant … now, that’s a different story!
9-1c All Shapes and Sizes
Some contracts—like those in the opener—are small. But contracts can also be large.
Lockheed Martin and Boeing spent years of work and millions of dollars competing for a
U.S. Defense Department aircraft contract. Why the fierce effort? The deal was potentially
good for 25 years and $200 billion. Lockheed won. The company earned the right to build
the next generation of fighter jets—3,000 planes, with different varieties of the aircraft to be
used by each of the American defense services and some allied forces as well.
Many contracts involve public issues. The Lockheed agreement concerns government
agencies deciding how to spend taxpayer money for national defense. Other contracts
concern intensely private matters. Mary Beth Whitehead signed a contract with William
and Elizabeth Stern, of New Jersey. For a fee of $10,000, Whitehead agreed to act as a
surrogate mother, and then deliver the baby to the Sterns for adoption after she carried it to
term. But when little Melissa was born, Whitehead changed her mind and fled to Florida
with the baby. The Sterns sued for breach of contract. Surrogacy contracts now lead to
hundreds of births per year. Are the contracts immoral? Should they be illegal? Are there
limits to what one person may pay another to do? The New Jersey Supreme Court, the first
to rule on the issue, declared the contract illegal and void. The court nonetheless awarded
Melissa to the Sterns, saying that it was in the child’s best interest to live with them.
Inevitably, legislators disagree about this emotional issue. Some states have passed statutes
permitting surrogacy, while others prohibit it.
At times, we even enter contracts without knowing it. Suppose you try to book a flight using
your frequent-flyer miles, but the airline tells you the terms of the frequent-flyer program have
changed and you must earn more mileage. According to the Supreme Court, you may well have
an enforceable agreement based on the terms the airline quoted when you earned the miles.1
9-1d Contracts Defined
We have seen that a contract is a promise that the law will enforce. As we look more closely at
the elements of contract law, we will encounter some intricate issues. This is partly because we
live in a complex society, which conducts its business in a wide variety of ways. Remember,
though, that we are usually interested in answering three basic questions, all relating to promises:
• Is it certain that the defendant promised to do something?
• If she did promise, is it fair to make her honor her word?
• If she did not promise, are there unusual reasons to hold her liable anyway?
1American Airlines, Inc. v. Wolens, 513 U.S. 219, 115 S. Ct. 817, 1995 U.S. LEXIS 690 (1995).
Contract
A legally enforceable
agreement.
216 U N I T 2 Contracts
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9-1e Development of Contract Law
Courts have not always assumed that promises are legally significant. In the twelfth and
thirteenth centuries, promises were not binding unless a person made them in writing and
affixed a seal to the document. This was seldom done, and therefore most promises were
unenforceable.
The common law changed very slowly, but by the fifteenth century, courts began
to allow some suits based on a broken promise. There were still major limitations.
Suppose a merchant hired a carpenter to build a new shop, and the carpenter failed to
start the job on time. Now courts would permit the suit, but only if the merchant
had paid some money to the carpenter. If the merchant made a 10 percent down
payment, the contract would be enforceable. But if the merchant merely promised to
pay when the building was done, and the carpenter never began work, the merchant
could recover nothing.
In 1602, English courts began to enforce mutual promises; that is, deals in which
neither party gave anything to the other but both promised to do something in the
future. Thus, if a farmer promised to deliver a certain quantity of wheat to a merchant
and the merchant agreed on the price, both parties were now bound by their promise,
even though there had been no down payment. This was a huge step forward in the
development of contract law, but many issues remained. Consider the following
employment case from 1792, which raises issues of public policy that still challenge
courts today.
DAVIS V. MASON
Court of King’s Bench
Michaelmas Term, 33d George III , p. 118 (1792)
C A S E S U M M A R Y
Facts: Mason was a surgeon/apothecary in the English
town of Thetford. Davis wished to apprentice himself to
Mason. The two agreed that Davis would work for Mason
and learn his profession. They further agreed that if Davis
left Mason’s practice, he would not set up a competing
establishment within 10 miles of Thetford at any time
within 14 years. Davis promised to pay £200 if he violated
the agreement not to compete.
Davis began working for Mason in July 1789. In
August 1791, Mason dismissed Davis, claiming miscon-
duct, though Davis denied it. Davis then established his
own practice within 10 miles of Thetford. Mason sued for
the £200.
Davis admitted promising to pay the money. But he
claimed that the agreement should be declared illegal and
unenforceable. He argued that 14 years was unreasonably
long to restrict him from the town of Thetford, and that 10
miles was too great a distance. (Ten miles in those days
might take the better part of a day to travel.) He added an
additional policy argument, saying that it was harmful to
the public health to restrict a doctor from practicing his
profession: If the people needed his service, they should
have it. Finally, he said that his “consideration” was too
great for this deal. In other words, it was unfair that he
should pay £200, because he did not receive anything of
that value from Mason.
Issue: Was the contract too unreasonable to enforce?
Decision: No. The parties made a reasonable agree-
ment. Judgment for the plaintiff.
Reasoning: Both Mason and Davis made promises, and
each expected to benefit from the agreement. Davis stood to
learn a trade, and Mason secured protection from competi-
tion in the future. Davis alleges that the contract was unrea-
sonable, but how long is too long? How far is too far? This
line is difficult to draw, and I will not even try. The people
of Thetford will suffer no harm because other doctors have
the right to practice medicine there without restriction.
Davis must pay the £200.
CHAPTER 9 Introduction to Contracts 217
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The contract between Davis and Mason is called a noncompetition agreement. Today
they are more common than ever, and frequently litigated. The policy issues that Davis
raised have never gone away. You may well be asked to sign a noncompetition agreement
sometime in your professional life. We look at the issue in detail in Chapter 11, on
consideration. That outcome was typical of contract cases for the next 100 years. Courts
took a laissez-faire approach, declaring that parties had freedom to contract and would have to
live with the consequences. Lord Kenyon saw Davis and Mason as equals, entering a
bargain that made basic sense, and he had no intention of rewriting it. After 500 years of
evolution, courts had come to regard promises as almost sacred. The law had gone from
ignoring most promises to enforcing nearly all.
By the early twentieth century, bargaining power in business deals had changed drama-
tically. Farms and small businesses were yielding place to huge corporations in a trend that
accelerated throughout the century. In the twenty-first century, multinational corporations
span many continents, wielding larger budgets and more power than many of the nations in
which they do business. When such a corporation contracts with a small company or an
individual consumer, the latter may have little or no leverage. Courts increasingly looked at
the basic fairness of contracts. Noncompetition agreements are no longer automatically
enforced. Courts may alter them or ignore them entirely because the parties have such
unequal power and because the public may have an interest in letting the employee go on
to compete. Davis’s argument—that the public is entitled to as many doctors as it needs—is
frequently more successful in court today than it was in the days of Lord Kenyon.
Legislatures and the courts limit the effect of promises in other ways. Suppose you
purchase a lawn mower with an attached tag, warning you that the manufacturer is not
responsible in the event of any malfunction or injury. You are required to sign a form
acknowledging that the manufacturer has no liability of any kind. That agreement is clear
enough—but a court will not enforce it. The law holds that the manufacturer has warranted
the product to be good for normal purposes, regardless of any language included in the sales
agreement. If the blade flies off and injures a child, the manufacturer is liable. This is
socially responsible, even though it interferes with a private agreement.
The law has not come full circle back to the early days of the common law. Courts still
enforce the great majority of contracts. But the possibility that a court will ignore an agree-
ment means that any contract is a little less certain than it would have been a century ago.
9-2 TYPES OF CONTRACTS
Before undertaking a study of contracts, you need to familiarize yourself with some impor-
tant vocabulary. This section will present five sets of terms.
9-2a Bilateral and Unilateral Contracts
In a bilateral contract, both parties make a promise. A producer says to Gloria, “I’ll pay you
$2 million to star in my new romantic comedy, which we are shooting three months from
now in Santa Fe.” Gloria says, “It’s a deal.” That is a bilateral contract. Each party has made
a promise to do something. The producer is now bound to pay Gloria $2 million, and Gloria
is obligated to show up on time and act in the movie. The vast majority of contracts are
bilateral contracts. They can be for services, such as this acting contract; they can be for the
sale of goods, such as 1,000 tons of steel, or for almost any other purpose. When the bargain
is a promise for a promise, it is a bilateral agreement.
In a unilateral contract, one party makes a promise that the other party can accept only
by actually doing something. These contracts are less common. Suppose the movie producer
tacks a sign to a community bulletin board. It has a picture of a dog with a phone number,
Bilateral contract
A promise made in exchange
for another promise.
Noncompetition
agreement
A contract in which one party
agrees not to compete with
another.
218 U N I T 2 Contracts
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and it reads, “I’ll pay $100 to anyone who returns my lost dog.” If Leo sees the sign, finds
the producer, and merely promises to find the dog, he has not created a contract. Because of
the terms on the sign, Leo must actually find and return the dog to stake a claim to the $100.
9-2b Executory and Executed Contracts
A contract is executory when it has been made, but one or more parties has not yet fulfilled
its obligations. Recall Gloria, who agrees to act in the producer’s film beginning in three
months. The moment Gloria and the producer strike their bargain, they have an executory
bilateral express contract.
A contract is executedwhen all parties have fulfilled their obligations. WhenGloria finishes
acting in the movie and the producer pays her final fee, their contract will be fully executed.
EXAM Strategy
Question: Abby has long coveted Nicola’s designer handbag because she saw one of
them in a movie. Finally, Nicola offers to sell her friend the bag for $350 in cash. “I
don’t have the money right now,” Abby replies, “but I’ll have it a week from Friday.
Is it a deal?” Nicola agrees to sell the bag. Use two terms to describe the contract.
Strategy: In a bilateral contract, both parties make a promise, but in a unilateral
agreement, only one side does so. An executory contract is one with unfulfilled
obligations, while an executed agreement is one with nothing left to be done.
Result: Nicola promised to sell the bag for $350 cash, and Abby agreed to pay.
Because both parties made a promise, this a bilateral agreement. The deal is not yet
completed, meaning that they have an executory contract.
9-2c Valid, Unenforceable, Voidable, and Void
Agreements
A valid contract is one that satisfies all of the law’s requirements. It has no problems in any
of the seven areas listed at the beginning of this chapter, and a court will enforce it. The
contract between Gloria and the producer is a valid contract, and if the producer fails to pay
Gloria, she will win a lawsuit to collect the unpaid fee.
An unenforceable agreement occurs when the parties intend to form a valid bargain, but a
court declares that some rule of law prevents enforcing it. Suppose Gloria and the producer orally
agree that shewill star inhismovie,whichhewill start filming in18months.The law, aswewill see
in Chapter 14, requires that this contract be in writing because it cannot be completed within one
year. If the producer signs up another actress two months later, Gloria has no claim against him.
A voidable contract occurs when the law permits one party to terminate the agreement.
This happens, for example, when an agreement has been signed under duress, or when the
other party has committed fraud. Assume that in negotiations, the producer lies to Gloria
about an important fact, which leads her to accept the contract. The producer tells her that
Steven Spielberg has signed on to be the film’s director. As we will learn in Chapter 13, this
fraudulent agreement is voidable at Gloria’s option. If Gloria later decides that another
director is acceptable, she may choose to stay in the contract. But if she decides that she
wants to cancel the agreement and sue, she can do that as well.
A void agreement is one that neither party can enforce, usually because the purpose of
the deal is illegal or because one of the parties had no legal authority to make a contract.
The following case illustrates the difference between voidable and void agreements.
Void agreement
A contract that neither party
can enforce, because the
bargain is illegal or one of the
parties had no legal authority to
make it.
Executory contract
An agreement in which one or
more parties has not yet fulfilled
its obligations.
Executed contract
An agreement in which all
parties have fulfilled their
obligations.
Valid contract
An agreement that satisfies
all of the law’s requirements
and is enforceable in court.
Unenforceable agreement
An agreement that a court will
not enforce.
Voidable contract
An agreement that may be
terminated by one of the
parties.
CHAPTER 9 Introduction to Contracts 219
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9-2d Express and Implied Contracts
In an express contract, the two parties explicitly state all the important terms of their agreement.
The vast majority of contracts are express contracts. The contract between the producer and
Gloria is an express contract because the parties explicitly state what Gloria will do, where and
when she will do it, and how much she will be paid. Some express contracts are oral, as that one
was, and some are written. They might be bilateral express contracts, as Gloria’s was, or
unilateral express contracts, as Leo’s was. Obviously, it is wise to make express contracts, and
to put them in writing. We emphasize, however, that many oral contracts are fully enforceable.
In an implied contract, the words and conduct of the parties indicate that they intended
an agreement. Suppose every Friday, for two months, the producer asks Lance to mow his
lawn, and loyal Lance does so each weekend. Then, for three more weekends, Lance
simply shows up without the producer asking, and the producer continues to pay for the
work done. But on the 12th weekend, when Lance rings the doorbell to collect, the
producer suddenly says, “I never asked you to mow it. Scram.” The producer is correct
MR. W FIREWORKS, INC. V. OZUNA
2009 Tex. App. LEXIS 8237
Court of Appeals of Texas, Fourth District, San Antonio, 2009
C A S E S U M M A R Y
Facts: Mr. W sold fireworks. Under Texas law, retailers
could only sell fireworks to the public during the two
weeks immediately before the Fourth of July and during
the two weeks immediately before New Year’s Day. And
so, fireworks sellers like Mr. W tended to lease property.
Mr. W leased a portion of Ozuna’s land. The lease
contract contained two key terms:
“In the event the sale of fireworks on the aforemen-
tioned property is or shall become unlawful during the
period of this lease and the term granted, this lease shall
become void.
“Lessor(s) agree not to sell or lease any part of said
property including any adjoining, adjacent, or contiguous
property to any person(s) or corporation for the purpose of
selling fireworks in competition to the Lessee during the
term of this lease, and for a period of ten years after lease is
terminated.” [Emphasis added.]
A longstanding San Antonio city ordinance banned
the sale of fireworks inside city limits, and also within
5,000 feet of city limits. Like all growing cities, San
Antonio sometimes annexed new land, and its city limits
changed. One annexation caused the Ozuna property to
fall within 5,000 feet of the new city limit, and it became
illegal to sell fireworks from the property. Mr. W stopped
selling fireworks and paying rent on Ozuna’s land.
Two years later, San Antonio’s border shifted again.
This time, the city disannexed some property and shrank.
The new city limits placed Ozuna’s property just beyond
the 5,000-foot no-fireworks zone. Ozuna then leased a part
of his land to Alamo Fireworks, a competitor of Mr. W.
Then the real fireworks began. Mr. W sued for breach
of contract, arguing that Ozuna had no right to lease to a
competitor for a period of 10 years. The trial court granted
Ozuna’s motion for summary judgment. Mr. W appealed.
Issue: Did Ozuna breach his contract with Mr. W by leasing
his land to a competitor?
Decision: No, the entire contract was void and therefore
no provisions were enforceable.
Reasoning: Contracts that require an illegal act are void,
which means that neither party can enforce any provision.
It is as if the contract never existed. Thus, Ozuna argued
that when the law made the sale of fireworks illegal, the
lease became void and the entire agreement was unen-
forceable.
In contrast, Mr. W wanted to enforce the provision
that prevented Ozuna from renting the land to competi-
tors but not the one that required him to pay rent. Mr. W’s
could not have it both ways. He could not choose to keep
the benefits of the contract while rejecting its obligations.
When selling fireworks became illegal, the entire lease
was extinguished, which released Ozuna from the non-
compete restriction.
Express contract
An agreement with all the
important terms explicitly
stated.
Implied contract
A contract may be formed
when words or conduct
suggest that the parties
intended a binding agreement.
220 U N I T 2 Contracts
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that there was no express contract because the parties had not spoken for several weeks. But
a court will probably rule that the conduct of the parties has implied a contract. Not only did
Lance mow the lawn every weekend, but the producer even paid on three weekends when
they had not spoken. It was reasonable for Lance to assume that he had a weekly deal to
mow and be paid.
Today, the hottest disputes about implied contracts continue to arise in the employment
setting. Many corporate employees have at-will relationships with their companies. This means
that the employees are free to quit at any time and the company has the right to fire them, for
virtually any reason. But often a company provides its workerswith personnelmanuals that lay out
certain rights. Does a handbook create a contract guaranteeing those rights?What is your opinion?
You Be the Judge
Facts: RogerDeMasseand
five others were employees-
at-will at ITT Corporation,
where they started working
at various times between
1960 and 1979. Each was
paid an hourly wage.
ITT issued an employee handbook, which it revised
four times over two decades.
The first four editions of the handbook stated that
within each job classification, any layoffs would be made
in reverse order of seniority. The fifth handbook made
two important changes. First, the document stated that
“nothing contained herein shall be construed as a guaran-
tee of continued employment. ITT does not guarantee
continued employment to employees and retains the right
to terminate or lay off employees.”
Second, the handbook stated that “ITT reserves the
right to amend, modify, or cancel this handbook, as well as
any or all of the various policies [or rules] outlined in it.”
Four years later, ITT notified its hourly employees that
layoff guidelines for hourly employees would be based not
on seniority, but on ability and performance. About 10 days
later, the six employees were laid off, though less-senior
employees kept their jobs. The six employees sued.
You Be The Judge: Did ITT have the right to unilaterally
change the layoff policy?
Argument for the workers: It is true that all of the plain-
tiffs were originally employees-at-will, subject to termination
at the company’s whim. However, things changed when the
company issued the first handbook. ITT chose to include a
promise that layoffs would be based on seniority. Long-term
workers and new employees all understood the promise and
relied on it. The company put it there to attract and retain
good workers. The policy worked. Responsible employees
understood that the longer they remained at ITT, the safer
their job was. Company and employees worked together for
many years with a common
understanding, and that is a
textbook definition of an
implied contract.
Once a contract is
formed, whether express
or implied, it is binding
on both sides. That is the whole point of a contract. If one
side could simply change the terms of an agreement on its
own, what value would any contract have? The company’s
legal argument is a perfect symbol of its arrogance: It
believes that because these workers are mere hourly
workers, they have no rights, even under contract law.
The company is mistaken. Implied contracts are binding,
and ITTshouldnotmakepromises it doesnot intend tokeep.
Argument for ITT: Once an at-will employee, always
one. ITT had the right to fire any of its employees at any
time—just as theworkers had the right to quit whenever they
wished. That never changed, and in case any workers forgot
it, the company reiterated the point in its most recent hand-
book. If the plaintiffs thought layoffs would happen in any
particular order, that is their error, not ours.
All workers were bound by the terms of whichever
handbook was then in place. For many years, the com-
pany had made a seniority-layoff promise. Had we fired a
senior worker during that period, he or she would have
had a legitimate complaint—and that is why we did not do
it. Instead, we gave everyone four years’ notice that things
would change. Any workers unhappy with the new poli-
cies should have left to find more congenial work.
Why should an employee be allowed to say, “I prefer
to rely on the old, outdated handbooks, not the new one”?
The plaintiffs’ position would mean that no company is
ever free to change its general work policies and rules.
Since when does an at-will employee have the right to
dictate company policy? That would be disastrous for the
whole economy—but fortunately it is not the law.
DEMASSE V. ITT
CORPORATION
194 Ariz. 500, 984 P.2d 1138
Supreme Court of Arizona, 1999
CHAPTER 9 Introduction to Contracts 221
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9-2e Promissory Estoppel and Quasi-Contracts
Now we turn away from “true” contracts and consider two unusual circumstances.
Sometimes, courts will enforce agreements even if they fail to meet the usual require-
ment of a contract. We emphasize that these remedies are uncommon exceptions to the
general rules. Most of the agreements that courts enforce are the express contracts that
we have already studied. Nonetheless, the next two remedies are still pivotal in some
lawsuits. In each case, a sympathetic plaintiff can demonstrate an injury but there is no
contract. The plaintiff cannot claim that the defendant breached a contract, because
none ever existed. The plaintiff must hope for more “creative” relief.
The two remedies can be confusingly similar. The best way to distinguish them is the
following:
• In promissory estoppel cases, the defendant made a promise that the plaintiff relied on.
• In quasi-contract cases, the defendant received a benefit from the plaintiff.
PROMISSORY ESTOPPEL
A fierce fire swept through Dana and Derek Andreason’s house in Utah, seriously
damaging it. The good news was that agents for Aetna Casualty promptly visited the
Andreasons and helped them through the crisis. The agents reassured the couple that
all of the damage was covered by their insurance, instructed them on which things to
throw out and replace, and helped them choose materials for repairing other items. The
bad news was that the agents were wrong: The Andreasons’ policy had expired six
weeks before the fire. When Derek Andreason presented a bill for $41,957 worth of
meticulously itemized work that he had done under the agents’ supervision, Aetna
refused to pay.
The Andreasons sued—but not for breach of contract. There was no contract—they
allowed their policy to expire. They sued Aetna under the legal theory of promissory
estoppel: Even when there is no contract, a plaintiff may use promissory estoppel to enforce
the defendant’s promise if he can show that:
• The defendant made a promise knowing that the plaintiff would likely rely on it;
• The plaintiff did rely on the promise; and
• The only way to avoid injustice is to enforce the promise.
Aetna made a promise to the Andreasons—namely, its assurance that all of the damage
was covered by insurance. The company knew that the Andreasons would rely on that
promise, which they did by ripping up a floor that might have been salvaged, throwing
out some furniture, and buying materials to repair the house.
Is enforcing the promise the only way to avoid injustice?
Yes, ruled the Utah Court of Appeals.2 The Andreasons’
conduct was reasonable and based entirely on what the
Aetna agents told them. Under promissory estoppel, the
Andreasons received virtually the same amount they would
have obtained had the insurance contract been valid.
There was plenty of romance in the following case.
Was there an enforceable promise?
Is enforcing the promise
the only way to avoid
injustice?
2Andreason v. Aetna Casualty & Surety Co., 848 P.2d 171, 1993 Utah App. LEXIS 26 (Utah App. 1993).
Promissory estoppel
A possible remedy for an
injured plaintiff in a case with
no valid contract, where the
plaintiff can show a promise,
reasonable reliance, and
injustice.
222 U N I T 2 Contracts
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Devil’s Advocate Why should one person be able to make repeated
promises over two decades and escape all
responsibility? Even if Hoyt’s precise words varied, each of his promises involved long-
term emotional and financial security for Norton. Norton was naïve, but Hoyt was
dishonest. The law should be a tool for teaching people like him a lesson.
Why have we chosen to illustrate an important point of law—promissory estoppel—with
a case that fails? Because that is the typical outcome. Plaintiffs allege promissory estoppel
very frequently, but seldom succeed. They do occasionally win, as the Andreasons demon-
strated earlier, but courts are skeptical of these claims. The lesson is clear: Before you rely
on a promise, negotiate a binding contract.
NORTON V. HOYT
278 F.Supp.2d 214
United States District Court for the District of Rhode Island, 2003
C A S E S U M M A R Y
Facts: Gail Norton sued Russell Hoyt, and this is what she
alleged. The two met when Norton, who was single, worked
as an elementary school teacher. Hoyt told her he was also
single, and they began an affair. She later learned that he
was married, but he assured her he was getting a divorce,
and they continued their relationship.
Six years later, Hoyt, who was rich, convinced Norton to
quit her job so that they could travel together. The couple
lived lavishly, spending time in Newport, Rhode Island,
where Hoyt was part of the yachting crowd, in London, the
Bahamas, and other agreeable places. Hoyt rented Norton an
apartment, bought her cars, and repeated his promises to
divorce his wife and marry his lover. He never did either.
After 23 years, Hoyt ended the relationship. Norton
became ill and saw various doctors for anxiety, depression,
headaches, stomach maladies, and weight loss. During one
joint therapy session, Hoyt told Norton and the psychiatrist
that he would continue to support her with $80,000 a year.
But he did not.
Norton sued, claiming promissory estoppel. Hoytmoved
for summary judgment. In ruling on the motion, the court
assumed that Norton’s allegations were true.
Issue: Was Norton entitled to support, based on promissory
estoppel?
Decision: No. Norton failed to establish promissory
estoppel.
Reasoning: Norton did not establish a clear, unambigu-
ous promise. She claimed that Hoyt promised to take care
of her for life. But what does “take care of for life” mean?
It could refer to emotional closeness, social pleasures, or
financial support.
Even assuming, for the sake of argument, that there
was a clear, unconditional promise, Norton’s reliance was
unreasonable. It is true that the couple discussed wed-
ding plans, but Norton knew that Hoyt was married and
that he spent time with his wife and children. She and
Hoyt never presented themselves as husband and wife.
Friends and family knew of their complicated living
arrangement. Further, Norton knew that Hoyt had lied
to her about his marital status, had never fulfilled his
promise of marriage, and was committing adultery by
spending time with her. At some point between year 1
of their affair and year 23, she should have grasped that
reliance on Hoyt’s promises was badly misplaced. Her
conduct was unreasonable, and she cannot establish pro-
missory estoppel.
Hoyt’s motion for summary judgment is granted.
CHAPTER 9 Introduction to Contracts 223
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QUASI-CONTRACT
Don Easterwood leased over 5,000 acres of farmland in Jackson County, Texas, from PIC
Realty for one year. The next year, he obtained a second one-year lease. During each year,
Easterwood farmed the land, harvested the crops, and prepared the land for the following
year’s planting. Toward the end of the second lease, after Easterwood had harvested his
crop, he and PIC began discussing the terms of another lease. While they negotiated,
Easterwood prepared the land for the following year, cutting and plowing the soil. But
the negotiations for a new lease failed, and Easterwood moved off the land. He sued PIC
Realty for the value of his work preparing the soil.
Easterwood had neither an express nor an implied contract for the value of his work. How
could he make any legal claim? By relying on the legal theory of a quasi-contract: Even when
there is no contract, a court may use quasi-contract to compensate a plaintiff who can show that:
• The plaintiff gave some benefit to the defendant;
• The plaintiff reasonably expected to be paid for the benefit and the defendant knew
this; and
• The defendant would be unjustly enriched if he did not pay.
If a court finds all of these elements present, it will generally award the value of the
goods or services that the plaintiff has conferred. The damages awarded are called quantum
meruit, meaning that the plaintiff gets “as much as he deserves.” The court is awarding
money that it believes the plaintiff morally ought to have, even though there was no valid
contract entitling her to it. This again is judicial activism, with the courts inventing a “quasi”
contract where no true contract exists. The purpose is justice, the term is contradictory.
Don Easterwood testified that in Jackson County, it was quite common for a tenant
farmer to prepare the soil for the following year but then be unable to farm the land. In
those cases, he claimed, the landowner compensated the farmer for the work done. Other
witnesses agreed that this was the local custom. The court ruled that indeed there was no
contract, but that all elements of quasi-contract had been satisfied. Easterwood gave a
benefit to PIC because the land was ready for planting. Jackson County custom caused
Easterwood to assume he would be paid, and PIC Realty knew it. Finally, said the court, it
would be unjust to let PIC benefit without paying anything. The court ordered PIC to pay
the fair market value of Easterwood’s labors.
FOUR THEORIES OF RECOVERY
Theory
Did the
Defendant Make
a Promise?
Is There a
Contract? Description
Express
Contract
Yes Yes The parties intend to contract and agree
on explicit terms.
Implied
Contract
Not explicitly Yes The parties do not formally agree, but
their words and conduct indicate an
intention to create a contract.
Promissory
Estoppel
Yes No There is no contract, but the defendant
makes a promise that she can foresee
will induce reliance; the plaintiff relies on
it; and it would be unjust not to enforce
the promise.
Quasi-
Contract
No No There is no intention to contract, but the
plaintiff gives some benefit to the
defendant, who knows that the plaintiff
expects compensation; it would be unjust
not to award the plaintiff damages.
Quasi-contract
A possible remedy for an
injured plaintiff in a case with
no valid contract, where the
plaintiff can show benefit to
the defendant, reasonable
expectation of payment,
and unjust enrichment.
Quantum meruit
“As much as he deserves”—the
damages awarded in a quasi-
contract case.
©
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EXAM Strategy
Question: The table above lists the different theories a plaintiff may use to recover
damages in a contract dispute. In the following examples, which one will each
plaintiff use in trying to win the case?
1. Company pays all employees 10 percent commission on new business they
develop. Company compensates each employee when the new customer pays
its first bill. After Leandro obtains three new clients, Company fires him.
When the new customers pay their bill, Company refuses to pay Leandro a
commission because he is no longer an employee. Leandro sues.
2. Burt agrees in writing to sell Red 100 lobsters for $15 each, payable by credit
card, in exactly 30 days. When the lobsters fail to arrive, Red sues.
3. Company handbook, given to all new hires, states that no employee will be
fired without a hearing and an appeal. Company fires Delores without a
hearing or appeal. She sues.
Strategy: In (1), the Company never promised to pay a commission to nonemployees,
so there is no contract. However, the Company benefited from Leandro’s work.
In (2) , the parties have clearly stated all terms to a simple sales agreement. In (3) ,
the Company and Delores never negotiated termination, but the handbook suggests
that all employees have certain rights.
Result: (1) is a case of quasi-contract because the company benefited and should
reasonably expect to pay. (2) is an express contract because all terms are clearly
stated. (3) is an implied contract, similar to the DeMasse case, based on the handbook.
9-3 SOURCES OF CONTRACT LAW
9-3a Common Law
We have seen the evolution of contract law from the twelfth century to the present. Express
and implied contracts, promissory estoppel, and quasi-contract were all crafted, over cen-
turies, by courts deciding one contract lawsuit at a time. Many contract lawsuits continue to
be decided using common law principles developed by courts.
9-3b Uniform Commercial Code
Business methods changed quickly during the first half of the last century. Transportation
sped up. Corporations routinely conducted business across state borders and around the
world. These developments presented a problem. Common law principles, whether
related to contracts, torts, or anything else, sometimes vary from one state to another.
New York and California courts often reach similar conclusions when presented with
similar cases, but they are under no obligation to do so. Business leaders became frustrated
that, to do business across the country, their companies had to deal with many different
sets of common law rules.
Executives, lawyers, and judges wanted a body of law for business transactions that
reflected modern commercial methods and provided uniformity throughout the United States.
It would be much easier, they thought, if some parts of contract law were the same in every
CHAPTER 9 Introduction to Contracts 225
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state. That desire gave birth to the Uniform Commercial Code (UCC), created in 1952. The
drafters intended the UCC to facilitate the easy formation and enforcement of contracts in a
fast-paced world. The Code governs many aspects of commerce, including the sale and leasing
of goods, negotiable instruments, bank deposits, letters of credit, investment securities, secured
transactions, and other commercial matters. Every state has adopted at least part of the UCC to
govern commercial transactions within that state. For our purposes in studying contracts, the
most important part of the Code is Article 2, which governs the sale of goods. “Goods” means
anything movable, except for money, securities, and certain legal rights. Goods include pencils,
commercial aircraft, books, and Christmas trees. Goods do not include land or a house because
neither is movable, nor do they include a stock certificate. A contract for the sale of 10,000
sneakers is governed by the UCC; a contract for the sale of a condominium in Marina del Rey is
governed by the California common law.
When analyzing any contract problem as a student or businessperson, you must note
whether the agreement concerns the sale of goods. For many issues, the common law and
the UCC are reasonably similar. But sometimes, the law is quite different under the two
sets of rules.
And so, the UCC governs contracts for a sale of goods, while common law principles
govern contracts for sales of services and everything else. Most of the time, it will be clear
whether the UCC or the common law applies. But what if a contract involves both goods
and services? When you get your oil changed, you are paying in part for the new oil and oil
filter (goods) and in part for the labor required to do the job (services). In a mixed contract,
Article 2 governs only if the primary purpose was the sale of goods. In the following case, the
court had to decide the primary purpose.
FALLSVIEW GLATT KOSHER CATERERS, INC. V.
ROSENFELD
2005 WL 53623
Civil Court, City of New York, 2005
C A S E S U M M A R Y
Facts: During the Jewish holidays, Fallsview Glatt Kosher
Caterers organized programs at Kutcher’s Country Club,
where it provided all accommodations, food, and entertain-
ment.
Fallsview sued Willie Rosenfeld, alleging that he had
requested accommodations for 15 members of his family,
agreeing to pay $24,050, and then failed to appear or pay.
Rosenfeld moved to dismiss, claiming that even if
there had been an agreement, it was never put in
writing. Under UCC Section 2-201, any contract for
the sale of goods worth $500 or more can be enforced
only if it is in writing and signed. Fallsview argued that
the agreement was not for the sale of goods, but for
services. The company claimed that because the con-
tract was not governed by the UCC, it should be
enforced even with no writing.
Issue: Was the agreement one for the sale of goods, requiring
a writing, or for services, enforceable with no writing?
Decision: Theagreementwas for services.Thedefendant’s
motion to dismiss is denied.
Reasoning: Rosenfeld contends that the predominant
purpose of the contract was the service of Kosher food. He
urges that the hotel accommodations and entertainment
were merely incidental benefits. This conclusion is com-
pelled, he suggests, by the very nature of the Passover
holiday. The essential religious obligation during this eight-
day period is to eat only food that is “Kosher for Passover.”
It is the desire to obtain acceptable nourishment that causes
customers to participate in such programs.
Fallsview countered by offering the court a schedule of
activities available during the Passover program. These
226 U N I T 2 Contracts
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EXAM Strategy
Question: Leila agrees to pay Kendrick $35,000 to repair windmills. Confident of
this cash, Kendrick contracts to buy Derrick’s used Porsche for $33,000. Then Leila
informs Kendrick she does not need his help and will not pay him. Kendrick tells
Derrick that he no longer wants the Porsche. Derrick sues Kendrick, and Kendrick
files suit against Leila. What law or laws govern these lawsuits?
Strategy: Always be conscious of whether a contract is for services or the sale of
goods. Different laws govern. To make that distinction, you must understand the
term “goods.” If you are clear about that, the question is answered easily.
Result: Goods means anything movable, and a Porsche is movable—one might say
“super-movable.” The UCC will control Derrick’s suit. Repairing windmills is
primarily a service. Kendrick’s lawsuit is governed by the common law of contracts.
Chapter Conclusion
Contracts govern countless areas of our lives, from intimate family issues to multibillion-
dollar corporate deals. Understanding contract principles is essential for a successful business
or professional career and is invaluable in private life. This knowledge is especially important
because courts no longer rubber-stamp any agreement that two parties have made. If we know
the issues that courts scrutinize, the agreement we draft is likelier to be enforced. We thus
achieve greater control over our affairs—the very purpose of a contract.
EXAM REVIEW
1. CONTRACTS: DEFINITION AND ELEMENTS A contract is a legally
enforceable promise. Analyzing whether a contract exists involves inquiring into these
issues: offer, acceptance, consideration, capacity, legal purpose, consent, and
sometimes, whether the deal is in writing. (pp. 215–216)
included tennis, racquetball, swimming, Swedish massage,
“make over face lift show,” “trivia time,” aerobics, bingo,
ice skating, dancing, “showtime,” “power walk,” arts and
crafts, day camp, ping-pong, Yiddish theater, board games,
horse racing, horseback riding, wine tasting, and indoor
bocce. The activities were provided, along with accommo-
dation and food, for an all-inclusive price. It is apparent that
the activities and accommodations were a major part of the
program, and that services were a more important aspect of
the agreement than were goods.
Fallsview also argues that if, as Rosenfeld claims,
hotel reservations are for the sale of goods, then all such
contracts made via telephone or the Internet would be
unenforceable, leaving the hospitality industry in an
impossible situation. That may or may not be true, but
it does indicate how important it is not to carelessly
apply a statutory provision to contracts beyond its scope.
UCC Section 2-201 was never meant to cover an agree-
ment involving such a full slate of accommodations and
activities.
CHAPTER 9 Introduction to Contracts 227
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2. DEVELOPMENT The development of contract law stretches into the distant
past. Before the fifteenth century, courts rarely enforced promises at all. By the 1600s,
courts enforced many mutual promises, and by 1900, most promises containing the
seven elements of a contract were strictly enforced. (pp. 217–218)
3. UNILATERAL AND BILATERAL CONTRACTS In bilateral contracts, the
parties exchange promises. In a unilateral contract, only one party makes a promise, and
the other must take some action—his return promise is insufficient to form a contract.
(pp. 218 –219)
4. EXECUTORY AND EXECUTED CONTRACTS In an executory contract, one
or both of the parties have not yet have not done everything that they promised to do.
In an executed contract, all parties have fully performed. (p. 219)
5. ENFORCEABILITY
• Valid contracts are fully enforceable.
• An unenforceable agreement is one with a legal defect.
• A voidable contract occurs when one party has an option to cancel the agreement.
• A void agreement means that the law will ignore the deal regardless of what the
parties want. (pp. 219–220)
Question: Yasmine is negotiating to buy Stewart’s house. She asks him what
condition the roof is in.
“Excellent,” he replies. “It is only 2 years old, and should last 25 more.” In fact,
Stewart knows that the roof is 26 years old and has had a series of leaks. The parties
sign a sales contract for $600,000. A week before Yasmine is to pay for the house and
take possession, she discovers the leaks and learns that the mandatory new roof will
cost $35,000. At the same time, she learns that the house has increased in value by
$60,000 since she signed the agreement. What options does Yasmine have?
Strategy: You know intuitively that Stewart’s conduct is as shabby as his roof.
What is the legal term for his deception? Fraud. Does fraud make an agreement
void or voidable? Does it matter? (See the “Result” at the end of this section.)
6. EXPRESS AND IMPLIED CONTRACTS If the parties formally agreed and
stated explicit terms, there is probably an express contract. If the parties did not
formally agree but their conduct, words, or past dealings indicate they intended a
binding agreement, there may be an implied contract. (pp. 220–221)
7. OTHER REMEDIES If there is no contract, are there other reasons to give the
plaintiff damages?
• A claim of promissory estoppel requires that the defendant made a promise
knowing that the plaintiff would likely rely, and the plaintiff did so. It would be
wrong to deny recovery.
• A claim of quasi-contract requires that the defendant received a benefit, knowing
that the plaintiff would expect compensation, and it would be unjust not to grant
it. (pp. 222–224)
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Question: The Hoffmans owned and operated a successful small bakery and
grocery store. They spoke with Lukowitz, an agent of Red Owl Stores, who
told them that for $18,000, Red Owl would build a store and fully stock it for
them. The Hoffmans sold their bakery and grocery store and purchased a lot
on which Red Owl was to build the store. Lukowitz then told Hoffman that
the price had gone up to $26,000. The Hoffmans borrowed the extra money
from relatives, but then Lukowitz informed them that the cost would be
$34,000. Negotiations broke off, and the Hoffmans sued. The court
determined that there was no contract because too many details had not been
worked out—the size of the store, its design, and the cost of constructing it.
Can the Hoffmans recover any money?
Strategy: Because there is no contract, the Hoffmans must rely on either
promissory estoppel or quasi-contract. Promissory estoppel focuses on the
defendant’s promise and the plaintiff’s reliance. Those suing in quasi-contract
must show that the defendant received a benefit for which it should
reasonably expect to pay. Does either fit here? (See the “Result” at the end of
this section.)
8. SOURCES OF CONTRACT LAW If a contract is for the sale of goods, the UCC
is the relevant body of law. For anything else, the common law governs. If a contract
involves both goods and services, a court will determine the agreement’s primary
purpose. (pp. 225–227)
Question: Honeywell, Inc. and Minolta Camera Co. had a contract providing
that Honeywell would give to Minolta various technical information on the design
of a specialized camera lens. Minolta would have the right to use the information
in its cameras, provided that Minolta also used certain Honeywell parts in its
cameras. Honeywell delivered to Minolta numerous technical documents,
computer software, and test equipment, and Honeywell engineers met with
Minolta engineers at least 20 times to discuss the equipment. Several years later,
Honeywell sued, claiming that Minolta had taken the design information but
failed to use Honeywell parts in its cameras. Minolta moved to dismiss, claiming
that the UCC required lawsuits concerning the sale of goods to be filed within
four years of the breach and that this lawsuit was too late. Honeywell answered
that the UCC did not apply, and that therefore, Minnesota’s six-year statute of
limitations governed. Who is right?
Strategy: Like many contracts, this one involves both goods, which are governed
by the UCC, and services, controlled by the common law. We decide which of
those two laws governs by using the predominant purpose test. Was this contract
primarily about selling goods or about providing services? (See the “Result” at the
end of this section.)
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5. Result: Indeed, it does matter. Stewart’s fraud makes the contract voidable by
Yasmine. She has the right to terminate the agreement and pay nothing. However,
she may go through with the contract if she prefers. The choice is hers—but
not Stewart’s.
7. Result: Red Owl received no benefit from the Hoffmans’ sale of their store or
purchase of the lot. However, Red Owl did make a promise and expected the
Hoffmans to rely on it, which they did. The Hoffmans won their claim of promissory
estoppel.
8. Result: The primary purpose of this agreement was not the sale of goods, but
rather the exchange of technical data, ideas, designs, and so forth. The common law
governs the contract, and Honeywell’s suit may go forward.
MULTIPLE-CHOICE QUESTIONS
1. A sitcom actor, exhausted after his 10-hour workweek, agrees to buy a briefcase full of
cocaine from Lewis for $12,000. Lewis and the actor have a contract.
(a) valid
(b) unenforceable
(c) voidable
(d) void
2. Carol says, “Pam, you’re my best friend in the world. I just inherited a million
bucks, and I want you to have some of it. Come with me to the bank tomorrow, and
I’ll give you $10,000.” “Sweet!” Pam replies. Later that day, Carol has a change of
heart. She is allowed to do so. Examine the list of the elements of a contract, and
cite the correct reason.
(a) The agreement was not put into writing.
(b) The agreement lacks a legal purpose.
(c) Pam did not give consideration.
(d) Pam does not have the capacity to make a contract.
3. On the first day of the baseball season, Dean orders a new Cardinals hat from
Amazon.com. At the moment he submits his order, Dean and Amazon have
an contract. Two days later, Amazon delivers the hat to Dean’s house.
At this point, Dean and Amazon have an contract.
(a) executory; executory
(b) executory; executed
(c) executed; executory
(d) executed; executed
230 U N I T 2 Contracts
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4. Linda goes to an electronics store and buys a high-definition TV. Lauren hires a
company to clean her swimming pool once a week. The governs
Linda’s contract with the store, and the governs Lauren’s contract with
the cleaning company.
(a) common law; common law
(b) common law; UCC
(c) UCC; common law
(d) UCC; UCC
5. Consider the following scenarios:
I. Madison says to a group of students, “I’ll pay $35 to the first one of you who
shows up at my house and mows my lawn.”
II. Lea posts a flyer around town that reads, “Reward: $500 for information about the
person who keyed my truck last Saturday night in the Wag-a-Bag parking lot. Call
Lea at 555-5309.”
Which of these proposes a unilateral contract?
(a) I only
(b) II only
(c) Both I and II
(d) None of the above
ESSAY QUESTIONS
1. Pennsylvania contracted with Envirotest Systems, Inc., an Arizona company, to
build 86 automobile emissions inspection stations in 25 counties and operate them
for seven years. This contract is worth hundreds of millions of dollars to Envirotest.
But Pennsylvania legislators suddenly opposed the entire system, claiming that it
would lead to long delays and high expenses for motorists. These lawmakers urged
that Pennsylvania simply stop construction of the new system. Was Pennsylvania
allowed to get out of the contract because its legislators concluded the whole system
is unwise?
2. Central Maine Power Co. made a promotional offer in which it promised to pay a
substantial sum to any homeowner or builder who constructed new housing
heated with electricity. Motel Services, Inc., which was building a small housing
project for the city of Waterville, Maine, decided to install electrical heat in the
units in order to qualify for the offer. It built the units and requested payment for
the full amount of the promotional offer. Is Central Maine obligated to pay? Why
or why not?
CHAPTER 9 Introduction to Contracts 231
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3. Interactive Data Corp. hired Daniel Foley as an assistant product manager at a
starting salary of $18,500. Over the next six years, Interactive steadily promoted
Foley until he became Los Angeles branch manager at a salary of $56,116.
Interactive’s officers repeatedly told Foley that he would have his job as long as his
performance was adequate. In addition, Interactive distributed an employee
handbook that specified “termination guidelines,” including a mandatory seven-
step pre-termination procedure. Two years later, Foley learned that his recently
hired supervisor, Robert Kuhne, was under investigation by the FBI for
embezzlement at his previous job. Foley reported this to Interactive officers. Shortly
thereafter, Interactive fired Foley. He sued, claiming that Interactive could fire him
only for good cause, after the seven-step procedure. What kind of a claim is he
making? Should he succeed?
4. ETHICS You want to lease your automobile to a friend for the summer but do not
want to pay a lawyer to draw up the lease. Joanna, a neighbor, is in law school. She is
not licensed to practice law. She offers to draft a lease for you for $100, and you
unwisely accept. Later, you refuse to pay her fee, and she sues to collect. Who will
win the lawsuit, and why? Apart from the law, was it morally right for the law student
to try to help you by drafting the lease? Was she acting helpfully, or foolishly, or
fraudulently? Is it just for you to agree to her fee and then refuse to pay it? What is
society’s interest in this dispute? Should a court be more concerned with the ethical
issue raised by the conduct of the two parties or with the social consequences of this
agreement?
5. YOU BE THE JUDGE WRITING PROBLEM John Stevens owned a
dilapidated apartment that he rented to James and Cora Chesney for a low rent.
The Chesneys began to remodel and rehabilitate the unit. Over a four-year
period, they installed two new bathrooms, carpeted the floors, installed new
septic and heating systems, and rewired, replumbed, and painted. Stevens
periodically stopped by and saw the work in progress. The Chesneys
transformed the unit into a respectable apartment. Three years after their work
was done, Stevens served the Chesneys with an eviction notice. The Chesneys
counterclaimed, seeking the value of the work they had done. Are they entitled
to it? Argument for Stevens: Mr. Stevens is willing to pay the Chesneys exactly
the amount he agreed to pay: nothing. The parties never contracted for the
Chesneys to fix up the apartment. In fact, they never even discussed such an
agreement. The Chesneys are making the absurd argument that anyone who
chooses to perform certain work, without ever discussing it with another party,
can finish the job and then charge it to the other person. If the Chesneys
expected to get paid, obviously they should have said so. If the court were to
allow this claim, it would be inviting other tenants to make improvements and
then bill the landlord. The law has never been so foolish. Argument for the
Chesneys: The law of quasi-contract was crafted for cases exactly like this. The
Chesneys have given an enormous benefit to Stevens by transforming the
apartment and enabling him to rent it at greater profit for many years to come.
Stevens saw the work being done and understood that the Chesneys expected
some compensation for these major renovations. If Stevens never intended to
pay the fair value of the work, he should have stopped the couple from doing
the work or notified them that there would be no compensation. It would be
unjust to allow the landlord to seize the value of the work, evict the tenants who
did it, and pay nothing.
232 U N I T 2 Contracts
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DISCUSSION QUESTIONS
1. Have you ever made an agreement that mattered to
you, only to have the other person refuse to follow
through on the deal? Looking at the list of elements
in the chapter, did your agreement amount to a
contract? If not, which element did it lack?
2. Consider promissory estoppel and quasi-contracts.
Do you like the fact that these doctrines exist?
Should courts have “wiggle room” to enforce deals
that fail to meet formal contract requirements?
Or, should the rule be “If it’s not an actual contract,
too bad. No deal.”
3. Is it sensible to have two different sets of contract
rules—one for sales of goods and another for
everything else? Would it be better to have a single
set of rules for all contracts?
4. In the case Davis v. Mason, a court considered an
early non-compete agreement. Did the court in
that case reach a proper conclusion? What should
courts say in similar cases in modern times?
5. Return to the opening scenario. Chris made a
valid agreement with Chez Luc, which is
enforceable in court. Does the thought of a
restaurant suing a patron for using his phone
seem odd? Why? If the restaurant does not plan
to take the patrons to court, why bother to have
a contract at all?
CHAPTER 9 Introduction to Contracts 233
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CHAPTER10
AGREEMENT
Interior. A glitzy café, New York. Evening. Bob,
a famous director, and Katrina, a glamorous
actress, sit at a table, near a wall of glass looking
onto a New York sidewalk that is filled with life
and motion. Bob sips a margarita while carefully
eyeing Katrina. Katrina stares at her wine glass.
BOB (smiling confidently):Body Work is going to
be huge—for the right actress. I know a film that’s
gonna gross a hundred million when I’m holding
one. I’m holding one.
KATRINA (perking up at the mention of money):
It is quirky. It’s fun. And she’s very strong, very
real.
BOB: She’s you. That’s why we’re sitting here. We
start shooting in seven months.
KATRINA (edging away from the table): I have a few
questions. That nude scene.
BOB: The one on the toboggan run?
KATRINA: That one was O.K. But the one in the
poultry factory—very explicit. I don’t work nude.
BOB: It’s not really nude. Think of all those feathers
fluttering around.
KATRINA: It’s nude.
BOB: We’ll work it out. This is a romantic comedy, not tawdry exploitation. Katrina,
we’re talking $2.5 million. A little accommodation, please. We’ll give you $600,000 up
front, and the rest deferred, the usual percentages.
KATRINA: Bob, my fee is $3 million. As you know. That hasn’t changed.
Katrina picks up her drink, doesn’t sip it, places it on the coaster, using both hands to
center it perfectly. He waits, as she stares silently at her glass.
BOB: We’re shooting in Santa Fe, the weather will be perfect. You have a suite at the
Excelsior, plus a trailer on location.
I should talk with my
agent. I’d need
something in writing
about the nude scene …
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KATRINA: I should talk with my agent. I’d need something in writing
about the nude scene, the fee, percentages—all the business stuff. I never
sign without talking to her.
Bob shrugs and sits back.
KATRINA (made anxious by the silence): I love the character, I really do.
BOB: You and several others love her. (That jolts her.) Agents can wait.
I have to put this together fast. We can get you the details you want in
writing. Body Work is going to be bigger than Sex in the City.
That one hooks her. She looks at Bob. He nods reassuringly. Bob sticks
out his hand, smiling. Katrina hesitates, lets go of her drink, and SHAKES
HANDS, looking unsure. Bob signals for the check.
Do Bob and Katrina have a deal? They seem to think so. But is her fee $2.5 million or $3
million? What if Katrina demands that all nude scenes be taken out, and Bob refuses?
Must she still act in the film? Or suppose her agent convinces her that Body Work is no
good even with changes. Has Katrina committed herself? What if Bob auditions another
actress the next day, likes her, and signs her? Does he owe Katrina her fee? Or suppose
Bob learns that the funding has fallen apart and there will be no film. Is Katrina entitled
to her money?
Bob and Katrina have acted out a classic problem in agreement, one of the basic issues in
contract law. Their lack of clarity means that disputes are likely and lawsuits possible.
Similar bargaining goes on every day around the country and around the world, and the
problems created are too frequently resolved in court. Some negotiating is done in person;
more is done over the phone, by fax, by email—or all of them combined. This chapter
highlights the most common sources of misunderstanding and litigation so that you can
avoid making contracts you never intended—or deals that you cannot enforce.
There almost certainly is no contract between Bob and Katrina. Bob’s offer was unclear.
Even if it was valid, Katrina counteroffered. When they shook hands, it is impossible to
know what terms each had in mind.
10-1 MEETING OF THE MINDS
Remember from the last chapter that contracts have seven key characteristics. Agreements
that have a problem in any of the areas do not amount to valid contracts. In this chapter, we
examine the first two items on the checklist.
Parties form a contract only if they have a meeting of the minds. For this to happen, one
side must make an offer and the other must make an acceptance. An offer proposes definite
terms, and an acceptance unconditionally agrees to them.
Throughout the chapter, keep in mind that courts make objective assessments when
evaluating offers and acceptances. A court will not try to get inside Katrina’s head and
decide what she was thinking as she shook hands. It will look at the handshake objectively,
deciding how a reasonable person would interpret her words and conduct. Katrina may
honestly have meant to conclude a deal for $3 million with no nude scenes, while Bob might
in good faith have believed he was committing himself to $2.5 million and absolute control
of the script. Neither belief will control the outcome.
Offer
An act or statement that
proposes definite terms and
permits the other party to
create a contract by accepting
those terms.
Offer
Acceptance
Contracts Checklist
Legality
Capacity
Consent
Writing
Consideration
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CHAPTER 10 Agreement 235
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10-2 OFFER
Bargaining begins with an offer. The person who makes an offer is the offeror. The person to
whom he makes that offer is the offeree. The terms are annoying but inescapable because, like
handcuffs, all courts use them
Two questions determine whether a statement is an offer:
• Do the offeror’s words and actions indicate an intention to make a bargain?
• Are the terms of the offer reasonably definite?
Zachary says to Sharon, “Come work in my English language center as a teacher. I’ll
pay you $800 per week for a 35-hour week, for six months starting Monday.” This is a valid
offer. Zachary’s words seem to indicate that he intends to make a bargain and his offer is
definite. If Sharon accepts, the parties have a contract that either one can enforce.
In the section below, we present several categories of statements that are generally not
valid offers.
10-2a Statements That Usually Do Not Amount to
Offers
INVITATIONS TO BARGAIN
An invitation to bargain is not an offer. Suppose Martha telephones Joe and leaves a
message on his answering machine, asking if Joe would consider selling his vacation condo
on Lake Michigan. Joe faxes a signed letter to Martha saying, “There is no way I could sell
the condo for less than $150,000.” Martha promptly sends Joe a cashier’s check for that
amount. Does she own the condo? No. Joe’s fax was not an offer. It is merely an invitation to
negotiate. Joe is indicating that he might well be happy to receive an offer from Martha, but
he is not promising to sell the condo for $150,000 or for any amount.
PRICE QUOTES
A price quote is generally not an offer. If ImperialTextile sends a list of fabric prices for thenew
year to its regular customers, the list is not an offer. Once again, the law regards it merely as a
solicitation of offers. Suppose Ralph orders 1,000 yards of fabric, quoted in the list at $40 per yard.
Ralph is making the offer, and Imperial may decline to sell at $40, or at any price, for that matter.
This can be an expensive point to learn. Leviton Manufacturing makes electrical fixtures
and switches. Litton Microwave manufactures ovens. Leviton sent a price list to Litton, stating
what it would charge for specially modified switches for use in Litton’s microwaves. The price
letter included a statement greatly limiting Leviton’s liability in the event of any problem with
the switches. Litton purchased thousands of the switches and used them in manufacturing its
microwaves. But consumers reported fires due to defects in the switches. Leviton claimed that
under the contract it had no liability. But the court held that the price letter was not an offer. It
was a request to receive an offer. Thus the contract ultimately formed did not include Leviton’s
liability exclusion. Litton won over $4 million.1 See Exhibit 10.1.
LETTERS OF INTENT
In complex business negotiations, the parties may spend months bargaining over dozens of
interrelated issues. Because each party wants to protect itself during the discussions,
ensuring that the other side is serious without binding itself to premature commitments,
1Litton Microwave Cooking Products v. Leviton Manufacturing Co., Inc., 15 F.3d 790, 1994 U.S. App.
LEXIS 1876 (8th Cir. 1994).
Offeree
The person to whom an offer is
made.
Offeror
The person who makes an
offer.
236 U N I T 2 Contracts
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it may be tempting during the negotiations to draft a letter of intent. The letter might help
distinguish a serious party from one with a casual interest, summarize the progress made
thus far, and assist the parties in securing necessary financing. Usually, letters of intent do
not create any legal obligation. They merely state what the parties are considering, not what
they have actually agreed to. But note that is possible for a letter of intent to bind the parties
if its language indicates that the parties intended to be bound.
ADVERTISEMENTS
Mary Mesaros received a notice from the United States Bureau of the Mint, announcing a
new $5 gold coin to commemorate the Statue of Liberty. The notice contained an order
form stating:
VERY IMPORTANT—PLEASE READ: YES, Please accept my order for the U.S. Liberty
Coins I have indicated. I understand that all sales are final and not subject to refund. Verifica-
tion of my order will be made by the Department of the Treasury, U.S. Mint. If my order is
received by December 31, I will be entitled to purchase the coins at the Pre-Issue Discount
price shown.
Mesaros ordered almost $2,000 worth of the coins. But the Mint was inundated with so
many requests for the coin that the supply was soon exhausted. Mesaros and thousands of
others never got their coins. This was particularly disappointing because the market value of
the coins doubled shortly after their issue. Mesaros sued on behalf of the entire class of
disappointed purchasers. Like most who sue based on an advertisement, she lost.2An
advertisement is generally not an offer. An advertisement is merely a request for offers.
The consumer makes the offer, whether by mail, as above, or by arriving at a merchant’s
store ready to buy. The seller is free to reject the offer.
Advertisers should be careful, however, not to be too specific in their ads. Some ads do
count as offers, as the following case illustrates.
Orders Goods (without Limited Warranty)
Sends Price List (with Limited Warranty)
Delivers Goods
S
Leviton
Leviton
Leviton
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Litton
Litton
Litton
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EXHIB IT 10.1 The Litton case demonstrates why it is important to distinguish a
valid offer from a mere price quote. Leviton’s price list (including a
limited warranty) was not an offer. When Litton ordered goods (with
no limit to the warranty), it was making an offer, which Leviton
accepted by delivering the goods. The resulting contract did not
contain the limited warranty that Leviton wanted, costing that com-
pany a $4 million judgment.
2Mesaros v. United States, 845 F.2d 1576, 1988 U.S. App. LEXIS 6055 (Fed. Cir. 1988).
Letter of intent
A letter that summarizes
negotiating progress.
CHAPTER 10 Agreement 237
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Carlill lived 50 years more, dying at the age of 96—of the flu.
This case serves as a cautionary tale. Running a “normal” ad which describes a product,
its features, and its price does not amount to an offer. But, if a company proposes to take an
action—like pay $100 to customers who take certain, specific actions—then it may find itself
contractually obligated to follow through on its promises. The acceptance of the offer makes
a unilateral contract.
Note also that, regardless ofwhether an ad counts as an offer, consumers have protection from
those shopkeepers who are intent upon deceit. Almost every state has some form of consumer
protection statute, which outlaws false advertising. For example, an automobile dealer who
advertises a remarkably low price but then has only one automobile at that price has probably
violated a consumer protection statute because the ad was published in bad faith, to trick
consumers into coming to the dealership. In the Mesaros case, the United States Mint did not
violate any consumer protection statute because it acted in good faith and simply ran out of coins.
AUCTIONS
It is the property you have always dreamed of owning—and it is up for auction! You arrive
bright and early, stand in front, bid early, bid often, bid higher, bid highest of all—it’s yours!
For five seconds. Then, to your horror, the auctioneer announces that none of the bids were
Landmark Case
Facts: In the early 1890s,
English citizens greatly
feared the Russian flu.
The Carbolic Smoke Ball
Company ran a newspaper
ad that contained two key
passages:
“£100 reward will be
paidby theCarbolic Smoke
Ball Company to any per-
son who contracts the influenza after having used the ball
three times daily for two weeks according to the printed
directions supplied with each ball.
“£1000 is deposited with the Alliance Bank, shewing
our sincerity in the matter.”
The product was a ball that contained carbolic acid.
Users would inhale vapors from the ball through a long tube.
Carlill purchased a smoke ball and used it as directed
for two months. She then caught the flu. She sued, arguing
that because her response to the ad had created a contract
with the company, she was entitled to £100.
The trial court agreed, awarding Carlill the money.
The company appealed.
Issues: Did the advertisement amount to an offer? If so, was
the offer accepted?
Decision: Yes. The ad
was an offer that only
required performance to
become a binding con-
tract.
Reasoning: TheCarbolic
Smoke Ball Company
made an express and
unmistakable promise to
pay £100 under certain cir-
cumstances. Did the company intend to make this state-
ment a promise? It sure sounded like a promise. The com-
pany mentioned its bank deposit of £1000 as proof of its
sincerity and intention to comply.
Was this promise a binding offer? Generally, accep-
tance should be communicated to the offeror. But some
offers, like this one, do not require notice of acceptance. It
was obvious by the company’s words and the nature of the
transaction that it did not expect notice of acceptance, just
performance. Carlill’s use of the smoke ball was her
acceptance. Because she got the flu despite her efforts,
the company must pay her.
It is possible that many people who use the Carbolic
Smoke Ball will get the flu. Too bad for the company; it
must pay them all.
CARLILL V. CARBOLIC SMOKE
BALL COMPANY
1 QB 256
Court of Appeal, 1892
238 U N I T 2 Contracts
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juicy enough and he is withdrawing the property. Robbery! Surely he cannot do that? But
he can. Auctions are exciting and useful, but you must understand the rules.
Every day, auctions are used to sell exquisite works of art, real estate, and many other
things. Placing an item up for auction is not an offer—it is merely a request for an offer. The
bids are the offers. If and when the hammer falls, the auctioneer has accepted the offer.
The important thing to know about a particular auction is whether it is conducted with
or without reserve. Most auctions are with reserve, meaning that the items for sale have a
minimum price. The law assumes that an auction is with reserve unless the auctioneer
clearly states otherwise. The auctioneer will not sell anything for less than its reserve
(minimum price). So when the bidding for your property failed to reach the reserve, the
auctioneer was free to withdraw it.
The rules are different in an auction without reserve. Here, there is no minimum. Once
the first bid is received, the auctioneer must sell the merchandise to the highest bidder.
EXAM Strategy
Question: Ahn and Chet are both unhappy. (1) Ahn, an interior designer, is
working on a hotel project. In the annual catalog of a furniture wholesaler, she sees
that sofa beds cost $3,000. Based on the catalog, she sends an order for 100 sofa beds
to the wholesaler. The wholesaler notifies Ahn that the price has gone up to $4,000.
(2) At an estate auction, held without reserve, Chet is the highest bidder on a rare
violin. The seller considers Chet’s bid too low and refuses to sell. Both Ahn and Chet
sue, but only one will win. Which plaintiff will win, and why?
Strategy: (1) A contract requires an offer and an acceptance. When the furniture
wholesaler sent out its catalog, did it make an offer that Ahn could accept? (2) Chet
was high bidder. At some auctions, the high bidder is merely making an offer, but at
others, he wins the item. Which kind of auction was this?
Result: (1) A price quote is generally not an offer. Ahn’s order for 100 sofas was the
offer, and the company was free to reject it. Ahn loses. (2) Most auctions are with
reserve, meaning that the high bidder is merely making an offer. However, this one
was without reserve. Chet gets the violin.
10-2b Problems with Definiteness
It is not enough that the offeror indicates that she intends to enter into an agreement. The
terms of the offer must also be definite. If they are vague, then even if the offeree agrees to
the deal, a court does not have enough information to enforce it and there is no contract.
You want a friend to work in your store for the holiday season. This is a definite offer:
“I offer you a job as a sales clerk in the store from November 1 through December 29,
40 hours per week at $10 per hour.” But suppose, by contrast, you say: “I offer you a job as
a sales clerk in the store during the holiday season. We will work out a fair wage once we
see how busy things get.” Your friend replies, “That’s fine with me.” This offer is
indefinite, and there is no contract. What is a fair wage? $15 per hour? Or $20 per hour?
What is the “holiday season”? How will the determinations be made? There is no binding
agreement.
The following case, which concerns a famous television show, presents a problem with
definiteness.
CHAPTER 10 Agreement 239
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Ethics Was it fair for Chase to use Baer’s services without compensation? Did
Baer really expect to get paid, or was he simply hoping that his work would
land him a job?
BAER V. CHASE
392 F.3d 609
Third Circuit Court of Appeals, 2004
C A S E S U M M A R Y
Facts: David Chase was a television writer-producer with
many credits, including a detective series called The Rock-
ford Files. He became interested in a new program, set in
New Jersey, about a “mob boss in therapy,” a concept he
eventually developed into The Sopranos. Robert Baer was
a prosecutor in New Jersey who wanted to write for tele-
vision. He submitted a Rockford Files script to Chase, who
agreed to meet with Baer.
When they met, Baer pitched a different idea, con-
cerning “a film or television series about the New Jersey
Mafia.” He did not realize Chase was already working on
such an idea. Later that year, Chase visited New Jersey.
Baer arranged meetings for Chase with local detectives
and prosecutors, who provided the producer with informa-
tion, material, and personal stories about their experiences
with organized crime. Detective Thomas Koczur drove
Chase and Baer to various New Jersey locations and intro-
duced Chase to Tony Spirito. Spirito shared stories about
loan sharking, power struggles between family members
connected with the mob, and two colorful individuals
known as Big Pussy and Little Pussy, both of whom later
became characters on the show.
Back in Los Angeles, Chase wrote and sent to Baer a
draft of the first Sopranos teleplay. Baer called Chase and
commented on the script. The two spoke at least four times
that year, and Baer sent Chase a letter about the script.
When The Sopranos became a hit television show,
Baer sued Chase. He alleged that on three separate occa-
sions, Chase had agreed that if the program succeeded,
Chase would “take care of Baer, and would “remunerate
Baer in a manner commensurate to the true value of his
services.” This happened twice on the phone, Baer
claimed, and once during Chase’s visit to New Jersey.
The understanding was that if the show failed, Chase
would owe nothing. Chase never paid Baer anything.
The district court dismissed the case, holding that the
alleged promises were too vague to be enforced. Baer
appealed.
Issue: Was Chase’s promise definite enough to be enforced?
Decision: No.Thepromisewas too indefinite tobeenforced.
Affirmed.
Reasoning: To create a binding agreement, the offer and
acceptance must be definite enough that a court can tell
what the parties were obligated to do. The parties need to
agree on all the essential terms; if they do not, there is no
enforceable contract.
One of the essential terms is price. The agreement
must either specify the compensation to be paid or describe
a method by which the parties can calculate it. The duration
of the contract is also basic: How long do the mutual obliga-
tions last?
There is no evidence that the parties agreed on how
much Chase would pay Baer, or when, or for what period.
The parties never defined what they meant by the “true
value” of Baer’s services, or how they would determine it.
The two never discussed the meaning of “success” as
applied to The Sopranos. They never agreed on how “prof-
its” were to be calculated. The parties never discussed
when the alleged agreement would begin or end.
Baer argues that the courts shouldmake an exception to
the principle of definiteness when the agreement concerns
an “idea submission.” The problem with his contention is
that there is not the slightest support for it in the law. There
is no precedent whatsoever for ignoring the definiteness
requirement, in this type of contract or any other.
240 U N I T 2 Contracts
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EXAM Strategy
Question: Niels owned three adjoining parcels of land in Arizona ranging from 60 to
120 acres. Hannah wanted to buy one. The two had dinner in Chicago and then sketched
this agreement: “Binding Contract: Niels agrees to sell one of his three Arizona lots to
Hannah. Within 14 days, the parties will meet on the land, decide which lot Hannah is
buying, and settle on a price. If they cannot agree on a price, they will decide a fair
method of doing so. Both parties agree to be bound by this contract.”Each signed. When
theymeet in Arizona, Niels refuses to sell any land, andHannah sues. What will happen?
Strategy: Do not be fooled by wording such as “Binding Contract.” Focus on the
legal issues: Was there a meeting of the minds? Niels and Hannah thought they had a
contract—but courts make an objective assessment, not subjective. Did Niels make
an offer? Were the terms definite?
Result: Both parties believed they had a binding deal, and both parties were wrong.
There are two primary issues—which lot is being sold and how much will it cost—and
neither is specified. How are they to select a lot? What is a “fair method” of determining
price? Other issues are not touched upon: When will the deal close, how will payment be
made, what happens if Hannah cannot finance the purchase? The terms are too vague.
The parties never reached a meeting of the minds, and Hannah will lose her suit.
10-2c The UCC and Open Terms
In the last chapter, we introduced the Uniform Commercial Code (UCC). Article 2 of the
UCC governs contracts when the primary purpose is a sale of goods. Remember that goods
are moveable, tangible objects. Usually, UCC provisions are not significantly different from
common law rules. But on occasion, the UCC modifies the common law rule in some major
way. In such cases, we will present a separate description of the key UCC provision. The
UCC as a whole is covered in Unit 3. Depending on the class time available, some instructors
prefer to discuss the UCC separately, while others like to include it in the general discussion
of contracts. This book is designed to work with either approach.
We have just seen that, under the common law, the terms of an offer must be definite.
But under the UCC, many indefinite contracts are allowed to stand. Throughout this unit,
we witness how the UCC makes the law of sales more flexible. There are several areas of
contract law where imperfect negotiations may still create a binding agreement under the
Code, even though the same negotiations under the common law would have yielded no
contract. “Open terms” is one such area.
YumaCountyCorp. produced natural gas. Yumawanted a long-term contract to sell its gas so
that it could be certain of recouping the expenses of exploration and drilling. Northwest Central
Pipeline, which operated an interstate pipeline, also wanted a deal for 10 ormore years so it could
make its own distribution contracts, knowing it would have a steady supply of natural gas in
a competitive market. But neither Yuma nor Northwest wanted to make a long-term price
commitment, because over a period of years the price of natural gas could double—or crash.
Each party wanted a binding agreement without a definitive price. If their negotiations had been
governedby the common law, theywouldhave run smack into the requirement of definiteness—
no price, no contract. But because this was a sale of goods, it was governed by the UCC.
Under UCC §2-204(3), even though one or more terms are left open, a contract does not fail
for indefiniteness if the parties have intended to make a contract and there is a reasonably certain
basis for giving an appropriate remedy. Thus, a contract for the sale of goods may be enforced
when a key term is missing. Business executives may have many reasons to leave open a delivery
date, a price, or some other term. But note that the parties must still have intended to create a
contract. The UCC will not create a contract where the parties never intended one.
CHAPTER 10 Agreement 241
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In some cases, the contract will state how the missing term is to be determined. Yuma
County and Northwest drafted a contract with alternative methods of determining the price.
In the event that the price of natural gas was regulated by the Federal Energy Regulatory
Commission (FERC), the price would be the highest allowed by the FERC. If the FERC
deregulated the price (as it ultimately did), the contract price would be the average of the
two highest prices paid by different gas producers in a specified geographic area.
GAP-FILLER PROVISIONS
Even if a UCC contract lacks a specific method for determining missing terms, the Code
itself contains gap-filler provisions, which are rules for supplying missing terms. Some of the
most important gap-filler provisions of the Code follow.
Open Price In general, if the parties do not settle on a price, the Code establishes that
the goods will be sold for a reasonable price. This will usually be the market value or a price
established by a neutral expert or agency. (UCC §2-305.)
Output and Requirements Provisions An output contract obligates the seller to
sell all of his output to the buyer, who agrees to accept it. For example, a cotton grower
might agree to sell all of his next crop to a textile firm. A requirements contract obligates a
buyer to obtain all of his needed goods from the seller. A vineyard might agree to buy all of
its wine bottles from one supplier. Output and requirements contracts are by definition
incomplete, since the exact quantity of the goods is unspecified. The Code requires that in
carrying out such contracts, both parties act in good faith. Neither party may suddenly
demand a quantity of goods (or offer a quantity of goods) that is disproportionate to their
past dealings or their reasonable estimates. (UCC §2-306.)
10-2d Termination of Offers
Once an offer has been made, it faces only two possible fates—it can be terminated or
accepted. If an offer is terminated, it can never be accepted. If it is accepted, and if there are
no problems with any of the five remaining elements on the Contracts Checklist, then a
valid contract is created. Offers can be terminated in four ways: revocation, rejection,
expiration, and by operation of law.
TERMINATION BY REVOCATION
An offer is revoked when the offeror “takes it back” before the offeree accepts. In general,
the offeror may revoke the offer any time before it has been accepted. Imagine that I call
you and say, “I’m going out of town this weekend. I’ll sell you my ticket to this weekend’s
football game for $75.” You tell me that you’ll think it over and call me back. An hour later,
my plans change. I call you a second time and say, “Sorry, but the deal’s off—I’m going to
the game after all.” I have revoked my offer, and you can no longer accept it.
In the next case, this rule was worth $100,000 to one of the parties.
Gap-filler provisions
UCC rules for supplying missing
terms.
Output contract
Obligates the seller to sell all of
his output to the buyer, who
agrees to accept it.
Requirements contract
Obligates a buyer to obtain all
of his needed goods from the
seller.
NADEL V. TOM CAT BAKERY
2009 N.Y. Misc. LEXIS 5105
Supreme Court of New York, New York County, 2009
C A S E S U M M A R Y
Facts: A Tom Cat Bakery delivery van struck Eliza-
beth Nadel as she crossed a street. Having suffered
significant injuries, Nadel filed suit. Before the trial
began, the attorney representing the bakery’s
owner offered a $100,000 settlement, which Nadel
refused.
While the jurywasdeliberating, thebakery’s lawyer again
offered Nadel the $100,000 settlement. She decided to think
242 U N I T 2 Contracts
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MAKING CONTRACTS TEMPORARILY IRREVOCABLE
Some offers cannot be revoked, at least for a time. Often, people and businesses need time to
evaluate offers. If a car dealer offers you a green sedan for $25,000, youmay want to shop around
for a few days to try to find a better price. In the meantime, you may want to make sure that the
green sedan is still available if you decide to return. Can you legally prevent the car dealer from
selling the car to anyone else while you ponder the offer? In some circumstances, yes.
Option Contract (All Types of Contracts) With an option contract, an interested
purchaser buys the right to have the offer held open.The offeror may not revoke an offer during
the option period. Suppose you pay the car dealer $250 to hold open its offer until February 2.
Later that day, the dealership notifies you that it is selling to someone else. Result? You can
enforce your contract. The car dealer had no power to revoke because you purchased an option.
Firm Offers (UCC Contracts Only) Once again, the UCC has changed the law on
the sale of goods. If a promise made in writing is signed by a merchant, and if it agrees to hold
open an offer for a stated period, then an offer may not be revoked. The open period may
not exceed three months. So, if the car dealer gives you a piece of paper that reads, “The
offer on the green sedan is open at $25,000 until Friday at noon,” he cannot revoke the offer
before Friday at noon, even though you have not paid him anything. (UCC §2-205.)
TERMINATION BY REJECTION
If an offeree clearly indicates that he does not want to take the offer, then he has rejected it.
If an offeree rejects an offer, the rejection immediately terminates the offer. Suppose a major
accounting firm telephones you and offers a job, starting at $80,000. You respond, “Nah. I’m
gonna work on my surfing for a year or two.” The next day, you come to your senses and
write the firm, accepting its offer. No contract. Your rejection terminated the offer and
ended your power to accept it.
Counteroffer A party makes a counteroffer when it responds to an offer with a new and
different proposal. Frederick faxes Kim, offering to sell a 50 percent interest in the Fab
Hotel in New York for only $135 million. Kim faxes back and says, “That’s too much, but
I’ll pay $115 million.” Moments later, Kim’s business partner convinces her that Frederick’s
offer was a bargain, and she faxes an acceptance of his $135 million offer. Does Kim have a
binding deal? No. A counteroffer is a rejection. When Kim offered $115 million, she
rejected Frederick’s offer. Her original fax created a new offer, for $115 million, which
Frederick never accepted. The parties have no contract at any price.
about it during lunch.Later that day, the jury sent anote to the
judge. The bakery owner told her lawyer that if the note
indicated the juryhad reached averdict, that he should revoke
the settlement offer.
Back in the courtroom, the bakery’s lawyer said, “My
understanding is that there’s a note …. I was given an
instruction that if the note is a verdict, my client wants to
take the verdict.”
Nadel’s lawyer then said, “My client will take the
settlement. My client will take the settlement.”
The trial court judge allowed the forewoman to read
the verdict, which awarded Nadel—nothing. She appealed,
claiming that a $100,000 settlement had been reached.
Issue: Did Nadel’s lawyer accept the settlement offer in time?
Decision: No, the bakery owner’s lawyer revoked the
offer before acceptance.
Reasoning: An offer definitely existed. And the twice-
repeated statement, “My client will take the settlement,”
indicates a clear desire to accept the proposal. The pro-
blem is that the acceptance came too late.
Analyzing the timeline, the bakery owner’s attorney indi-
cated that if a verdict had been returned, he revoked the offer.
This notice was given before the attempted acceptance. And
so, since a verdict had in fact been returned, the offer was no
longer open.
The parties did not reach a binding settlement
agreement.
Counteroffer
A return offer and a rejection of
the original offer.
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TERMINATION BY EXPIRATION
An offeror may set a time limit. Quentin calls you and offers you a job in his next motion
picture. He tells you, “I’ve got to know by tomorrow night.” If you call him in three days to
accept, you are out of the picture. When an offer specifies a time limit for acceptance, that
period is binding.
If the offer specifies no time limit, the offeree has a reasonable period in which to accept.
A reasonable period varies, depending upon the type of offer, previous dealings between
the parties, and any normal trade usage or customary practices in a particular industry.
TERMINATION BY OPERATION OF LAW
In some circumstances, the law itself terminates an offer. If an offeror dies or becomes
mentally incapacitated, the offer terminates automatically and immediately. Arnie offers you
a job as an assistant in his hot-air balloon business. Before you can even accept, Arnie tumbles
out of a balloon at 3,000 feet. The offer terminates along with Arnie.
Destruction of the subject matter terminates the offer. A car dealer offers to sell you a
rare 1938 Bugatti for $7,500,000 if you bring cash the next day. You arrive, suitcase stuffed
with cash, just in time to see Arnie drop 3,000 feet through the air and crush the Bugatti.
The dealer’s offer is terminated.
10-3 ACCEPTANCE
As we have seen, when there is a valid offer outstanding, it remains effective until it is terminated
or accepted. An offeree accepts by saying or doing something that a reasonable person would
understand tomean that he definitelywants to take the offer. Assume thatEllie offers to sell Gene
her old iPod for $50. If Gene says, “I accept your offer,” then he has indeed accepted, but there is
no need to be so formal. He can accept the offer by saying, “It’s a deal,” or, “I’ll take it,” or any
number of things. He need not even speak. If he hands her a $50 bill, he also accepts the offer.
It is worth noting that the offeree must say or do something to accept. Marge telephones
Vick and leaves a message on his answering machine: “I’ll pay $75 for your business law
textbook from last semester. I’m desperate to get a copy, so I will assume you agree unless I
hear from you by 6:00 tonight.” Marge hears nothing by the deadline and assumes she has a
deal. She is mistaken. Vick neither said nor did anything to indicate that he accepted.
10-3a Mirror Image Rule
If only he had known! A splendid university, an excellent position as department chair—
gone. And all because of the mirror image rule.
Ohio State University wrote to Philip Foster offering
him an appointment as a professor and chair of the art
history department. His position was to begin July 1, and
he had until June 2 to accept the job. On June 2, Foster
telephoned the dean and left a message accepting the
position, effective July 15. Later, Foster thought better of it
and wrote the university, accepting the school’s starting
date of July 1. Too late! Professor Foster never did occupy
that chair at Ohio State. The court held that since his
acceptance varied the starting date, it was a counteroffer.
And a counteroffer, as we know, is a rejection.3
3Foster v. Ohio State University, 41 Ohio App. 3d 86, 534 N.E.2d 1220, 1987 Ohio App. LEXIS 10761
(Ohio Ct. App. 1987).
Was it sensible to deny the
professor a job over a mere
14-day difference? Sensible
or not, that is the law.
244 U N I T 2 Contracts
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Was it sensible to deny the professor a job over a mere 14-day difference? Sensible or
not, that is the law. The common lawmirror image rule requires that acceptance be on precisely
the same terms as the offer. If the acceptance contains terms that add or contradict the offer,
even in minor ways, courts generally consider it a counteroffer. The rule worked reasonably
well in the 19th century, when parties would write an original contract and exchange it,
penciling in any changes. But now that businesses use standardized forms to purchase most
goods and services, the rule creates enormous difficulties. Sellers use forms they have prepared,
with all conditions stated to their advantage, and buyers employ their own forms, with terms
they prefer. The forms are exchanged in the mail or electronically, with neither side clearly
agreeing to the other party’s terms.
The problem is known as the “battle of forms.” Once again, the UCC has entered the
fray, attempting to provide flexibility and common sense for those contracts involving the
sale of goods. But for contracts governed by the common law, such as Professor Foster’s, the
mirror image rule is still the law.
10-3b UCC and the Battle of Forms
UCC §2-207 dramatically modifies the mirror image rule for the sale of goods. Under this
provision, an acceptance that adds additional or different terms often will create a contract.
ADDITIONAL OR DIFFERENT TERMS
One basic principle of the common law of contracts remains unchanged: The key to creation
of a contract is a valid offer that the offeree intends to accept. If there is no intent to accept,
there is no contract. The big change brought about by UCC §2-207 is this: An offeree who
accepts may include in the acceptance terms that are additional to or different from those in
the offer. Thus, even with additional or different terms, the acceptance may well create a
contract.
Example A. Wholesaler writes to Manufacturer, offering to buy “10,000 wheelbarrows at $50 per
unit. Payable on delivery, 30 days from today’s date.” Manufacturer writes back, “We accept your
offer of 10,000 wheelbarrows at $50 per unit, payable on delivery. Interest at normal trade rates for
unpaid balances.” Manufacturer clearly intends to form a contract. The company has added a new
term, but there is still a valid contract.
However, if the offeree states that her acceptance is conditioned on the offeror’s assent to
the new terms, there is no contract.
Example B. Same offer as above. Manufacturer adds the interest rate clause and states, “Our
acceptance is conditional upon your agreement to this interest rate.” Manufacturer has made a
counteroffer. There is no contract, yet. If Wholesaler accepts the counteroffer, there is a contract;
if Wholesaler does not accept it, there is no contract.
Additional terms are those that bring up new issues, such as interest rates, not contained
in the original offer. Additional terms in the acceptance are considered proposals to add to
the contract. Assuming that both parties are merchants, the additional terms will generally
become part of the contract. Thus, in Example A, the interest rate will become a part of the
binding deal. If Wholesaler is late in paying, it must pay whatever interest rate is current.
In three circumstances, the additional terms in the acceptance do not become part of the
contract:
• If the original offer insisted on its own terms. In other words, if Wholesaler wrote, “I
offer to buy them on the following terms and no other terms,” then the Manufacturer is
not free to make additions.
• If the additional terms materially alter the original offer. Suppose Manufacturer wrote
back, “We accept your offer for 10,000 wheelbarrows. Delivery will be made within
Mirror image rule
Requires that acceptance be
on precisely the same terms as
the offer.
CHAPTER 10 Agreement 245
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180 days, unless we notify you of late delivery.” Manufacturer has changed the time
from 30 days to 180 days, with a possible extension beyond that. That is a material
alteration, and it will not become part of the contract. By contrast, Manufacturer’s new
language concerning “interest at normal trade rates” was not a material alteration, and
therefore that interest rate becomes part of the contract.
• If the offeror receives the additional terms and promptly objects to them.
Different terms are those that contradict terms in the offer. For example, if the seller’s
form clearly states that no warranty is included, and the buyer’s form says the seller warrants
all goods for three years, the acceptance contains different terms. An acceptance may
contain different terms and still create a contract. But in these cases, courts have struggled
to decide what the terms of the contract are. The majority of states hold that different
(contradictory) terms cancel each other out. Neither term is included in the contract.
Instead, the neutral terms from the Code itself are “read into” the contract. These are the
gap-filler terms discussed above. If, for example, the forms had contradictory warranty
clauses (as they almost always do), the different terms would cancel each other out, and
the warranty clauses from the UCC would be substituted.4
EXAM Strategy
Question: Elaine faxes an offer to Raoul. Raoul writes, “I accept. Please note, I will
charge 2 percent interest per month for any unpaid money.” He signs the document
and faxes it back to Elaine. Do the two have a binding contract?
Strategy: Slow down, this is trickier than it seems. Raoul has added a term to
Elaine’s offer. We must take two steps to decide whether there is a contract. In a
contract for services, acceptance must mirror the offer, but not so in an agreement for
the sale of goods.
Result: If this is an agreement for services, there is no contract. However, if this
agreement is for goods, the additional term may become part of an enforceable
contract.
Question: Assume that Elaine’s offer concerns goods. Is there an agreement?
Strategy: Under UCC §2-207, an additional term will become part of a binding
agreement for goods except in three instances. What are the three exceptions?
Result: Raoul’s extra term will be incorporated in a binding contract unless
(1) Elaine’s offer made clear she would accept no other terms; (2) Raoul’s interest
rate is a material alteration of the offer (almost never the case for interest rates); or
(3) Elaine promptly rejects the interest rate.
4Not all states follow this rule, however. Some courts have held that when the acceptance contains
terms that contradict those in the offer, the language in the offer should be final. A few courts have
ruled that the terms in the acceptance should control.
246 U N I T 2 Contracts
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10-3c Clickwraps and Shrinkwraps
You want to purchase Attila brand software and download it to your computer. You type in
your credit card number and other information, agreeing to pay $99. Attila also requires that
you “read and agree to” all of the company’s terms. You click “I agree,” without having read
one word of the terms. Three frustrating weeks later, tired of trying to operate defective
Attilaware, you demand a refund and threaten to sue. The company replies that you are
barred from suing because the terms you agreed to included an arbitration clause. To resolve
any disputes, you must travel to Attila’s hometown, halfway across the nation, use an arbitrator
that the company chooses, pay one-half the arbitrator’s fee, and also pay Attila’s legal bills if
you should lose. The agreement makes it financially impossible for you to get your money
back. Is that contract enforceable?
You have entered into a “clickwrap” agreement. Similar agreements, called “shrinkwraps,”
are packaged inside many electronic products. A shrinkwrap notice might require that before
inserting a purchased CD into your computer, you must read and agree to all terms in the
brochure. Clickwraps and shrinkwraps often include arbitration clauses. They frequently limit
the seller’s liability if anything goes wrong, saying that the manufacturer’s maximum responsi-
bility is to refund the purchase price (even if the software destroys your hard drive).
Many courts that have analyzed these issues have ruled that clickwrap and shrinkwrap
agreements are indeed binding, even against consumers. The courts have emphasized that
sellers are entitled to offer a product on any terms they wish, and that shrinkwrap and
clickwrap are the most efficient methods of including complicated terms in a small space.
Think before you click!5
However, some courts have refused to enforce such contracts against a consumer, stating
that the buyer never understood or agreed to the shrinkwrapped terms. The court in the
following case works hard to balance the competing interests, and in the process demon-
strates that this new area of law is very much in flux.
SPECHT V. NETSCAPE COMMUNICATIONS
CORPORATION
306 F.3d 17
Second Circuit Court of Appeals, 2002
C A S E S U M M A R Y
Facts: A group of plaintiffs sued Netscape, claiming that
two of the company’s products illegally captured private
information about files that they downloaded from the
Internet. The plaintiffs alleged that this was electronic
eavesdropping, in violation of two federal statutes.
From Netscape’s Web page, the plaintiffs had down-
loaded SmartDownload, a software plug-in that enabled them
to download the company’s Communicator software. The
Web page advertised the benefits of Smart-Download, and
near the bottom of the screen was a tinted button labeled
“Download.”Theplaintiffs clicked todownload. If, insteadof
downloading, they had scrolled further down, they would
have seen an invitation to “review and agree to the terms of
the Netscape SmartDownload software license agreement.”
By clicking the appropriate button, they would have been
sent to a series of linked pages, and finally arrived at a license
5ProCD, Inc. v. Zeidenberg, 86 F.3d 1447 (7th Cir. 1996), is the leading case to enforce shrinkwrap
agreements (and, by extension, clickwraps). Klocek v. Gateway, 104 F. Supp. 1332 (D. Kan. 2000), is
one of the few cases to reject such contracts. Klocek, however, was dismissed for failure to reach the
federal court $75,000 jurisdictional level.
CHAPTER 10 Agreement 247
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The plaintiffs in Specht won because they knew nothing about the arbitration clause and
were unlikely to discover it on the company’s website. Notice what happens when a user
does know about terms posted online. Register.com was a registrar of Internet domain
names, meaning that it issued domain names to people and companies establishing a new
website. The company was legally obligated to make available to the public, for free, the
names and contact information of its customers. Register was also in the business of assisting
owners, for a fee, to develop their websites.
Verio, Inc., competed in the site development business. Verio’s automated software
program (robot) would search Register.com daily, seeking information about new sites. After
Verio obtained contact information, a notice would appear on the Register site, stating:
By submitting a query, you agree that under no circumstances will you use this data to support
the transmission of mass unsolicited, commercial advertising or solicitation via email.
In fact, though, Verio used the contact information for exactly that purpose, sending
mass emailings to owners of new websites, soliciting their development business. Register
sued. Verio defended by stating it was not bound by the notice because the notice did not
appear until after it had obtained the information. Verio argued that when it sent the
queries, it was unaware of any restrictions on use of the data. The court was unpersuaded,
and explained its reasoning with a simple but telling metaphor:
The situation might be compared to one in which plaintiff P maintains a roadside fruit stand
displaying bins of apples. A visitor, defendant D, takes an apple and bites into it. As D turns to
leave, D sees a sign, visible only as one turns to exit, which says “Apples—50 cents apiece.” D
does not pay for the apple. D believes he has no obligation to pay because he had no notice
when he bit into the apple that 50 cents was expected in return. D’s view is that he never agreed
to pay for the apple. Thereafter, each day, several times a day, D revisits the stand, takes an
apple, and eats it. D never leaves money.
agreement. Among the terms was an agreement to arbitrate
any dispute. In other words, a consumer downloading Smart-
Download was in theory giving up the right to file suit if
anything went wrong, and agreeing to settle the dispute by
arbitration.However, the plaintiffs never reviewed the license
terms.
In the district court, Netscape moved to dismiss
the case and compel arbitration. Netscape claimed that the
plaintiffs had forfeited any right to sue based on the license
agreement. The district court denied the company’s motion,
ruling that the plaintiffs had not agreed to the terms of the
license. Netscape appealed.
Issue: Had the plaintiffs agreed to arbitrate their claims?
Decision: No, the plaintiffs did not agree to arbitration.
Reasoning: Netscape contends that if the plaintiffs had
scrolled down to the next screen, they would have dis-
covered the license terms. This means that they were on
notice of those terms and effectively agreed to them.
When a contract is based on paper documents, courts
often find that notice like this does bind the parties. If one
document adequately advises a party that the agreement
includes terms detailed in a second document, the terms
can be enforceable. The same principle sometimes applies
in the world of e-commerce, when pages contain pop-up
screens and hyperlinks to other sites. The question in this
case is whether the plaintiffs received sufficient notice of the
licensing terms. Did they give real consent to those terms?
What the plaintiffs saw was a screen filled with praise
for a fast, free plug-in called SmartDownload. The plain-
tiffs were urged to “Download Now!” At the very bottom
was a “Download” button. There was no immediately
visible notice that license terms were detailed elsewhere,
or that the company required assent to the terms.
The company claims that the position of the scroll bar
notified the plaintiffs that there was additional information
below the download button. This is unrealistic. A reason-
able person would not conclude from the scroll bar position
that important licensing terms were referred to farther
down. When consumers are urged to download free soft-
ware at the click of a button, a reference to license terms
placed on a submerged screen is not enough to put them
on notice of those terms. The plaintiffs never assented to
the terms.
The lower court denied the motion to compel arbitra-
tion. That order is affirmed.
248 U N I T 2 Contracts
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P sues D in contract for the price of the apples taken. D defends on the ground that on no
occasion did he see P’s price notice until after he had bitten into the apples. D may well prevail as
to the first apple taken. D had no reason to understand upon taking it that P was demanding the
payment. In our view, however, D cannot continue on a daily basis to take apples for free,
knowing full well that P is offering them only in exchange for 50 cents in compensation, merely
because the sign demanding payment is so placed that on each occasion D does not see it until he
has bitten into the apple.
Register.com won its case. Verio was prohibited from using the contact information for
mass emailings because it had actual knowledge of the restrictions placed on its use.6
10-3d Communication of Acceptance
The offeree must communicate his acceptance for it to be effective. The questions that typically
arise concern the method, the manner, and the time of acceptance.
METHOD AND MANNER OF ACCEPTANCE
The term “method” refers to whether acceptance is done in person or by mail, telephone,
email, or fax. The term “manner” refers to whether the offeree accepts by promising, by
making a down payment, by performing, and so forth. If an offer demands acceptance in a
particular method or manner, the offeree must follow those requirements. An offer might
specify that it be accepted in writing, or in person, or before midnight on June 23. An offeror
can set any requirements she wishes. Omri might say to Oliver, “I’ll sell you my bike for
$200. You must accept my offer by standing on a chair in the lunchroom tomorrow and
reciting a poem about a cow.” Oliver can only accept the offer in the exact manner specified
if he wants to form a contract.
If the offer does not specify a type of acceptance, the offeree may accept in any reason-
able manner and method. An offer generally may be accepted by performance or by a
promise, unless it specifies a particular method. The same freedom applies to the method. If
Masako faxes Eric an offer to sell 1,000 acres in Montana for $800,000, Eric may accept by
mail or fax. Both are routinely used in real estate transactions, and either is reasonable.
TIME OF ACCEPTANCE: THE MAILBOX RULE
An acceptance is generally effective upon dispatch, meaning the moment it is out of the
offeree’s control. Terminations, on the other hand, are effective when received. When
Masako faxes her offer to sell land to Eric, and he mails his acceptance, the contract is
binding the moment he puts the letter into the mail. In most cases, thismailbox rule is just a
detail. But it becomes important when the offeror revokes her offer at about the same time
the offeree accepts. Who wins? Suppose Masako’s offer has one twist:
• On Monday morning, Masako faxes her offer to Eric.
• On Monday afternoon, Eric writes, “I accept” on the fax, and Masako mails a
revocation of her offer.
• On Tuesday morning, Eric mails his acceptance.
• On Thursday morning, Masako’s revocation arrives at Eric’s office.
• On Friday morning, Eric’s acceptance arrives at Masako’s office.
Outcome? Eric has an enforceable contract. Masako’s offer was effective when it reached
Eric. His acceptance was effective on Tuesday morning, when he mailed it. Nothing that
happens later can “undo” the contract.
6Register.com v. Verio, Inc., 353 F.3d 393 (2d Cir. 2004).
Mailbox rule
Acceptance is generally
effective upon dispatch.
Terminations are effective
when received.
CHAPTER 10 Agreement 249
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Chapter Conclusion
The law of offer and acceptance can be complex. Yet for all its faults, the law is not
the principal source of dispute between parties unhappy with negotiations. Most litigation
concerning offer and acceptance comes from lack of clarity on the part of the people
negotiating. The many examples discussed are all understandable given the speed and
fluidity of the real world of business. But the executive who insists on clarity is likelier in
the long run to spend more time doing business and less time in court.
EXAM REVIEW
1. MEETING OF THE MINDS The parties can form a contract only if they have a
meeting of the minds, which requires that they understand each other and show that
they intend to reach an agreement. (p. 235)
SOLDAU V. ORGANON, INC.
860 F.2d 355, 1988 U.S. App. LEXIS 14757
Ninth Circuit Court of Appeals, 1988
C A S E S U M M A R Y
Facts: Organon fired John Soldau. Then the company
sent to him a letter offering to pay him double the normal
severance pay, provided Soldau would sign a full release,
that is, a document giving up any and all claims he might
have against Organon. The release was included with the
letter. Soldau signed it, dated it, and took it to the nearest
post office, where he deposited it in the mailbox. When he
returned home, Soldau discovered in the mail a check
from Organon for the double severance pay. He hustled
back to the post office, where he persuaded a postal clerk
to open the mailbox and retrieve the release he had
posted. He then cashed Organon’s check and finally filed
a suit against the company, alleging that his firing was age
discrimination.
The federal district court gave summary judgment for
Organon, ruling that Soldau’s acceptance of the proposed
release was effective when he mailed it, creating a con-
tract. He appealed.
Issue: Did Soldau create a contract by mailing the release?
Decision: Yes. Soldau created an enforceable contract.
Affirmed.
Reasoning: Soldau argues that federal law should govern
this case, not California law. In fact, it makes no difference
because both court systems use the “mailbox” rule. Accep-
tance is effective when dispatched. The U.S. Supreme
Court adopted the rule almost 100 years ago. Since then,
every court, treatise, and commentator has approved the
rule, both in the United States and most common law
countries. The mailbox rule offers a reasonable method of
balancing the risks between two parties. Leaving it as a
settled principle creates certainty in contract formation.
The moment Soldau put the envelope in the mail-
box, the company became obligated to give him double
severance pay, and he gave up any right to file suit.
250 U N I T 2 Contracts
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Question: Norv owned a Ford dealership and wanted to expand by obtaining a
BMW outlet. He spoke with Jackson and other BMW executives on several
occasions. Norv now claims that those discussions resulted in an oral contract that
requires BMW to grant him a franchise, but the company disagrees. Norv’s
strongest evidence of a contract is the fact that Jackson gave him forms on which
to order BMWs. Jackson answered that it was his standard practice to give such
forms to prospective dealers, so that if the franchise were approved, car orders
could be processed quickly. Norv states that he was “shocked” when BMW
refused to go through with the deal. Is there a contract?
Strategy: A court makes an objective assessment of what the parties did and said to
determine whether they had a meeting of the minds and intended to form a
contract. Norv’s “shock” is irrelevant. Do the order forms indicate a meeting of
the minds? Was there additional evidence that the parties had reached an
agreement? (See the “Result” at the end of this section.)
2. OFFER An offer is an act or statement that proposes definite terms and permits the
other party to create a contract by accepting those terms. (p. 235)
3. OTHER STATEMENTS Invitations to bargain, price quotes, letters of intent, and
advertisements are generally not offers. However, an ad in which a company proposes
to take a specific action when a customer takes a specific action can amount to an
offer. And letters of intent that indicate the parties intended to be bound can also
count as offers. (pp. 236–239)
Question: “Huge selection of Guernsey sweaters,” reads a newspaper ad from
Stuffed Shirt, a clothing retailer. “Regularly $135, today only $65.” Waldo arrives
at Stuffed Shirt at 4:00 that afternoon, but the shop clerk says there are no more
sweaters. He shows Waldo a newly arrived Shetland sweater that sells for $145.
Waldo sues, claiming breach of contract and violation of a consumer protection
statute. Who will prevail?
(a) Waldo will win the breach of contract suit and the consumer protection suit.
(b) Waldo will lose the breach of contract suit but might win the consumer
protection suit.
(c) Waldo will lose the consumer protection suit but should win the breach of contract suit.
(d) Waldo will win the consumer protection suit only if he wins the contract case.
(e) Waldo will lose both the breach of contract suit and the consumer
protection suit.
Strategy: Waldo assumes that he is accepting the store’s offer. But did Stuffed
Shirt make an offer? If not, there cannot be a contract. Does the consumer
protection statute help him? (See the “Result” at the end of this section.)
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CHAPTER 10 Agreement 251
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4. DEFINITENESS The terms of the offer must be definite, although under the
UCC the parties may create a contract that has open terms. (pp. 239–240)
5. TERMINATION An offer may be terminated by revocation, rejection, expiration,
or operation of law. (pp. 242–244)
Question: Rick is selling his Espresso Coffee Maker. He sends Tamara an email,
offering to sell the machine for $350. Tamara promptly emails back, offering to
buy the item for $300. She hears nothing from Rick, so an hour later Tamara stops
by his apartment, where she learns that he just sold the machine to his roommate
for $250. She sues Rick. Outcome?
(a) Tamara will win because her offer was higher than the roommate’s.
(b) Tamara will win because Rick never responded to her offer.
(c) Tamara will win because both parties made clear offers, in writing.
(d) Tamara will lose because she rejected Rick’s offer.
(e) Tamara will lose because her offer was not definite.
Strategy: A valid contract requires a definite offer and acceptance. Rick made a
valid offer. When Tamara said she would buy the machine for a lower amount, was
that acceptance? If not, what was it? (See the “Result” at the end of this section.)
6. MIRROR IMAGE RULE AND UCC §2-207 The common law mirror image
rule requires acceptance on precisely the same terms as the offer. Under the UCC, an
offeree may often create a contract even when the acceptance includes terms that are
additional to or different from those in the offer. (pp. 244–245)
7. CLICKWRAPS Clickwrap and shrinkwrap agreements are generally enforceable.
(pp. 247–249)
8. MANNER OF ACCEPTANCE If an offer demands acceptance in a particular
method or manner, the offeree must follow those requirements. If the offer does not
specify a type of acceptance, the offeree may accept in any reasonable manner and
medium. (p. 249)
9. MAILBOX RULE An acceptance is generally effective upon dispatch, meaning
from the moment it is out of the offeree’s control. Terminations usually are not
effective until received. (pp. 249 –250)
1. Result: The order forms are neither an offer nor an acceptance. Norv has offered no
evidence that the parties agreed on price, date of performance, or any other key terms.
There is no contract. Norv allowed eagerness and optimism to replace common
sense.7
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7Based on Arnold Pontiac-GMC, Inc. v. General Motors Co., 786 F.2d 564 (3d Cir. 1986).
252 U N I T 2 Contracts
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3. Result: An advertisement is usually not an offer, but merely a solicitation of one. It
is Waldo who is making the offer, which the store may reject. Waldo loses his contract
case, but he may win under the consumer protection statute. The correct answer is (b).
If Stuffed Shirt proclaimed “Huge selection” when there were only five sweaters, the
store was deliberately misleading consumers, and Waldo wins. However, if there was
indeed a large selection, and Waldo arrived too late, he is out of luck.
5. Result: Tamara made a counteroffer of $300. A counteroffer is a rejection.
Tamara rejected Rick’s offer and simultaneously offered to buy the coffee maker
at a lower price. Rick was under no obligation to sell to Tamara at any price. He will
win Tamara’s suit.
MULTIPLE-CHOICE QUESTIONS
1. Rebecca, in Honolulu, faxes a job offer to Spike, in Pittsburgh, saying, “We can pay
you $55,000 per year, starting June 1.” Spike faxes a reply, saying, “Thank you! I
accept your generous offer, though I will also need $3,000 in relocation money. See
you June 1. Can’t wait!” On June 1, Spike arrives, to find that his position is filled by
Gus. He sues Rebecca.
(a) Spike wins $55,000.
(b) Spike wins $58,000.
(c) Spike wins $3,000.
(d) Spike wins restitution.
(e) Spike wins nothing.
2. Arturo hires Kate to work in his new sporting goods store. “Look,” he explains, “I can
only pay you $9 an hour. But if business is good a year from now, and you’re still here,
I’m sure I can pay you a healthy bonus.” Four months later, Arturo terminates Kate.
She sues.
(a) Kate will win her job back, plus the year’s pay and the bonus.
(b) Kate will win the year’s pay and the bonus.
(c) Kate will win only the bonus.
(d) Kate will win only her job back.
(e) Kate will win nothing.
3. Manny offers to sell Gina his TV for $100 on January 1. On January 2, Gina writes
out a letter of acceptance. On January 3, Gina drops the letter in a mailbox. On
January 4, a postal worker gets the letter out of the mailbox and takes it to the post
office. On January 5, the letter arrives in Manny’s mailbox. When (if ever) was a
contract formed?
(a) January 2
(b) January 3
(c) January 4
(d) January 5
(e) None of the above—a contract has not been formed.
CHAPTER 10 Agreement 253
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4. Frank, an accountant, says to Missy, “I’ll sell you my laptop for $100.” Missy asks,
“Will you give me until tomorrow to make up my mind?” “Sure,” Frank replies.
Which of the following is true?
(a) Frank cannot revoke his offer, no matter what.
(b) Frank cannot revoke his offer, but only if Missy pays him to keep the offer open
until tomorrow.
(c) Frank can revoke his offer no matter what, because he is not a merchant.
(d) Frank can revoke his offer no matter what, because he did not promise Missy
anything in writing.
5. Which of the following amounts to an offer?
(a) Ed says to Carmen, “I offer to sell you my pen for $1.”
(b) Ed says to Carmen, “I’ll sell you my pen for $1.”
(c) Ed writes, “I’ll sell you my pen for $1,” and gives the note to Carmen.
(d) All of the above.
(e) (a) and (c) only.
ESSAY QUESTIONS
1. The town of Sanford, Maine, decided to auction off a lot it owned. The town advertised
that it would accept bids through the mail, up to a specified date. Arthur and Arline
Chevalier mailed in a bid that turned out to be the highest. When the town refused to
sell them the lot, they sued. Result?
2. The Tufte family leased a 260-acre farm from the Travelers Insurance Co. Toward
the end of the lease, Travelers mailed the Tuftes an option to renew the lease. The
option arrived at the Tuftes’ house on March 30, and gave them until April 14 to
accept. On April 13, the Tuftes signed and mailed their acceptance, which Travelers
received on April 19. Travelers claimed there was no lease and attempted to evict the
Tuftes from the farm. May they stay?
3. Consolidated Edison Co. of New York (Con Ed) sought bids from General Electric
Co. (GE) and others to supply it with two huge transformers. Con Ed required that
the bids be held open for 90 days. GE submitted a written bid and included a clause
holding the bid open for 90 days. During that period, Con Ed accepted GE’s bid, but
GE refused to honor it. Is there a contract?
4. The Dukes leased land from Lillian Whatley. Toward the end of their lease,
they sent Ms. Whatley a new contract, renewing the lease for three years and
giving themselves the option to buy the land at any time during the lease for
$50,000. Ms. Whatley crossed out the clause giving them an option to buy. She
added a sentence at the bottom, saying, “Should I, Lillian Whatley, decide to
sell at end [sic] of three years, I will give the Dukes the first chance to buy.”
Then she signed the lease, which the Dukes accepted in the changed form.
They continued to pay the rent until Ms. Whatley sold the land to another
couple for $35,000. The Dukes sued. Are the Dukes entitled to the land at
$50,000? At $35,000?
254 U N I T 2 Contracts
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5. YOU BE THE JUDGE WRITING PROBLEM Academy Chicago Publishers
(Academy) approached the widow of author John Cheever about printing some of his
unpublished stories. She signed a contract, which stated:
The Author will deliver to the Publisher on a mutually agreeable date one copy of the
manuscript of the Work as finally arranged by the editor and satisfactory to the Publisher in
form and content …. Within a reasonable time and a mutually agreeable date after delivery
of the final revised manuscript, the Publisher will publish the Work at its own expense, in
such style and manner and at such price as it deems best, and will keep the Work in print
as long as it deems it expedient.
Within a year, Academy had located and delivered to Mrs. Cheever more than
60 unpublished stories. But she refused to go ahead with the project. Academy sued for
the right to publish the book. The trial court ruled that the agreement was valid; the
appeals court affirmed; and the case went to the Illinois Supreme Court. Was Academy’s
offer valid, and was the contract enforceable? Argument for Mrs. Cheever: The
agreement is too vague to be enforceable. None of the essential terms are specified: the
number of stories, their length, who selects them, the date of publication, the size or cost
of the book, or anything else. There is no contract. Argument for Academy: Mrs.
Cheever wanted to publish this book and agreed in writing to help Academy do so. Both
parties understood the essential nature of the book and were willing to permit some
flexibility, to ensure a good edition. She has no right to back out now.
DISCUSSION QUESTIONS
1. Advertisements usually do not amount to offers. Is
this fair? Should businesses have legal obligations
to sell items at an advertised price?
2. Most auctions are held “with reserve.” If you place
the highest bid at such an auction, and if your bid
is below the reserve, then you do not get the item.
Is this fair? Should the law award you the item at
the price you bid?
3. Someone offers to sell you a concert ticket for $50,
and you reply, “I’ll give you $40,” The seller
refuses to sell at the lower price, and you say, “OK,
OK, I’ll pay you $50.” Clearly, no contract has
been formed, because you made a counteroffer. If
the seller has changed her mind and no longer
wants to sell for $50, she doesn’t have to. But is
this fair? If it is all part of the same conversation,
should you be able to accept the $50 offer and get
the ticket?
4. If you click an “I agree” box, odds are that its
terms are binding on you, even if the box contains
dozens or even hundreds of lines of dense text.
Is this fair? Should the law change to limit the
enforceability of clickwraps?
5. Courts stick to objective (reasonable person)
standards when evaluating offers and
acceptances. Juries are not asked to “get inside
someone’s head”; they are instructed to
determine what a reasonable person would think
of offerors’ and offereees’ statements. Is this
practice reasonable? Would it be better if the
law directly considered whether people wanted to
make contracts?
CHAPTER 10 Agreement 255
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CHAPTER11
CONSIDERATION
Have you ever rented a movie that you did not
want every one of your friends to know about?
Cathryn Harris did. Imagine her shock when she
rented a movie online from Blockbuster, only to
find out that this news was automatically trans-
mitted to her Facebook page and then broadcast
to all her “friends.” Just think how bad that
could be.
Harris sued Blockbuster for this violation of
her privacy, only to find out she had clicked
away her right to sue. To rent the movie, she
had had to click that little box saying she agreed
to all the terms and conditions. And one of those terms
and conditions was an agreement to arbitrate, not
litigate. Can Blockbuster get away with this?
It turns out that this movie has a happy ending. The
court ruled that the contract between Harris and
Blockbuster was unenforceable because there was no
consideration.
To rent the movie, she
had to click that little box
saying she agreed to all
the terms and conditions.
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Consideration is our next step on the road to understanding contracts. In the last chapter, we
learned what it takes to create an agreement. But an agreement is not necessarily a legally
enforceable contract.
This is the first of four chapters that will examine problems that can prevent an
agreement from becoming a contract. A lack of consideration is one of them. Without it, a
promise is “just a promise” and nothing more.
11-1 WHAT IS CONSIDERATION?
The central idea of consideration is simple: Contracts must be a two-way street. If one side
gets all the benefit and the other side gets nothing, then an agreement lacks consideration
and is not an enforceable contract.
There are three rules of consideration:
1. Both parties must get something of measureable value from the contract. That
thing can be money, boots, an agreement not to sue, or anything else that has
real value.
2. A promise to give something of value counts as consideration. A promise to mow
someone’s lawn next week is the equivalent of actually doing the yard work when
evaluating whether consideration exists.
3. The two parties must have bargained for whatever was exchanged and struck a deal:
“If you do this, I’ll do that.” If you just decide to deliver a cake to your neighbor’s
house without her knowing, that may be something of value, but since you two did
not bargain for it, there is no contract, and she does not owe you the price of the cake.
Let’s take an example: Sally’s Shoe Store and Baker Boots agree that she will pay
$20,000 for 100 pairs of boots. They both get something of value—Sally gets the boots,
Baker gets the money. A contract is formed when the promises are made because a promise
to give something of value counts. The two have bargained for this deal, so there is valid
consideration.
Now for an example where there is no consideration. Marvin works at Sally’s. At 9 a.m.,
he is in a good mood and promises to buy his coworker a Starbucks latte during the lunch
hour. The delighted coworker agrees. Later that morning, the coworker is rude to Marvin,
who then changes his mind about buying the coffee. He is free to do so. His promise created
a one-way street: The coworker stood to receive all the benefit of the agreement, while
Marvin got nothing. Because Marvin received no value, there is no contract.
11-1a What Is Value?
As we have seen, an essential part of consideration is that both parties must get something
of value. That item of value can be either an “act” or a “forbearance.”
ACT
A party commits an act when she does something she was not legally required to do in the
first place. She might do a job, deliver an item, or pay money, for example. An act does not
count if the party was simply complying with the law or fulfilling her obligations under an
existing contract. Thus, for example, suppose that your professor tells the university that she
will not post final grades unless she is paid an extra $5,000. Even if the university agrees to
this outrageous demand, that agreement is not a valid contract because the professor is
already under an obligation to post final grades.
Offer
Acceptance
Contracts Checklist
Legality
Capacity
Consent
Writing
Consideration
Act
Any action that a party was not
legally required to take in the
first place.
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CHAPTER 11 Consideration 257
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FORBEARANCE
A forbearance is, in essence, the opposite of an act. A plaintiff forbears if he agrees not to do
something he had a legal right to do. An entrepreneur might promise a competitor not to
open a competing business, or an elderly driver (with a valid driver’s license) might promise
concerned family members that he will not drive at night.
Let’s apply these ideas to the most famous of all consideration lawsuits. Our story
begins in 1869, when a well-meaning uncle makes a promise to his nephew. Ever since
Hamer v. Sidway appeared, generations of American law students have dutifully inhaled the
facts and sworn by its wisdom; now you, too, may drink it in.
The issue of value in a contract is an important one, so let’s look at another case. In the
movies, when a character wants to get serious about keeping a promise—really serious—he
sometimes signs an agreement in blood. As it turns out, this kind of thing actually happens
in real life. In the following case, did the promise of forbearance have value? Did a contract
signed in blood count? You be the judge.
Landmark Case
Facts: This is a story
with two Stories. William
Story wanted his nephew
to grow up healthy and
prosperous. In 1869, he
promised the 15-year-old
boy (also William Story)
$5,000 if the lad would
refrain from drinking liquor,
using tobacco, swearing,
and playing cards or billiards for money until his twenty-first
birthday. (In that wild era—can you believe it?—the nephew
had a legal right to do all those things.) The nephew agreed
and, what is more, he kept his word. When he reached his
twenty-first birthday, the nephew notified his uncle that he
had honored the agreement. The uncle congratulated the
young man and promised to give him the money, but he said
he would wait a few more years before handing over the cash,
until the nephew was mature enough to handle such a large
sum. The uncle died in 1887 without having paid, and his
estate refused to honor the promise. Because the nephew had
transferred his rights in themoney, it was aman namedHamer
who eventually sought to collect from the uncle’s estate. The
estate argued that since the nephew had given no considera-
tion for the uncle’s promise, there was no enforceable contract.
The trial court found for the plaintiff, and the uncle’s estate
appealed.
Issue: Did the nephew
give consideration for the
uncle’s promise?
Decision: Yes, the nep-
hew’s conduct was valid
consideration and the con-
tract must be enforced.
Reasoning: The uncle’s
estate argues that the con-
duct, far from harming the
boy, actually aided him. Because it is wise to avoid tobacco,
alcohol, and gambling, the nephew’s decision to give up those
vices could never be consideration for a contract. The agree-
ment could be enforced only if the behavior somehow bene-
fited the uncle—which it did not. The estate’s argument,
however, is unpersuasive. Courts do not and should not ask
whether agreed-on behavior actually helps anyone. What mat-
ters is simply this: Did one party do something or refrain from
doing something at the request of the other party? If so, that
conduct or forbearance is consideration, and the contract is
enforceable.
Before making the agreement, the nephew had law-
fully used alcohol and tobacco. When his uncle promised
him $5,000, the nephew gave up the various activities,
restricting his freedom of action for several years. Because
the nephew did what his uncle requested, the contract
must be enforced whether or not anyone benefited.
HAMER V. SIDWAY
124 N.Y. 538, 27 N.E. 256, 1891 N.Y. LEXIS 1396
New York Court of Appeals, 1891
C A S E S U M M A R Y
Forbearance
Refraining from doing
something that one has a legal
right to do.
258 U N I T 2 Contracts
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11-1b Adequacy of Consideration
Gold can make people crazy. At the turn of the 20th century, John Tuppela joined the gold
rush to Alaska. He bought a mine and worked it hard, a disciplined man in an unforgiving
enterprise. Sadly, his prospecting proved futile and mental problems overwhelmed him. In
1914, a court declared him insane and locked him in an institution in Portland, Oregon. Four
years later, Tuppela emerged and learned to his ecstasy that gold had been discovered in his
mine, now valued at over half a million dollars. Then the bad news hit: A court-appointed
guardian had sold the mine for pennies while Tuppela was institutionalized. Destitute and
forlorn, Tuppela turned to his lifelong friend, Embola, saying, “If you will give me $50 so I
can go to Alaska and get my property back, I will pay you $10,000 when I win my property.”
Embola accepted the offer, advancing the $50.
After a long and bitter fight, Tuppela won back his mine, though a guardian would still
supervise his assets. Tuppela asked the guardian to pay the full $10,000 to Embola, but the
guardian refused. Embola sued, and the issue was whether his $50 was adequate consideration
to support Tuppela’s promise of $10,000. A happy ending: Embola won and recovered his
money.
Courts seldom inquire into the adequacy of consideration. Although the difference
between Embola’s $50 and Tuppela’s $10,000 was huge, it was not for a court to decide
You Be the Judge
Facts: Stephen Sonwas a
part owner and operator of
two corporations. Because
the businesses were cor-
porations, Sonwas not per-
sonally liable for the debts
of either one.
Jinsoo Kim invested a total of about $170,000 in the
companies. Eventually, both of them failed, and Kim lost
his investment. Son felt guilty over Kim’s losses.
Later, Son and Kim met in a sushi restaurant and
drank heroic quantities of alcohol. At one point, Son
pricked his finger with a safety pin and wrote the follow-
ing in his own blood: “Sir, please forgive me. Because of
my deeds, you have suffered financially. I will repay you
to the best of my ability.” In return, Kim agreed not to sue
him for the money owed.
Son later refused to honor the bloody document and
pay Kim the money. Kim filed suit to enforce their contract.
The judge determined that the promise did not create a
contract because there had been no consideration.
You Be the Judge: Was there consideration?
Argument for Kim: As a part of the deal made at the sushi
restaurant, Kim agreed not to sue Son. What could be more of
a forbearance than that? Kim had a right to sue at any time, and
he gave the right up. Even
if Kim was unlikely to win,
Son would still prefer not to
be sued.
Besides, the fact that
Son signed the agreement
in blood indicates how ser-
iously he took the obligation to repay his loyal investor. At a
minimum, Son eased his guilty conscience by making the
agreement, and surely that is worth something.
Argument for Son: Who among you has not at one
point or another become intoxicated, experienced emo-
tions more powerful than usual, and regretted them the
next morning? Whether calling an ex-girlfriend and pro-
fessing endless love or writing out an agreement in your
own blood, it is all the same.
A promise not to file a meritless lawsuit has no value at
all. It did not matter to Son whether or not Kim filed suit
because Kim could not possibly win. If this promise counts as
value, then the concept of consideration is meaningless
because anyone can promise not to sue anytime. Son had
no obligation to pay Kim. And the bloody napkin does not
change that fact because it was made without consideration
of any kind. It is an ordinary promise, not a contract that
creates any legal obligation.
KIM V. SON
2009 Cal. App. LEXIS 2011
Court of Appeal of California, 2009
CHAPTER 11 Consideration 259
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whether the parties had made an intelligent bargain. Embola undertook a risk, and his $50
was valid consideration. The question of adequacy is for the parties as they bargain, not for
the courts.
Law professors often call this the “peppercorn rule,” a reference to a Civil War–era case
in which a judge mused, “What is a valuable consideration? A peppercorn.”1 Even the tiniest
benefit to a plaintiff counts, so long as it has a measureable value.
EXAM Strategy
Question: 50 Cent has been rapping all day, and he is very thirsty. He pulls his
Ferrari into the parking lot of a convenience store. The store turns out to be closed,
but luckily for him, a PepsiCo machine sits outside. While walking over to it, he
realizes that he has left his wallet at home. Frustrated, he whistles to a 10-year-old kid
who is walking by. “Hey kid!” he shouts. “I need to borrow fifty cents!” “I know who
you are!” the kid replies. Fiddy tries again. “No, no, I need to borrow fifty cents!”
The kid walks over. “Well, I’m not going to just give you my last fifty cents. But
maybe you can sell me something.” 50 Cent cannot believe it, but he really is very
thirsty. He takes off a Rolex, which is his least expensive bling. “How about this?”
“Deal,” the kid says, handing over two quarters. Is the kid entitled to keep the watch?
Strategy: Even in extreme cases, courts rarely take an interest in how much
consideration is given, or whether everyone got a “good deal.” Even though the
Rolex is worth thousands of times more than the quarters, the quarters still count
under the peppercorn rule.
Result: After this transaction, 50 Cent may have second thoughts, but they will be
too late. The kid committed an act by handing over his money—he was under no
legal obligation to do so. And 50 Cent received something of small but measureable
value. So there is consideration to support this deal, and 50 Cent would not get his
watch back.
11-1c Illusory Promises
Annabel calls Jim and says, “I’ll sell you my bicycle for 325 bucks. Interested?” Jim says,
“I’ll look at it tonight in the bike rack. If I like what I see, I’ll pay you in the morning.” At
sunrise, Jim shows up with the $325, but Annabel refuses to sell. Can Jim enforce their deal?
No. He said he would buy the bicycle if he liked it, keeping for himself the power to get out
of the agreement for any reason at all. He is not committing himself to do anything, and the
law considers his promise illusory—that is, not really a promise at all. An illusory promise is
not consideration. Because he has given no consideration, there is no contract, and neither
party can enforce the deal.
Let’s revisit the Blockbuster case from the opening scenario. Blockbuster’s clickwrap
box read, in part:
Blockbuster may at any time, and at its sole discretion, modify these Terms and Conditions of
Use, including without limitation the Privacy Policy, with or without notice. Such modifications
will be effective immediately upon posting.
1Hobbs v. Duff, 23 Cal. 596 (1863).
260 U N I T 2 Contracts
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Because Blockbuster had the ability to change the rules at any time for any reason, the
court determined that the contract was illusory and that Harris was not bound by Blockbus-
ter’s arbitration clause.2
11-2 APPLICATIONS OF CONSIDERATION
We will spend the remainder of the chapter looking at specific situations in which con-
sideration plays a central role.
11-2a The UCC: Consideration in Requirements and
Output Contracts
In a requirements contract, the buyer agrees to purchase 100 percent of her goods from one
seller. The seller agrees to sell the buyer whatever quantity she reasonably needs. The
quantity is not stated in the contract, though it may be estimated based on previous years or
best calculations. The common law regarded requirements contracts as void because the
buyer held all the power. She could purchase a vast quantity or none at all. She was making
no commitment, and hence was giving no consideration. Common law courts refused to
enforce requirements contracts, as well as their counterpart, output contracts.
In an output contract, the seller guarantees to sell 100 percent of its output to one
buyer, and the buyer agrees to accept the entire quantity. For example, a timber company
might agree to sell all of its wood products to a lumber wholesaler. The common law
frowned on this because now it was the seller who was making no real commitment.
The problem with the common law rule was that many merchants valued these contracts.
Consider the utility of requirements contracts. From the buyer’s viewpoint, a requirements
contract provides flexibility. The buyer can adjust purchases based on consumer demands. The
agreement also guarantees her a source of goods in a competitive market. For a seller, the
requirements agreement will ensure him at least this one outlet and will prevent competitors
from selling to this buyer. The contract should enable the seller to spend less on marketing and
may enable him to predict sales more accurately. Output contracts have similar value.
The UCC responded in a forthright fashion: Section 2-306 expressly allows output and
requirements contracts in the sale of goods.3 However, the Code places one limitation on
how much the buyer may demand (or the seller may offer):
A term which measures the quantity by the output of the seller or the requirements of the buyer
means such actual output or requirements as may occur in good faith, …
The “good faith” phrase is critical. In requirements contracts, courts have ruled that it is
the “good faith” that a buyer brings to the deal that represents her consideration.4 In other
words, by agreeing to act in good faith, she actually is limiting her options. Because she is
obligating herself, the deal becomes binding. Beware that this is not just wordplay. A buyer
must make its requirement demands in good faith, based on the expectations the parties had
when they signed the deal.
2Harris v. Blockbuster Inc., 622 F. Supp. 2d 396 (N.D. Tex. 2009).
3UCC §2-306(2) permits a related type of contract, the exclusive dealing agreement. Here, either a buyer or
a seller of goods agrees to deal exclusively with the other party. The results are similar to an output or
requirements agreement. Once again, one party is receiving a guarantee in exchange for a promise that the
common law would have considered illusory. Under the Code, such a deal is enforceable.
4Famous Brands, Inc. v. David Sherman Corp., 814 F.2d 517, 1987 U.S. App. LEXIS 3634 (8th Cir.
1987).
CHAPTER 11 Consideration 261
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Suppose that you operate a T-shirt business. You and a wholesaler agree on a two-year
requirements contract with a fixed price of $3 per T-shirt and an estimate of 150 T-shirts per
week. If business is slow the first two months, you are permitted to purchase only 25 T-shirts
per week if that is all you are selling. Should sales suddenly boom and you need 200 per week,
you may also require that many. Both of those demands are made in good faith. But suppose
the price of cotton skyrockets and the wholesale cost of T-shirts everywhere suddenly doubles.
You have a two-year guaranteed price of $3 per T-shirt. Could you demand 2,000 T-shirts per
week, knowing that you will be able to resell the shirts to other retailers for a big profit? No.
That is not acting in good faith based on the original expectations of the parties. Thewholesaler
is free to ignore your exorbitant demand. The legal requirement has come full circle: Your good
faith is valid consideration and makes the deal enforceable—but it is binding on you, too.
EXAM Strategy
Question: Will bought simple wood furniture and custom-painted it for sale to
interior designers. He entered into a written agreement to buy all the furniture he
needed, for two years, from Wood Knot, Inc. Wood Knot agreed to supply Will with
all the furniture he requested. During the second year, Will’s business grew, and he
requested 28 percent more furniture than in the first year. Wood Knot would not
deliver unless Will would pay a higher price per unit, which Will would not. Will
sued. What kind of a contract was this? Will Will win? Why or why not?
Strategy: Because this agreement did not specify the quantity of goods being sold,
we know that it was either a requirements contract or an output contract. Review the
difference between the two. Which was this agreement? These contracts are now
legal, with one major limitation. What is that limitation? Apply it here.
Result: This was a requirements contract because Will agreed to purchase all his
furniture from Wood Knot. Under the UCC, requirements contracts are enforceable,
provided the buyer makes his demands in good faith. Will’s increased order was a
result of his booming business. Indeed, he entered into this agreement to protect his
ability to grow his company. He made the request in good faith, the contract is
enforceable, and yes—Will will win.
11-2b Preexisting Duty
As we have seen, a promise to do something that a party is
already obligated to do is not consideration. Of course,
exceptions are the spice of law, and the preexisting duty
rule provides us with a rackful. Courts have created these
exceptions because a rigid application of the rule might
interfere with legitimate business goals.
EXCEPTION: ADDITIONAL WORK
When a party agrees to do something above and beyond what he is obligated to do, his
promise is generally valid consideration. Cecil has promised to build a fabulous swimming
pool/cabana for Nathalie for $250,000. When the work is half complete, he offers to build
the cabana out of seashells rather than pine wood. If Nathalie agrees to a new price of
$300,000 for the pool complex, she is obligated to pay because Cecil’s extra work is valid
consideration for her promise.
Of course, exceptions are
the spice of law …
262 U N I T 2 Contracts
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EXCEPTION: MODIFICATION
If both parties agree that a modification is necessary, the surest way to accomplish that is to
rescind the original contract and draft a new one. To rescind means to cancel. Thus, if neither
party has completed its obligations, the agreement to rescind will terminate each party’s rights
and obligations under the old contract. This should be done in writing. Then the parties sign
the new agreement. Courts will generally enforce a rescission and modification provided both
parties voluntarily entered into it, in good faith. If one side, determined to earn greater profits,
unfairly coerces the other into the changes, the modification is invalid.
Once again, the UCC has changed the common law, making it easier for merchants to
modify agreements for the sale of goods. UCC §2-209 provides:
• An agreement modifying a contract within this Article needs no consideration to be
binding.
• A signed agreement which excludes modification or rescission except by a signed
writing cannot be otherwise modified or rescinded.
Here is how these two provisions work together. Mike’s Magic Mania (MMM) agrees to
deliver 500 rabbits and 500 top hats to State University for the school’s Sleight of Hand 101
course. The goods, including 100 cages and 1,000 pounds of rabbit food, are to arrive no
later than September 1, in time for the new semester, with payment on delivery. By
September 20, no rabbits have appeared, in or out of hats. The university buys similar
products from another supply house at a 25 percent steeper price and sues MMM for the
difference. Mike claims that in early September, the dean had orally agreed to permit delivery in
October. The dean is on sabbatical in Tahiti and cannot be reached for comment. Is the alleged
modification valid?
Under the common law, the modification would have been void because MMM gave
no consideration for the extended delivery date. However, this is a sale of goods, and under
UCC §2-209, an oral modification may be valid even without consideration. Unfortunately
for Mike, though, the original agreement included a clause forbidding oral modification. Any
changes had to be in writing, signed by both parties. Mike never obtained such a document.
Even if the dean did make the oral agreement, the university wins.
The following case arose in a setting that is traumatic and lamentably common: A
homeowner could not make his mortgage payments. Foreclosure loomed. Did the parties
agree to save the home?
You Be the Judge
Facts: Herbert White
owned a house in Atlanta.
He refinanced his home
through Citizens Trust
Bank, but fell behind
on his loan payments. He
owed about $43,000. The
bank notified White that it
intended to foreclose. After some delays, the bank sent
White a formal notice that it would sell his house at a
foreclosure sale on the courthouse steps, on May 7. The
finance agreement provided that if the bank foreclosed,
White owed the full amount.
On that date, White
arrived and offered the bank
$35,000 to stop the foreclo-
sure. The bank’s collection
manager, D.J. Hughlett,
accepted the money and
drafted a letter, which he
andWhite signed:
Citizens Trust Bank agrees to postpone the foreclo-
sure [based on] a payment of $33,000 in certified funds
and a possible $2,000 from the account of Cora
White Cummings on the above-referenced property. Our
Attorney, William A. Broughman, will forward to you a
CITIZENS TRUST BANK
V. WHITE
274 Ga.App.508, 618 S.E.2d 9
Georgia Court of Appeals, 2005
CHAPTER 11 Consideration 263
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EXAM Strategy
Question: Star Struck, a Hollywood talent agency, employs Puneet as one of its
young agents and Max as a part-time delivery boy. Puneet’s contract is for one year.
She earns $5,000 per month, payable on the last day of each month. After she has
worked at the firm for four months, a Star Struck executive says to her, “We are
having cash flow problems. We cannot pay you this month, and will probably fall
about two months behind. However, if you will agree to do Max’s job for the next few
months, we can pay you on time.” Puneet cheerfully agrees to the deal. However,
after a few weeks of the extra labor, Puneet confesses that she is overwhelmed and
can no longer do Max’s job. Star Struck fires her. Puneet sues. Was there a binding
agreement for Puneet to do Max’s work?
Strategy: Star Struck made an offer to Puneet and she accepted it. But a contract
needs more than offer and acceptance. Both parties must give consideration. Had they
done more than they were required to do under their preexisting duty?
Result: A promise to do what a party is already obligated to do is not consideration.
Star Struck was required to pay Puneet every month, so its “offer” included no
consideration. Without consideration, there can be no agreement. Puneet was not
obligated to do Max’s job, and she will win this lawsuit.
written agreement, for your signature, to consummate this
transaction. The payoff balance as of 11:05 a.m. is
$7,986.43. If his sister pays the $2,000, the balance will
be $5,986.43.
White did pay the extra $2,000. Hughlett decided that
the signed letter was a forbearance agreement with White, so
he did not bother to send an additional document. Hughlett
believed that White would pay the balance within 30 days,
but White never did so. The bank sent a new foreclosure
notice and did in fact sell the house.
White sued the bank, claiming that it had breached
its agreement not to foreclose. The jury agreed, awarding
White $250,000 in compensatory damages. The bank
appealed, arguing that White gave no consideration for
the agreement because he was already obligated to pay
the full balance.
You Be the Judge: Was the signed letter an enforceable
contract?
Argument for the Bank: Mr. White fell behind on his
mortgage payments. As soon as the bank notified him that it
was foreclosing, his full debt became due. When he offered to
pay a percentage of that debt, he was fulfilling a preexisting
duty. He was legally obligated to pay the $35,000 that he
“offered,” along with the full balance due. A promise to do
what a party is required to do is never consideration. Without
consideration, there is no contract.
The jury made an emotional decision based on sym-
pathy for the debtor. That type of decision leads to bad
policy and bad law. The policy is poor because if every-
one were allowed to default without suffering a loss, no
bank would lend money and most citizens could never
buy a house. The law is even worse because the case
should not have gone to a jury. The trial judge should
have dismissed the suit based on the preexisting duty
rule.
Argument for Mr. White: There were two parties to
this agreement, and both believed they had a binding
agreement. The bank’s officer agreed to postpone
foreclosure. He also promised to forward a formal
document confirming the understanding but did not
do so. And why did he send no other document?
Because he believed the bank had already agreed to
halt any foreclosure effort. He was right.
Mr. White paid 80 percent of the balance due. It is
wrong for the bank to take the money and then break its
promise. Furthermore, it is absurd to foreclose based on
such a modest debt. The legal argument about considera-
tion is nonsense. Mr. White’s consideration was a check
for $35,000.
The jury award indicates a group of average citizens
who were angry about what the bank did. The verdict
should be affirmed.
264 U N I T 2 Contracts
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EXCEPTION: UNFORESEEN CIRCUMSTANCES
Hugo has a deal to repair major highways. Hugo hires Hal’s Hauling to cart soil and debris.
Hal’s trucks begin work, but after crossing the work site several times, they sink to their
axles in sinister, sucking slime. Hal demands an additional 35 percent payment from Hugo
to complete the job, pointing out that the surface was dry and cracked and that neither Hal
nor Hugo was aware of the subsurface water. Hal howls that he must use different trucks
with different tires and work more slowly to permit the soil to dry. Hugo hems and haws and
finally agrees. But when the hauling is finished, Hugo refuses to pay the extra money. Is
Hugo liable?
Yes. When unforeseen circumstances cause a party to make a promise regarding an
unfinished project, that promise is generally valid consideration. Even though Hal is only
promising to finish what he was already obligated to do, his promise is valid consideration
because neither party knew of the subsoil mud. Hal was facing a situation quite different
from what the parties anticipated. It is almost as though he were undertaking a new project.
Hal has given consideration, and Hugo is bound by his promise to pay extra money.
11-3 SETTLEMENT OF DEBTS
You claim that your friend Felicity owes you $90,000, but she refuses to pay. Finally, when
you are desperate, Felicity offers you a cashier’s check for $60,000—provided you accept it
as full settlement. To get your hands on some money, you agree and cash the check. The
next day, you sue Felicity for $30,000. Who wins? It will depend principally upon one major
issue: Was Felicity’s debt liquidated or unliquidated?
11-3a Liquidated Debt
A liquidated debt is one in which there is no dispute about the amount owed. A loan is a
typical example. If a bank lends you $10,000, and the note obligates you to repay that amount on
June 1 of the following year, you clearly owe that sum. The debt is liquidated.
In cases of liquidated debt, if the creditor agrees to take less than the full amount as full
payment, her agreement is not binding. The debtor has given no consideration to support
the creditor’s promise to accept a reduced payment, and therefore the creditor is not bound
by her word. The reasoning is simply that the debtor is already obligated to pay the full
amount, so no bargaining could reasonably cause the creditor to accept less. If Felicity’s
debt to you is liquidated, your agreement to accept $60,000 is not binding, and you will
successfully sue for the balance.
EXCEPTION: DIFFERENT PERFORMANCE
There is one important exception to this rule. If the debtor offers a different performance to
settle the liquidated debt, and the creditor agrees to take it as full settlement, the agreement
is binding. Suppose that Felicity, instead of paying $60,000, offers you five acres in Alaska,
and you accept. When you accept the deed to the land, you have given up your entire claim,
regardless of the land’s precise value.
11-3b Unliquidated Debt: Accord and Satisfaction
A debt is unliquidated for either of two reasons: (1) the parties dispute whether any money
is owed, or (2) the parties agree that some money is owed but dispute how much. When a
debt is unliquidated for either reason, the parties may enter into a binding agreement to
settle for less than what the creditor demands.
Liquidated debt
A debt in which there is no
dispute about the amount
owed.
Unliquidated debt
A debt that is disputed because
the parties disagree over its
existence or amount.
CHAPTER 11 Consideration 265
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Such a compromise will be enforced if:
• The debt is unliquidated;
• The parties agree that the creditor will accept as full payment a sum less than she has
claimed; and
• The debtor pays the amount agreed upon.
This agreement is called an accord and satisfaction. The accord is the agreement to
settle for less than the creditor claims. The satisfaction is the actual payment of that
compromised sum. An accord and satisfaction is valid consideration to support the creditor’s
agreement to drop all claims. Each party is giving up something: The creditor gives up her
full claim, and the debtor gives up his assertion that he owed little or nothing.
ACCORD AND SATISFACTION BY CHECK
Most accord and satisfaction agreements involve payment by check. UCC §3-311 governs
these agreements, using the same common law rules described above.5 The Code specifies
that when the debtor writes “full settlement” on the check, a creditor who cashes the check
generally has entered into an accord and satisfaction. If Felicity’s debt is unliquidated, and
she gives you a check with “full payment of all debts” written on the face in bold letters,
the moment you deposit the check, you lose any claim to more money. What happens if the
debtor makes such a notation but the creditor changes it? A massage therapist learned
the answer and felt sore for days.
HENCHES V. TAYLOR
138 Wash. App. 1026, 2007 WL 1241525
Washington Court of Appeals, 2007
C A S E S U M M A R Y
Facts: Jim Henches, a licensed massage therapist, trea-
ted Benjamin Taylor after he was injured in a car accident.
When all treatments were finished, Henches billed Taylor
for more than $7,000. Taylor’s insurance company claimed
the bill was exorbitant, and paid only $2,625, for 24 mas-
sage treatments.
Henches continued to send bills to Taylor, not only for
the balance due, but for additional time spent consulting
with Taylor’s other health care providers, preparing to
testify in Taylor’s personal injury lawsuit, and attempting
to collect his debts. In response to a bill for $11,945.86,
Taylor’s lawyer James Harris sent Henches a letter, stating:
I have reviewed your billing statements and am having a
difficult time understanding a number of charges you included.
By my calculations, the amount owed to you is approximately
$5,243.45. I have enclosed a check for that amount as payment
in full to settle Mr. Taylor’s account with you.
The letter was accompanied by a check with “final
payment” written on the notation line. Henches filed suit,
seeking the full balance. Then he wrote “attorney/fee” on
the check, over the word “final,” and deposited the check.
The trial court gave summary judgment to Taylor,
ruling that deposit of the check constituted accord and
satisfaction. Henches appealed.
Issue: Was there an accord and satisfaction, discharging the
debt?
Decision: Yes, depositing the check created an accord
and satisfaction.
Reasoning: An accord and satisfaction exists when three
circumstances arise. Parties have a legitimately disputed debt.
They agree that a partial payment of the debt will settle the
dispute. Finally, the defendant accepts the partial payment.
Accord and satisfaction
A completed agreement to
settle a debt for less than the
sum claimed.
5A check is legally an instrument, which is why this section comes from Article 3 of the Code. For a
full discussion of instruments, see Chapter 22.
266 U N I T 2 Contracts
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UCC EXCEPTIONS
The Code creates two exceptions for accord and satisfaction cases involving checks.
The first exception concerns “organizations,” which typically are businesses. The
general rule of §3-311 is potentially calamitous to them because a company that
receives thousands of checks every day is unlikely to inspect all notations. A consumer
who owes $12,000 on a credit card might write “full settlement” on a $200 check,
potentially extinguishing the entire debt through accord and satisfaction. Under the
exception, if an organization notifies a debtor that any offers to settle for less than
the debt claimed must be made to a particular official, and the check is sent to anyone
else in the organization, depositing the check generally does not create an accord
and satisfaction. Thus a clerk who deposits 900 checks daily for payment of MasterCard debts
will not have inadvertently entered into dozens of accord and satisfaction agreements.
The second exception allows a way out to most creditors who have inadvertently
created an accord and satisfaction. If, within 90 days of cashing a “full payment”
check, the creditor offers repayment of the same amount to the debtor, there is no
accord and satisfaction. Homer claims that Virgil owes him $7 million but foolishly
cashes Virgil’s check for $3 million, without understanding that “paid in full” means
just what it says. Homer has created an accord and satisfaction. But if he promptly
sends Virgil a check for $3 million, he has undone the agreement and may sue for the
full amount.
11-4 CONSIDERATION: TRENDS
11-4a Employment Agreements
In a noncompete agreement, an employee promises not to work for a competitor for
some time after leaving the company. It used to be that these covenants were rare and
reserved for top officers, but they have now become commonplace throughout many
organizations. We will talk about them more in the next chapter, but often these
covenants raise an issue of consideration: What consideration does the employee
receive for signing a covenant not to compete? After all, the company is already under
an obligation to pay the employee for working. What additional value does the
employee receive in return for signing the agreement?
Although this area of law is developing and is a bit murky, the following case reflects
the current majority view. Sometimes consideration issues can drive you nuts.
In this case, the defendant easily established the
first and third elements. The parties had a genuine dispute
over the costly treatments, and Henches deposited
the check. But Henches claimed that he had not
agreed to accept the check as full payment of the
debt. In the end, his own actions contradicted his
argument.
When he wrote “attorney/fee” over the word “final,”
Henches indicated that he knew that Taylor intended for
the check to be a final settlement. If an amount is in dispute
and the defendant offers partial payment as full settlement,
then accepting this money counts as full satisfaction, no
matter what else the plaintiff may do. When Henches depos-
ited the check, he lost the ability to seek any further payment.
CHAPTER 11 Consideration 267
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11-4b Promissory Estoppel and “Moral Consideration”
Judges have a tool by which they can enforce agreements even if there is no consideration.
Under the doctrine of promissory estoppel, a judge has the discretion to “ignore” the fact
that consideration does not exist if a promise causes foreseeable reliance by a plaintiff and a
great injustice would be done if the promise were broken. Some courts will use the phrase
“moral consideration” to describe this basic idea.
For example, consider a pledge to charity. If Dave promises to give money to charity
and then fails to make the donation, there is no consideration because he has received
nothing in return. If the charity sues to enforce the promise, it cannot show that it has
committed an act or forbearance.6
Nevertheless, some courts will force donors to make good on their donations anyway.
Especially in the case of large donations, courts will often cite the “grave injustices” that can
follow from this kind of promise breaking. “If you don’t give the ‘Coats for Kids’ program
the $100,000 you’ve pledged, then thousands of children will go without a coat this winter,”
a judge might say. Also, it may be that the charity has relied on the pledge to open another
SNIDER BOLT & SCREW V. QUALITY SCREW & NUT
2009 U.S. Dist. LEXIS 50797
United States District Court for the Western District of Kentucky, 2009
C A S E S U M M A R Y
Facts: James Scott began working for Snider Bolt &
Screw in 1999. In 2002, Scott signed an employment
agreement with Snider, which included a covenant not
to compete. The covenant prohibited him from taking a
job with a competitor for one year after leaving Snider.
Three years later, Scott quit his job at Snider and imme-
diately went to work for Quality Screw & Nut.
Snider obtained a temporary restraining order that banned
Scott from working at his new job. Quality argued that the
covenant not to compete was void for lack of consideration. It
asked the court to lift the temporary restraining order.
Issue: Was there consideration for the covenant not to compete?
Decision: Yes, the covenant was supported by adequate
consideration.
Reasoning: The central question here is whether the
2002 covenant had consideration—that is, whether both
Snider and Scott received new benefits.
From 1999 to 2002, Scott worked for Snider without a
contract. Snider could have fired him at any time. Upon
signing the employment agreement, Scott promised not to
compete with Snider in the future, a new promise. Snider
got the benefit of that promise of loyalty. After going to
work for Quality in 2005, Scott argued that the covenant was
void for lack of consideration because he got nothing in
return for his promise.
But that was not true: The employment contract did
bind Snider in a new way. In the contract, Snider impli-
citly promised continued employment. Snider could
have fired Scott, but did not. Kentucky courts have
found that an implied promise to continue employment
counts as consideration, whether the employee is at will
or has a contract.
The covenant was supported by adequate considera-
tion. The motion to lift the temporary restraining order is
denied.
6An exception to this, of course, would be if the charity agreed to give Dave something at the time he
made the pledge. As a “fix” for consideration problems, many charities send donors something of
trivial value when pledges are made—maybe a water bottle or a tote bag. Under the peppercorn rule,
even something of small value counts as a legal act, and it converts a mere promise of a donation into
an enforceable contract.
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storefront or undertake a new program. Courts are likely to enforce the pledge in these
circumstances.
It is unwise to make charitable pledges, especially large pledges, if you might change
your mind.
EXAM Strategy
Question: In an Alabama case, Webb saved McGowin’s life by preventing a giant
block of wood from falling on his head.7 Webb was permanently disabled in the
accident and was never able to work again. Later, McGowin promised to give Webb
money every two weeks for the rest of his life. McGowin made the payments for
awhile but then stopped. Webb sued.
Strategy: No consideration exists here. McGowin made the promise to pay the
money after Webb’s heroic act. Webb did not give McGowin anything of value in
return for the promise to pay money. But what about promissory estoppel?
Result: In the case, the court found that “moral consideration” was present, and that
Webb was entitled to the payments to prevent substantial injustice.
It is important to note that applications of promissory estoppel and similar doctrines are
rare. Ordinarily, if there is no consideration, then there is no contract. However, in extreme
cases, it is possible for a court to enforce a deal even without consideration. But this is not
something you can count on.
Chapter Conclusion
This ancient doctrine of consideration is simple to state but subtle to apply. The
parties must bargain and enter into an exchange of promises or actions. If they do
not, there is no consideration and the courts are unlikely to enforce any promise
made. A variety of exceptions modify the law, but a party wishing to render its
future more predictable—the purpose of a contract—will rely on a solid bargain and
exchange.
EXAM REVIEW
1. CONSIDERATION There are three rules of consideration:
1. Both parties must get something of measureable value from the contract.
2. A promise to give something of value counts as consideration.
3. The two parties must have bargained for whatever was exchanged. (p. 257)
7Webb v. McGowin, 168 So. 196 (Ala.1935).
CHAPTER 11 Consideration 269
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2. ACT OR FORBEARANCE The item of value can be either an act or a
forbearance. (pp. 258–259)
Question: An aunt saw her eight-year-old nephew enter the room, remarked
what a nice boy he was, and said, “I would like to take care of him now.” She
promptly wrote a note, promising to pay the boy $3,000 upon her death. Her
estate refused to pay. Is it obligated to do so?
Strategy: A contract is enforceable only if the parties have given consideration.
The consideration might be an act or a forbearance. Did the nephew give
consideration? (See the “Result” at the end of this section.)
3. ADEQUACY The courts will seldom inquire into the adequacy of consideration.
This is the “peppercorn rule.” (pp. 259–260)
4. ILLUSORY PROMISES An illusory promise is not consideration. (pp. 260–261)
Question: Eagle ran convenience stores. He entered into an agreement with
Commercial Movie in which Commercial would provide Eagle with DVDs for
rental. Eagle would pay Commercial 50 percent of the rental revenues. If Eagle
stopped using Commercial’s service, Eagle could not use a competitor’s services
for 18 months. The agreement also provided: “Commercial shall not be liable for
compensation or damages of any kind, whether on account of the loss by Eagle of
profits, sales or expenditures, or on account of any other event or cause
whatsoever.” Eagle complied with the agreement for two years but then began
using a competitor’s service, and Commercial sued. Eagle claimed that the
agreement was unenforceable for lack of consideration. Please rule.
Strategy: In this case, both parties seem to have given consideration. But there is
a flaw in the “promise” that Commercial made. Commercial can never be liable to
Eagle—no matter what happens. (See the “Result” at the end of this section.)
5. REQUIREMENT AND OUTPUT CONTRACTS Under sales law, requirement
and output contracts are valid. Although one side controls the quantity, its agreement
to make demands in good faith is consideration. (pp. 261–262)
6. PREEXISTING DUTY Under the doctrine of preexisting duty, a promise to do
something that the party is already legally obligated to perform is generally not
consideration. (p. 262)
7. LIQUIDATED DEBT A liquidated debt is one in which there is no dispute about
the amount owed. For a liquidated debt, a creditor’s promise to accept less than the
full amount is not binding. (p. 265)
8. UNLIQUIDATED DEBT For an unliquidated debt, if the parties agree that the
creditor will accept less than the full amount claimed and the debtor performs, there is
an accord and satisfaction and the creditor may not claim any balance. (pp. 265–266)
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9. “FULL PAYMENT” Notations In most states, payment by a check that has a “full
payment” notation will create an accord and satisfaction unless the creditor is an
organization that has notified the debtor that full payment offers must go to a certain
officer. (p. 267)
Question: When White’s wife died, he filed a claim with Boston Mutual for
$10,000 death benefits under her insurance policy. The insurer rejected the claim,
saying that his wife had misrepresented her medical condition in the application
form. The company sent White a check for $478.75, which it said represented “a
full refund of all applicable premiums paid” for the coverage. White deposited the
check. Had the parties reached an accord and satisfaction?
Strategy: The UCC permits parties to enter into an accord and satisfaction by
check. The debtor must make clear that the check is offered in full payment of a
disputed debt. Debtors generally do that by writing “Final Settlement,”
“Accepted as Full Payment of All Debts,” or some similar notation on the check.
Had the insurance company complied with that requirement? (See the “Result” at
the end of this section.)
10. PROMISSORY ESTOPPEL Sometimes, to prevent injustice, courts will
enforce agreements even if no consideration is present. These deals are still not
formal contracts, but the courts will enforce a promise nonetheless. (pp. 268–269)
Question: Phil Philanthropist called PBS during a fund drive and pledged to
donate $100,000. PBS then planned and began to produce a Fourth of July Sesame
Street special, counting on the large donation to fund it. Later, Phil changed his mind
and said he had decided not to donate the money after all. PBS sued because without
the money, it would not be able to complete the show. Will PBS win the lawsuit?
Strategy: Analyze the promise to donate the $100,000. Does it contain
consideration? If not, is there any other legal possibility? (See the “Result” at the
end of this section.)
2. Result: The nephew gave no consideration. He did not promise to do anything.
He committed no act or forbearance. Without consideration, there is no enforceable
contract. The estate wins.
4. Result: Commercial’s promise was illusory. The company was free to walk away
from the deal at any time. Commercial could never be held liable. Commercial gave
no consideration, and there was no binding contract for either party to enforce.
9. Result: The insurer merely stated that its check was a refund of premiums.
Nowhere did the company indicate that the check was full payment of its disputed
obligation. The company should have made it clear that it would not pay any
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CHAPTER 11 Consideration 271
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benefits and that this payment was all that it would offer. There was no accord and
satisfaction.
10. Result: There is no “regular” consideration here because Phil received no
measureable benefit and PBS did not act or forbear. But PBS can likely make a
strong case that a great injustice will be done if the money is not paid. A judge
might well decide to apply the doctrine of promissory estoppel and require Phil to
make the donation.
MULTIPLE-CHOICE QUESTIONS
1. For consideration to exist, there must be:
(a) A bargained-for exchange
(b) A manifestation of mutual assent
(c) Genuineness of assent
(d) Substantially equal economic benefits to both parties
2. Which of the following requires consideration in order to be binding on the
parties?
(a) Modification of a contract involving the sale of real estate
(b) Modification of a sale of goods contract under the UCC
(c) Both (a) and (b)
(d) None of the above
3. Ted’s wallet is as empty as his bank account, and he needs $3,500 immediately.
Fortunately, he has three gold coins that he inherited from his grandfather. Each
is worth $2,500, but it is Sunday, and the local rare coins store is closed. When
approached, Ted’s neighbor Andrea agrees to buy the first coin for $2,300.
Another neighbor, Cami, agrees to buy the second for $1,100. A final neighbor,
Lorne, offers “all the money I have on me”—$100—for the last coin.
Desperate, Ted agrees to the proposal. Which of the deals is supported by
consideration?
(a) Ted’s agreement with Andrea only
(b) Ted’s agreements with Andrea and Cami only
(c) All three of the agreements
(d) None of the agreements
4. In a(n) contract, the seller guarantees to sell 100 percent of its output to
one buyer, and the buyer agrees to accept the entire quantity. This kind of
arrangement acceptable under the UCC.
(a) output; is
(b) output; is not
(c) requirements; is
(d) requirements; is not
272 U N I T 2 Contracts
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5. Noncompete agreements are common features of employment contracts. Currently,
courts enforce these clauses.
(a) always
(b) usually
(c) rarely
(d) never
ESSAY QUESTIONS
1. American Bakeries had a fleet of over 3,000 delivery trucks. Because of the increasing
cost of gasoline, the company was interested in converting the trucks to propane fuel. It
signed a requirements contract with Empire Gas, in which Empire would convert
“approximately 3,000” trucks to propane fuel, as American Bakeries requested, and would
then sell all the required propane fuel to run the trucks. But American Bakeries changed its
mind and never requested a single conversion. Empire sued for lost profits. Who won?
2. CeCe Hylton and Edward Meztista, partners in a small advertising firm, agreed to
terminate the business and split assets evenly. Meztista gave Hylton a two-page
document showing assets, liabilities, and a bottom line of $35,235.67, with half due to
each partner. Hylton questioned the accounting and asked to see the books. Meztista
did not permit Hylton to see any records and refused to answer her phone calls.
Instead, he gave her a check in the amount of $17,617.83, on which he wrote “Final
payment/payment in full.” Hylton cashed the check, but she wrote on it, “Under
protest—cashing this check does not constitute my acceptance of this amount as
payment in full.” Hylton then filed suit, demanding additional monies. Meztista
claimed that the parties had made an accord and satisfaction. What is the best
argument for each party? Who should win?
3. ETHICS Melnick built a house for Gintzler, but the foundation was defective.
Gintzler agreed to accept the foundation if Melnick guaranteed to make future repairs
caused by the defects. Melnick agreed but later refused to make any repairs. Melnick
argued that his promise to make future repairs was unsupported by consideration.
Who will win the suit? Is either party acting unethically? Which one, and why?
4. Sami walks into a restaurant. She is given a menu, which indicates that lobster is $30.
Sami orders the lobster. It arrives, and Sami thinks it is very tasty. When the bill
arrives, Sami tries to execute a clever ploy she learned about in her business law class.
She writes a check to the restaurant for $20 and writes “full settlement” across the
top. The waiter accepts the check without looking at it, and the restaurant manager
later deposits it in the restaurant’s bank account. Is this a liquidated or an
unliquidated debt? Is Sami off the hook for the last $10?
5. In the bleachers …
“You’re a prince, George!” Mike exclaimed. “Who else would give me a ticket to the
big game?”
“No one, Mike, no one.”
“Let me offer my thanks. I’ll buy you a beer!”
CHAPTER 11 Consideration 273
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“Ah,” George said. “A large beer would hit the spot right now.”
“Small. Let me buy you a small beer.”
“Ah, well, good enough.”
Mike stood and took his wallet from his pocket. He was distressed to find a very small
number of bills inside. “There’s bad news, George!” he said.
“What’s that?”
“I can’t buy you the beer, George.”
George considered that for a moment. “I’ll tell you what, Mike,” he said. “If you
march to the concession stand right this minute and get me my beer, I won’t punch
you in the face.”
“It’s a deal!” Mike said.
Discuss the consideration issues raised by this exchange.
6. Jack Tallas came to the United States from Greece in 1914. He lived in Salt Lake City
for nearly 70 years, achieving great success in insurance and real estate. During the
last 14 years of his life, his friend Peter Dementas helped him with numerous personal
and business chores. Two months before his death, Tallas dictated a memorandum to
Dementas, in Greek, stating:
PETER K. DEMENTAS is my best friend I have in this country, and since he came to the
United States, he treats me like a father and I think of him as my own son. He takes me in
his car grocery shopping. He drives me to the doctor and also takes me every week to
Bingham to pick up my mail, collect the rents, and manage my properties. For all the
services Peter has given me all these years, I owe to him the amount of $50,000 (Fifty
Thousand Dollars). I will shortly change my will to include him as my heir.
Tallas signed the memorandum, but he did not in fact alter his will to include Dementas.
The estate refused to pay, and Dementas sued. Was there consideration? Please rule.
DISCUSSION QUESTIONS
8See Japan’s Civil Code, Article 549.
Apply the following material to the next three questions.
Some view consideration as a technicality that
allows people to make promises and then back out of
them. Perhaps all promises should be enforced. In
Japan, for example, promises to give gifts are
enforceable without consideration.8
In the United States, if I promise to give you a gift
merely because I feel like being nice, I can freely
change my mind as far as contract law is concerned.
A court will not make me follow through because there
is no consideration.
In Japan, I would be obligated to buy the gift if all
other elements of a contract were present—an offer, an
acceptance, and so forth.
Some argue that consideration in U.S. law is a
doctrine left over from centuries long past, that it lacks
any reasonable modern purpose, and that it should be
abolished.
274 U N I T 2 Contracts
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1. Do you agree with this statement: “A person should
always keep his or her word.”
2. When it comes to giving gifts, which is better—the
Japanese or American rule?
3. Are there any specific types of agreements (perhaps
high-value, long-term, extremely time-consuming
ones) that should definitely require consideration?
4. In the gold rush example, Embola gave Tuppela
$50 in exchange for a promise of $10,000 later.
Under the peppercorn rule, the deal was a contract.
Is the peppercorn rule sensible? Should courts
require a more even exchange of value?
5. In the last two chapters, we have examined
clickwrap boxes. Sometimes courts refuse to enforce
clickwrap terms because of problems with
acceptance or consideration, but usually the terms
are enforced. Is there a way to make clickwraps fair
to both sides? Would it be better to ban clickwrap
boxes altogether?
CHAPTER 11 Consideration 275
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CHAPTER12
LEGALITY
Soheil Sadri, a California resident, did some
serious gambling at Caesar’s Tahoe casino in
Nevada. And lost. To keep gambling, he wrote
checks to Caesar’s and then signed two
memoranda pledging to repay all money
advanced. After two days, with his losses totaling
more than $22,000, he went home. Back in
California, Sadri stopped payment on the checks
and refused to pay any of the money he owed
Caesar’s. The casino sued. In defense, Sadri
claimed that California law considered
his agreements illegal and unenforceable.
He was unquestionably correct about one thing:
a contract that is illegal is void and unenforceable.
A contract that is illegal
is void and
unenforceable.
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12-1 CONTRACTS THAT VIOLATE
A STATUTE
In this chapter, we examine a variety of contracts that courts will not enforce. Illegal
agreements fall into two groups: those that violate a statute, and those that violate public
policy.
12-1a Wagers
Gambling is big business. Almost all states now permit some form of wagering, from casinos
to racetracks to lotteries, and they eagerly collect the billions of dollars in revenue gener-
ated. Supporters urge that casinos create jobs and steady income, boost state coffers, and
take business away from organized crime. Critics argue that naive citizens inevitably lose
money they can ill afford to forfeit, and that addicted gamblers destroy their families and
weaken the fabric of communities. With citizens and states divided over the ethics of
gambling, it is inevitable that we have conflicts such as the dispute between Sadri and
Caesar’s. The basic rule, however, is clear: A gambling contract is illegal unless it is a type of
wagering specifically authorized by state statute.
In California, as in many states, gambling on credit is not allowed. In other words,
it is illegal to lend money to help someone wager. But in Nevada, gambling on credit
is legal, and debt memoranda such as Sadri’s are enforceable contracts. Caesar’s sued
Sadri in California (where he lived). The result? The court admitted that California’s
attitude toward gambling had changed, and that bingo, poker clubs, and lotteries were
common. Nonetheless, the court denied that the new tolerance extended to wagering
on credit:
There is a special reason for treating gambling on credit differently from gambling itself.
Having lost his or her cash, the pathological gambler will continue to play on credit, if
extended, in an attempt to win back the losses. This is why enforcement of gambling debts
has always been against public policy in California and should remain so, regardless of
shifting public attitudes about gambling itself. If Californians want to play, so be it. But
the law should not invite them to play themselves into debt. The judiciary cannot protect
pathological gamblers from themselves, but we can refuse to participate in their financial
ruin.1
Caesar’s lost and Sadri kept his money. However, do not become too excited at the
prospect of risk-free wagering. Casinos responded to cases like Sadri by changing their
practices. Most now extend credit only to a gambler who agrees that disputes about
repayment will be settled in Nevada courts. Because such contracts are legal in that state,
the casino is able to obtain a judgment against a defaulting debtor and—yes—enforce that
judgment in the gambler’s home state.
Despite these more restrictive casino practices, Sadri’s dispute is a useful starting place
from which to examine contract legality because it illustrates two important themes.
First, morality is a significant part of contract legality. In refusing to enforce an obligation that
Sadri undeniably had made, the California court relied on the human and social consequences of
gambling and on the ethics of judicial enforcement of gambling debts. Second, “void” really
means just that: A court will not intercede to assist either party to an illegal agreement, even if its
refusal leaves one party shortchanged.
1Metropolitan Creditors Service of Sacramento v. Sadri, 15 Cal. App. 4th 1821, 1993 Cal. App. LEXIS 559,
19 Cal. Rptr. 2d 646 (Cal. Ct. App. 1993).
CHAPTER 12 Legality 277
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12-1b Insurance
Another market in which “wagering” unexpectedly pops up is that of insurance. You may
certainly insure your own life for any sum you choose. But may you insure someone else’s
life? Anyone taking out a policy on the life of another must have an insurable interest in that
person. The most common insurable interest is family connection, such as spouses or parents.
Other valid interests include creditor-debtor status (the creditor wants payment if the debtor
dies) and business association (an executive in the company is so valuable that the firm will
need compensation if something happens to him). If there is no insurable interest, there is
generally no contract.
EXAM Strategy
Question: Jimenez sold Breton a used motorcycle for $5,500, payable in weekly
installments. Jimenez then purchased an insurance policy on Breton’s life, worth
$320,000 if Breton died in an accident. Breton promptly died in a collision with an
automobile. The insurance company offered only $5,500, representing the balance
due on the motorcycle. Jimenez sued, demanding $320,000. Make an argument that
the insurance company should win.
Strategy: The issue is whether Jimenez had an insurable interest in Breton’s life. If
he had no interest, he cannot collect on an insurance policy. If he had an interest,
what was it? For how much money?
Result: Jimenez’s had an interest in Breton’s life to insure payment of the
motorcycle debt—$5,500. Beyond that, this policy represented a wager by Jimenez
that Breton was going to die. Contracts for such wagers are unenforceable. Jimenez is
entitled only to $5,500.2
12-1c Licensing Statutes
You sue your next-door neighbor in small claims court, charging that he keeps a kangaroo in
his backyard and that the beast has disrupted your family barbecues by leaping over the
fence, demanding salad, and even kicking your cousin in the ear. Your friend Foster, a
graduate student from Melbourne, offers to help you prepare the case, and you agree to pay
him 10 percent of anything you recover. Foster proves surprisingly adept at organizing
documents and arguments. You win $1,200, and Foster demands $120. Must you pay? The
answer is determined by the law of licensing.
States require licenses for anyone who practices a profession, such as law or medicine,
works as a contractor or plumber, and for many other kinds of work. These licenses are required
in order to protect the public. States demand that an electrician be licensed because the work is
potentially dangerous to a homeowner: The person doing the work must know an amp from a
watt. When a licensing requirement is designed to protect the public, any contract made by an
unlicensed worker is unenforceable. Your friend Foster is unlicensed to practice law. Even
though Foster did a fine job with your small claims case, he cannot enforce his contract for $120.
States use other licenses simply to raise money. For example, most states require a
license to open certain kinds of retail stores. This requirement does not protect the public
because the state will not investigate the store owner the way it will examine a prospective
2Jimenez v. Protective Life Insurance Co., 8 Cal. App. 4th 528 (Cal. App. 1992).
278 U N I T 2 Contracts
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lawyer or electrician. The state is simply raising money. When a licensing requirement is
designed merely to raise revenue, a contract made by an unlicensed person is generally
enforceable. Thus, if you open a stationery store and forget to pay the state’s licensing fee,
you can still enforce a contract to buy 10,000 envelopes from a wholesaler at a bargain price.
Many cases, such as the following one, involve contractors seeking to recover money for
work they did without a license.
12-1d Usury
It pays to understand usury.
Henry Paper and Anthony Pugliese were real estate developers. They bought property
in Florida, intending to erect an office building. Walter Gross, another developer, agreed to
lend them $200,000 at 15 percent interest. Gross knew the partners were desperate for the
money, so at the loan closing, he demanded 15 percent equity (ownership) in the partner-
ship, in addition to the interest. Paper and Pugliese had no choice but to sign the agree-
ment. The two partners never repaid the loan, and when Gross sued, the court ruled that
they need never pay a cent.
Usury laws prohibit charging excess interest on loans. Some states, such as New York, set
very strict limits. Others, like Utah, allow for virtually any rate. A lender who charges a usurious
rate of interest may forfeit the illegal interest, all interest, or, in some states, the entire loan.
Florida law requires a lender who exceeds 25 percent interest to forfeit the entire debt.
Where was the usury in Gross’s case? Just here: When Gross insisted on a 15 percent share
of the partnership, he was simply extracting additional interest and disguising it as partner-
ship equity. The Paper-Pugliese partnership had equity assets of $600,000. A 15 percent
equity, plus interest payments of 15 percent over 18 months, was the equivalent of a per
annum interest rate of 45 percent. Gross probably thought he had made a deal that was too
good to be true. And in the state of Florida, it was. He lost the entire debt.3
AUTHENTIC HOME IMPROVEMENTS V. MAYO
2006 WL 2687533
District of Columbia Superior Court, 2006
C A S E S U M M A R Y
Facts: Authentic Home Improvements performed work
on Diane Mayo’s home, but she sued for return of the
money she had paid. In court, Authentic’s owner acknowl-
edged that he did not have a contractor’s license when the
company began the work, but expected to obtain it soon.
The court ordered Authentic to refund Mayo the entire
sum she had paid, and the company agreed. Later, how-
ever, Authentic returned to court, stating that things had
changed. The license had in fact been issued soon after
work began. Authentic argued that it should not be obli-
gated to return Mayo’s money, and was in fact entitled to
its full fee for the work accomplished.
Issue: Did the new license entitle Authentic to its fee?
Decision: No.Thenew licensedidnot change theoutcome.
Reasoning: Consumers lose billions each year on fraudu-
lent home improvement schemes. For this reason, courts
strictly interpret licensing requirements for contractors.
Even when homeowners knowingly hire a contractor who
lacks a license and then benefit from his work, they are not
required to pay him.
Authentic lacked a license when the work on Mayo’s
home started. The relevant statute plainly requires a license
in hand before a job begins. A driver cannot drive a car
without license plates merely because she expects delivery
of her plates soon, and the same principle applies here.
Authentic remains obligated to refund Mayo’s money.
3Jersey Palm-Gross, Inc. v. Paper, 639 So.2d 664, 1994 Fla. App. LEXIS 6597 (Fla. Ct. App. 1994).
CHAPTER 12 Legality 279
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CREDIT CARD DEBT
Many consumers are desperate to obtain credit cards on any terms. When First Premier
Bank launched a credit card with a 79.9 percent rate of interest, 700,000 people applied for it
within the next two years.
How can such a rate exist?
Even if a state’s usury statute applies to credit cards, savvy lenders can often avoid
limits on interest rates. For example, national banks can choose the interest rate either in
the state where they are located or where the consumer lives. Of course, they choose the
higher one. Also, many card issuers require borrowers to sign contracts that say the laws of a
lender-friendly state will be applied to all future disputes. New York customers might agree
to live by Utah laws, for example.
Most courts continue to enforce these contracts that impose high out-of-state rates. But
since the financial meltdown of 2008, some courts have started to express distaste for this
practice. In the following case, a New York court addressed the issue.
AMERICAN EXPRESS TRAVEL RELATED SERVICES
COMPANY, INC. V. ASSIH
893 N.Y.S.2d 438
Civil Court of the City of New York, Richmond County, 2009
Facts: When Titus Assih missed a payment on his Amer-
ican Express card, his interest rate ballooned from 12.24% to
21%, and eventually to 27.99%. Assih, a New York resident,
made small payments for a time, but soon he stopped pay-
ing altogether.
American Express sued Assih in New York. It asked
the court to apply Utah law, as provided in the credit card
agreement. But the agreement’s only connection to Utah
was that American Express had assigned its interest to a
one-branch bank in Utah.
Assih argued thatNewYork law,which sets strict limits on
the maximum interest rate for credit cards, should apply
instead.
Issues: Should New York or Utah law apply? Did the
increased rates violate usury statutes?
Decision: New York law should apply and the increased
rates were illegal.
Reasoning: Haveyouever seen theWizard ofOz?Theanswer
is probably yes and no. Youmay have seen the film, but no one
in the movie has ever actually seen the Wizard himself, leaving
Dorothy to wonder whether the ruler of Oz really exists.
Like the Land of Oz, run by the mysterious Wizard,
the Land of Credit Cards binds consumers to agreements
they never see or sign. These contracts may change with-
out notice and are subject to the interest rate of a faraway
state. And the consumers may have no idea!
Utah law permits any rate of interest so long as the
parties agree to it. No wonder American Express chose
Utah law. But New York courts will not enforce a contract
if they have to apply the law of a state that has no relation-
ship to the parties.
Utah had nothing to do with this transaction. Amer-
ican Express was a New York corporation whose principal
place of business was New York. Assih lived in New York.
He used his American Express card in New York. He sent
his credit card payments to a New York address. There-
fore, New York, not Utah, law must apply.
New York’s civil usury statute sets the legal rate
of interest at 16%; New York’s criminal usury rate is
25%. Except for Assih’s initial 12.24% rate, all of the
interest rates American Express charged violated the
New York civil usury statutes. Assih’s last billings at
27.99% even exceeded New York’s criminal rate.
The Wizard of Oz warned Dorothy against arousing
“the wrath of the great and powerful Oz.” At risk of
arousing the wrath of American Express, this court held
that under New York law, the usurious contract between
American Express and Assih was void.
280 U N I T 2 Contracts
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12-2 CONTRACTS THAT VIOLATE PUBLIC
POLICY
In the preceding section, we saw that courts refuse to enforce contracts that violate a statute.
However, a judge may declare a contract illegal even if it does not violate a statute. In this
section, we examine cases in which a public policy prohibits certain contracts. In other words,
we focus primarily on common law rules.
12-2a Restraint of Trade: Noncompete Agreements
In a noncompete agreement (sometimes called a covenant not to compete), an employee
promises not to work for a competitor for some time after leaving his company. For example,
an anchorwoman for an NBC news affiliate in Miami might agree that she will not anchor
any other Miami station’s news show for one year after she leaves her present employer.
Noncompetes are often valid, but the common law places some restrictions on them.
It was once true that these covenants were rare and reserved for top corporate officers,
but they have now become commonplace in many organizations at virtually all levels.
Employers have legitimate concerns that employees might go to work for a competitor
and take with them valuable information about doing business in that industry. Some
employers, though, attempt to place harsh restrictions on their employees simply to dis-
courage them from leaving.
Employees often view noncompetes as unfair and unduly burdensome. Nonetheless,
noncompete agreements are enforceable, so long as they are reasonable in time, activity, and
territory. In other words, a noncompete providing that you cannot work in the same industry in
the same city for one year is likely to be valid, but not an agreement that essentially prevents you
from working at all, such as one that prohibits you from doing any job, anywhere, for ten years.
Was the noncompete in the following case styled fairly, or was the employee clipped?
KING V. HEAD START FAMILY HAIR SALONS, INC.
886 So.2d 769
Supreme Court of Alabama, 2004
C A S E S U M M A R Y
Facts: Kathy King was a single mother supporting a
college-age daughter. For 25 years, she had worked as a
hairstylist. For the most recent 16 years, she had worked at
Head Start, which provided haircuts, coloring, and styling
for men and women. King was primarily a stylist, though she
had also managed one of the Head Start facilities.
King quit Head Start and began working as man-
ager of a Sports Clips shop, located in the same mall as
the store she just left. Sports Clip offered only haircuts,
and primarily served men and boys. Head Start filed
suit, claiming that King was violating the noncompeti-
tion agreement that she had signed. The agreement
prohibited King from working at a competing business
within a two-mile radius of any Head Start facility for
12 months after leaving the company. The trial court
issued an injunction enforcing the noncompete. King
appealed.
Issue: Was the noncompetition agreement valid?
Decision: The agreement was only partly valid.
Reasoning: Head Start does business in 30 locations
throughout Jefferson and Shelby counties. Virtually every
hair-care facility in those counties is located within 2 miles
of a Head Start business, and is thus covered by the
noncompetition agreement. The contract is essentially
a blanket restriction, entirely barring King from this
business.
CHAPTER 12 Legality 281
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SALE OF A BUSINESS
Kory has operated a real estate office, Hearth Attack, in a small city for 35 years, building an
excellent reputation and many ties with the community. She offers to sell you the business
and its goodwill for $300,000. But you need assurance that Kory will not take your money
and promptly open a competing office across the street. With her reputation and connec-
tions, she would ruin your chances of success. Also, you have paid her a significant sum, so
even if she does not work, she is unlikely to go hungry any time soon. You insist on a
noncompete clause in the sale contract. In this clause, Kory promises that for one year, she
will not open a new real estate office or go to work for a competing company within a 10-
mile radius of Hearth Attack. Suppose, six months after selling you the business, Kory goes
to work for a competing real estate agency two blocks away. You seek an injunction to
prevent her from working. Who wins?
Noncompete agreements related to the sale of a
business are also enforceable if reasonable in time, activ-
ity, and territory. Courts are generally stricter in enfor-
cing agreements related to the sale of a business than
they are ones that are based simply on employment.
Kory is almost certainly bound by her agreement. One
year is a reasonable time to allow you to get your new
business started. A 10-mile radius is probably about the
area that Hearth Attack covers, and realty is obviously a
fair business from which to prohibit Kory. A court will
probably grant the injunction, barring Kory from her
new job.
EXAM Strategy
Question: Caf-Fiend is an expanding chain of coffeehouses. The company
offers to buy Bessie’s Coffee Shop, in St. Louis, on these terms: Bessie will
manage the store, as Caf-Fiend’s employee, for one year after the sale. For four
years after the sale, Bessie will not open a competing restaurant anywhere
within 12 miles. For the same four years, she will not work anywhere in the
United States for a competing coffee retailer. Are the last two terms enforceable
against Bessie?
With her reputation and
connections, she would
ruin your chances of
success.
King works to support herself and her daughter. She is
40 years old and has worked in the hair-care industry for 25
years. She cannot be expected at this stage in life to learn
new job skills.
Enforcing the noncompetition agreement would inflict a
gravehardshiponher. Itwouldbeunfair topermit the contract
to impoverish King and her daughter. On the other hand,
Head Start is entitled to some of the protection that it sought
in this agreement.The company has a valid concern: if King is
permitted to work anywhere she wants, she could take away
many customers fromHead Start. The trial court should fash-
ion a more reasonable geographic restriction, one that will
permit King to ply her trade while ensuring that Head Start
does not unfairly lose customers. For example, the lower court
could prohibit King from working within 2 miles of the Head
Start salon where she previously worked, or some variation on
that idea.
Reversed and remanded.
282 U N I T 2 Contracts
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Strategy: This contract includes two noncompete clauses. In the first, Bessie agrees
not to open a competing business. Courts generally enforce such clauses if they are
reasonable in time, geography, and scope of activity. Is this clause reasonable? The
second clause involves employment. Courts take a dimmer view of these agreements.
Is this clause essential to protect the company’s business? Is it unduly harsh for Bessie?
Result: The first restriction is reasonable. Caf-Fiend is entitled to prevent Bessie
from opening her own coffeehouse around the corner and drawing her old customers.
The second clause is unfair to Bessie. If she wants to move from St. Louis to San
Diego and work as a store manager, she is prohibited. It is impossible to see how such
employment would harm Caf-Fiend—but it certainly takes away Bessie’s career
options. The first restriction is valid, the second one unenforceable.
THE CALIFORNIA EXCEPTION
In California, the law on noncompetes is different from the rest of the country. In this
important state, noncompete agreements are not enforceable in employment contracts. In
other words, a noncompete is valid only if (1) the employee signs it at the same time she is
selling her share of a company and (2) it is reasonable in time, activity, and territory.
12-2b The Legality of Noncompetition Clauses
(Noncompetes)
Type of Noncompetition
Agreement When Enforceable
Not ancillary to a sale of
business or employment
Never
Ancillary to a sale of
business
If reasonable in time, geography, and scope of activity
Ancillary to employment Contract is more likely to
be enforced when it
involves:
• Trade secrets or
confidential
information: These are
almost always
protected
• Customer lists
developed over
extended period of time
and carefully protected
• Limited time and
geographical scope
• Terms essential to
protect the employer’s
business
Contract is less likely to
be enforced when it
involves:
• Employee who already
had the skills when he
arrived, or merely
developed general skills
on the job
• Customer lists that can
be derived from public
sources
• Excessive time or
geographical scope
• Terms that are unduly
harsh on the employee
or contrary to public
interest
©
C
en
g
ag
e
Le
ar
n
in
g
CHAPTER 12 Legality 283
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12-2c Exculpatory Clauses
You decide to capitalize on your expert ability as a skier and open a ski school in Colorado,
“Pike’s Pique.” But you realize that skiing sometimes causes injuries, so you require anyone
signing up for lessons to sign this form:
I agree to hold Pike’s Pique and its employees entirely harmless in the event that I am injured in
any way or for any reason or cause, including but not limited to any acts, whether negligent or
otherwise, of Pike’s Pique or any employee or agent thereof.
The day your school opens, Sara Beth, an instructor, deliberately pushes Toby over a
cliff because Toby criticized her clothes. Eddie, a beginning student, “blows out” his knee
attempting an advanced racing turn. And Maureen, another student, reaches the bottom of a
steep run and slams into a snowmobile that Sara Beth parked there. Maureen, Eddie, and
Toby’s families all sue Pike’s Pique. You defend based on the form you had them sign.
Does it save the day?
The form on which you are relying is an exculpatory clause, that is, one that attempts
to release you from liability in the event of injury to another party. Exculpatory clauses are
common. Ski schools use them, and so do parking lots, landlords, warehouses, sports
franchises, and day-care centers. All manner of businesses hope to avoid large tort judg-
ments by requiring their customers to give up any right to recover. Is such a clause valid?
Sometimes. Courts frequently—but do not always—ignore exculpatory clauses, finding that
one party was forcing the other party to give up legal rights that no one should be forced to
surrender.
An exculpatory clause is generally unenforceable when it attempts to exclude an inten-
tional tort or gross negligence. When Sara Beth pushes Toby over a cliff, that is the
intentional tort of battery. A court will not enforce the exculpatory clause. Sara Beth is
clearly liable.4 As to the snowmobile at the bottom of the run, if a court determines that was
gross negligence (carelessness far greater than ordinary negligence), then the exculpatory
clause will again be ignored. If, however, it was ordinary negligence, then we must continue
the analysis.
An exculpatory clause is usually unenforceable when the affected activity is in the public
interest, such as medical care, public transportation, or some essential service. Suppose
Eddie goes to a doctor for surgery on his damaged knee, and the doctor requires him to sign
an exculpatory clause. The doctor negligently performs the surgery, accidentally leaving his
cuff links in Eddie’s left knee. The exculpatory clause will not protect the doctor. Medical
care is an essential service, and the public cannot give up its right to demand reasonable work.
But what about Eddie’s suit against Pike’s Pique? Eddie claims that he should never
have been allowed to attempt an advanced maneuver. His suit is for ordinary negligence,
and the exculpatory clause probably does bar him from recovery. Skiing is a recreational
activity. No one is obligated to do it, and there is no strong public interest in ensuring that
we have access to ski slopes.
An exculpatory clause is generally unenforceable when the parties have greatly unequal
bargaining power. When Maureen flies to Colorado, suppose that the airline requires her to
sign a form contract with an exculpatory clause. Because the airline almost certainly has
much greater bargaining power, it can afford to offer a “take it or leave it” contract. The
bargaining power is so unequal, though, that the clause is probably unenforceable. Does
Pike’s Pique have a similar advantage? Probably not. Ski schools are not essential and are
much smaller enterprises. A dissatisfied customer might refuse to sign such an agreement
and take her business elsewhere. A court probably will not see the parties as grossly unequal.
Exculpatory clause
A contract provision that
attempts to release one party
from liability in the event the
other is injured.
4Note that Pike’s Pique is probably not liable under agency law principles that preclude an employer’s
liability for an employee’s intentional tort.
284 U N I T 2 Contracts
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An exculpatory clause is generally unenforceable unless the clause is clearly written and
readily visible. If Pike’s Pique gave all ski students an eight-page contract, and the excul-
patory clause was at the bottom of page seven in small print, the average customer would
never notice it. The clause would be void.
In the following case, the court focused on the public policy concerns of exculpatory
clauses used in a very common setting. Should the exculpatory clause stop the tenant from
suing the landlord? You be the judge.
BAILMENT CASES
Exculpatory clauses are very common in bailment cases. Bailment means giving
possession and control of personal property to another person. The person giving up
possession is the bailor, and the one accepting possession is the bailee. When you
leave your laptop computer with a dealer to be repaired, you create a bailment. The
same is true when you check your coat at a restaurant or lend your Matisse to a
museum. Bailees often try to limit their liability for damage to property by using an
exculpatory clause.
Judges are slightly more apt to enforce an exculpatory clause in a bailment case
because any harm is to property and not persons. But courts will still look at many of the
You Be the Judge
Facts: Barbara Richards
leased an apartment atTwin
Lakes, a complex owned by
Lenna Ransburg. The writ-
ten lease declared that:
• Twin Lakes would
“gratuitously”maintain the
common areas.
• Richards’s use of the facilities would be “at her
own risk.”
• Twin Lakes was not responsible for any harm to
the tenant or her guests, anywhere on the property
(including the parking lot), even if the damage was
caused by Twin Lakes’ negligence.
It snowed. As Richards walked across the parking lot
to her car, she slipped and fell on snow-covered ice.
Richards sued Ransburg, who moved for summary judg-
ment based on the exculpatory clause. The trial court
denied Ransburg’s motion, and she appealed.
You Be the Judge: Was the exculpatory clause valid?
Argument for Tenant: An exculpatory clause in a con-
tract for an essential service violates public policy. When
an ill person seeks medical care, his doctor cannot require
him to sign an exculpatory clause. In the same way, a
person has to live somewhere. Her landlord cannot force
her to sign a waiver.
Landlords tend to
be wealthy and power-
ful. There is generally no
equalityofbargainingpower
between them.The tenants
arenot freely agreeing to the
exculpatory language.
Moreover, if a landlord fails to maintain property, not
just the tenant is at risk. Visitors, the mail carrier, and the
general public could all walk through the Twin Lakes
parking lot. The public’s interest is served when landlords
maintain their properties. They must be held liable when
they negligently fail to maintain common areas and inju-
ries result.
Argument for Landlord: Ms. Richards does indeed
have to live somewhere, but she does not have to live
on the plaintiff’s property. Surely there are many dozens
of properties nearby. If Richards had been dissatisfied
with any part of the proposed lease—excessive rent, strict
rules, or an exculpatory clause—she was free to take her
business to another landlord.
Landlords may generally be wealthier than their
tenants, but that fact alone does not mean that a landlord
is so powerful that leases are offered on a “take it or leave
it” basis. Here, the landlord stated the exculpatory clause
plainly. This is a clear contract between adults, and it
should stand in its entirety.
Bailor
One who creates a bailment by
delivering goods to another.
RANSBURG V. RICHARDS
770 N.E.2d 393
Indiana Court of Appeals, 2002
Bailment
Giving possession and control
of personal property to another
person.
Bailee
A person who rightfully
possesses goods belonging to
another.
CHAPTER 12 Legality 285
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same criteria we have just examined to decide whether a bailment contract is enforceable.
In particular, when the bailee is engaged in an important public service, a court is once
again likely to ignore the exculpatory clause. The following contrasting cases illustrate this.
In Weiss v. Freeman,5 Weiss stored personal goods in Freeman’s self-storage facility.
Freeman’s contract included an exculpatory clause relieving it of any and all liability. Weiss’s goods
were damaged by mildew, and she sued. The court held the exculpatory clause valid. The court
considered self-storage to be a significant business, but not as vital as medical care or housing. It
pointed out that a storage facility would not know what each customer stored and therefore could
not anticipate the harm that might occur. Freedom of contract should prevail, the clause was
enforceable, and Weiss got no money.
But in Gardner v. Downtown Porsche Audi,6 Gardner left his Porsche 911 at Downtown for
repairs. He signed an exculpatory clause saying that Downtown was “Not Responsible for
Loss or Damage to Cars or Articles Left in Cars in Case of Fire, Theft, or Any Other Cause
Beyond Our Control.” Due to Downtown’s negligence, Gardner’s Porsche was stolen. The
court held the exculpatory clause void. It ruled that contemporary society is utterly depen-
dent upon automobile transportation and Downtown was therefore in a business of great
public importance. No repair shop should be able to contract away liability, and Gardner
won. (This case also illustrates that using 17 uppercase letters in one sentence does not
guarantee legal victory.)
EXAM Strategy
Facts: Shauna flew a World War II fighter aircraft as a member of an exhibition
flight team. While the team was performing in a delta formation, another plane
collided with Shauna’s aircraft, causing her to crash-land and leaving her
permanently disabled. Shauna sued the other pilot and the team. The defendants
moved to dismiss based on an exculpatory clause that Shauna had signed. The
clause was one paragraph long, and it stated that Shauna knew team flying was
inherently dangerous and could result in injury or death. She agreed not to hold
the team or any members liable in case of an accident. Shauna argued that the
clause should not be enforced against her if she could prove the other pilot was
negligent. Please rule.
Strategy: The issue is whether the exculpatory clause is valid. Courts are likely
to declare such clauses void if they concern vital activities like medical care,
exclude an intentional tort or gross negligence, or if the parties had unequal
bargaining power.
Result: This is a clear, short clause, between parties with equal bargaining
power, and does not exclude an intentional tort or gross negligence. The activity
is unimportant to the public welfare. The clause is valid. Even if the other
pilot was negligent, Shauna will lose, meaning the court should dismiss her
lawsuit.
51994 Tenn. App. LEXIS 393 (Tenn. Ct. App. 1993).
6180 Cal. App. 3d 713, 225 Cal. Rptr. 757, 1986 Cal. App. LEXIS 1542 (Cal. Ct. App. 1986).
286 U N I T 2 Contracts
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12-2d Unconscionable Contracts
Gail Waters was young, naive, and insecure. A serious injury when she was 12 years old left
her with an annuity, that is, a guaranteed annual payment for many years. When Gail
was 21, she became involved with Thomas Beauchemin, an ex-convict, who introduced
her to drugs. Beauchemin suggested that Gail sell her annuity to some friends of his,
and she agreed. Beauchemin arranged for a lawyer to draw up a contract, and Gail
signed it. She received $50,000 for her annuity, which at that time had a cash value of
$189,000 and was worth, over its remaining 25 years, $694,000. Gail later decided this
was not a wise bargain. Was the contract enforceable? That depends on the law of
unconscionability.
An unconscionable contract is one that a court refuses to enforce because of funda-
mental unfairness. Even if a contract does not violate any specific statute or public policy, it
may still be void if it “shocks the conscience” of the court.
Historically, a contract was considered unconscionable if it was “such as no man in his
senses and not under delusion would make on the one hand, and as no honest and fair man
would accept on the other.”7 The two factors that most often led a court to find unconscion-
ability were (1) oppression, meaning that one party used its superior power to force a
contract on the weaker party, and (2) surprise, meaning that the weaker party did not fully
understand the consequences of its agreement.
These cases have always been controversial because it is not easy to define oppression
and unfair surprise. Further, anytime a court rejects a contract as unconscionable, it
diminishes freedom of contract. If one party can escape a deal based on something as hard
to define as unconscionability, then no one can rely as confidently on any agreement. As an
English jurist said in 1824, “public policy is a very unruly horse, and when once you get
astride it, you never know where it will carry you.”8
Gail Waters won her case. The Massachusetts high court ruled:
Beauchemin introduced the plaintiff to drugs, exhausted her credit card accounts to the sum of
$6,000, unduly influenced her, suggested that the plaintiff sell her annuity contract, initiated the
contract negotiations, was the agent of the defendants, and benefited from the contract between
the plaintiff and the defendants. The defendants were represented by legal counsel; the plaintiff
was not. The cash value of the annuity policy at the time the contract was executed was
approximately four times greater than the price to be paid by the defendants. For payment of
not more than $50,000 the defendants were to receive an asset that could be immediately
exchanged for $189,000, or they could elect to hold it for its guaranteed term and receive
$694,000.
The defendants assumed no risk and the plaintiff gained no advantage. We are satisfied that
the disparity of interests in this contract is so gross that the court cannot resist the inference that it
was improperly obtained and is unconscionable.9
ADHESION CONTRACTS
A related issue concerns adhesion contracts, which are standard form contracts prepared by
one party and given to the other on a “take it or leave it” basis. We have all encountered
them many times when purchasing goods or services. When a form contract is vigorously
negotiated between equally powerful corporations, the resulting bargain is generally
enforced. However, when the contract is simply presented to a consumer who has no ability
to bargain, it is an adhesion contract and subject to an unconscionability challenge.
Adhesion contracts
Standard form contracts
prepared by one party and
presented to the other on a
“take it or leave it” basis.
Oppression
One party uses its superior
power to force a contract on
the weaker party.
7Hume v. United States, 132 U.S. 406, 411, 10 S. Ct. 134, 1889 U.S. LEXIS 1888 (1889), quoting Earl of
Chesterfield v. Janssen, 38 Eng. Rep. 82, 100 (Ch. 1750).
8Richardson v. Mellish, 2 Bing. 229, 103 Eng. Rep. 294, 303 (1824).
9Waters v. Min Ltd., 412 Mass. 64, 587 N.E.2d 231, 1992 Mass. LEXIS 66 (1992).
CHAPTER 12 Legality 287
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THE UCC: UNCONSCIONABILITY AND SALES LAW
With the creation of the Uniform Commercial Code (UCC), the law of unconscionability got
a boost. The Code explicitly adopts unconscionability as a reason to reject a contract.10
Although the Code directly applies only to the sale of goods, its unconscionability section
has proven to be influential in other cases as well, and courts today are more receptive than
they were 100 years ago to a contract defense of fundamental unfairness.
The drafters of the UCC reinforced the principle of unconscionability by including it in
§2-302:
If the court as a matter of law finds the contract or any clause of the contract to have been
unconscionable at the time it was made the court may refuse to enforce the contract, or it may
enforce the remainder of the contract without the unconscionable clause, or it may so limit the
application of any unconscionable clause as to avoid any unconscionable result.
In Code cases, the issue of unconscionability often arises when a company attempts to
limit the normal contract law remedies. Yet the Code itself allows such limitations, provided
they are reasonable.
Section 2-719 provides in part:
[A contract] may provide for remedies in addition to or in substitution for those provided [by the
Code itself] and may limit or alter the measure of damages recoverable … as by limiting the buyer’s
remedies to return of the goods and repayment of the price .…
WORLDWIDE INSURANCE V. KLOPP
603 A.2d 788, 1992 Del. LEXIS 13
Supreme Court of Delaware, 1992
C A S E S U M M A R Y
Facts: Ruth Klopp had auto insurance with Worldwide.
She was injured in a serious accident that left her with
permanent neck and back injuries. The other driver was
uninsured, so Klopp filed a claim with Worldwide under
her “uninsured motorist” coverage. Her policy required
arbitration of such a claim, and the arbitrators awarded
Klopp $90,000. But the policy also stated that if the
arbitrators awarded more than the statutory minimum
amount of insurance ($15,000), either side could appeal
the award and request a full trial. Worldwide appealed and
demanded a trial.
In the trial court, Klopp claimed that the appeal
provision was unconscionable and void. The trial court
agreed and entered judgment for the full $90,000. World-
wide appealed.
Issue: Was the provision that required arbitration and then
permitted appeal by either party void as unconscionable?
Decision: Yes. The contract provision was unconscion-
able. Affirmed.
Reasoning: Worldwide contended that the arbitration
provision was clear and unambiguous, but Klopp
argued that it was grossly unfair. State policy favors
the use of arbitration to resolve disputes, but it rejects
any part of a contract of adhesion that is uncon-
scionable.
This contract bound both parties to a low award, one
that an insurance company would be unlikely to appeal
anyway. Either party may appeal a high award, but com-
mon sense suggests that only the insurer would do so.
The policy enabled the insurer to avoid a high arbitration
award that may have been perfectly fair.
This policy promoted litigation and provided an arbi-
tration “escape hatch” that favored insurance companies.
The provision was unconscionable and void.
10UCC §2-302.
288 U N I T 2 Contracts
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In other words, the Code includes two potentially competing sections: §2-719 permits
a seller to insist that the buyer’s only remedy for defective goods is return of the purchase
price, but §2-302 says that any unconscionable provision is unenforceable. In lawsuits
concerning defective goods, the seller often argues that the buyer’s only remedies are
those stated in the agreement, and the buyer responds that the contract limitation is
unconscionable.
Electronic Data Systems (EDS) agreed to create complex software for Chubb Life
America at a cost of $21 million. Chubb agreed to make staggered payments over many
months as the work proceeded. The contract included a limitation on remedies, stating
that if EDS became liable to Chubb, its maximum liability would be equal to two
monthly payments.
EDS’s work was woefully late and unusable, forcing Chubb to obtain its software
elsewhere. Chubb sued, claiming $40 million in damages based on the money paid to
EDS and additional funds spent purchasing alternative goods. EDS argued that the contract
limited its liability to two monthly payments, a fraction of Chubb’s damage. Chubb, of
course, responded that the limitation was unconscionable.
The court noted that both parties were large, sophisticated corporations. As they
negotiated the agreement, the companies both used experienced attorneys and indepen-
dent consultants. This was no contract of adhesion presented to a meek consumer, but an
allocation of risk resulting from hard bargaining. The court declared that the clause was
valid, and EDS owed no more than two monthly payments.11
Chapter Conclusion
It is not enough to bargain effectively and obtain a contract that gives you exactly what you
want. You must also be sure that the contract is legal. What appears to be an insurance
contract might legally be an invalid wager. Unintentionally forgetting to obtain a state
license to perform a certain job could mean you will never be paid for it. Bargaining a
contract with a noncompete or exculpatory clause that is too one-sided may lead a court to
ignore it. Legality is multifaceted, sometimes subtle, and always important.
EXAM REVIEW
Illegal contracts are void and unenforceable. Illegality most often arises in these settings:
1. WAGERING A purely speculative contract—whether for gambling or insurance—
is likely to be unenforceable. (p. 277)
2. LICENSING When the licensing statute is designed to protect the public, a
contract by an unlicensed plaintiff is generally unenforceable. When such a statute is
designed merely to raise revenue, a contract by an unlicensed plaintiff is generally
enforceable. (pp. 278–279)
11Colonial Life Insurance Co. v. Electronic Data Systems Corp., 817 F. Supp. 235, 1993 U.S. Dist. LEXIS
4123 (D.N.H. 1993).
CHAPTER 12 Legality 289
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Question: James Wagner agreed to build a house for Nancy Graham. Wagner was
not licensed as a contractor, and Graham knew it. When the house was finished,
Graham refused to pay the final $23,000, and Wagner sued. Who will prevail?
Strategy: A licensing statute designed to protect the public is strictly enforced,
but that is not true for one intended only to raise revenue. What was the purpose
of this statute? (See the “Result” at the end of this section.)
3. USURY Excessive interest is generally unenforceable and may be fatal to the
entire debt. Credit card debt is often exempt from usury laws. (pp. 279–280)
Question: McElroy owned 104 acres worth about $230,000. He got into financial
difficulties and approached Grisham, asking to borrow $100,000. Grisham refused,
but ultimately the two reached this agreement: McElroy would sell Grisham his
property for $80,000, and the contract would include a clause allowing McElroy to
repurchase the land within two years for $120,000. McElroy later claimed the
contract was void. Is he right?
Strategy: Loans involving usury do not always include a clearly visible interest
rate. You may have to do some simple math to see the interest being charged.
McElroy wanted to borrow $100,000, but instead sold his property, with the right
to repurchase. If he did repurchase, how much interest would he have effectively
paid? (See the “Result” at the end of this section.)
4. NONCOMPETE A noncompete clause in the sale of a business must be limited to
a reasonable time, geographic area, and scope of activity. In an employment contract,
such a clause is considered reasonable—and enforceable—only to protect trade
secrets, confidential information, and customer lists. (pp. 281–283)
Question: The purchaser of a business insisted on putting this clause in the sales
contract: The seller would not compete, for five years, “anywhere in the United
States, the continent of North America, or anywhere else on earth.” What danger
does that contract represent to the purchaser?
Strategy: This is a noncompete clause based on the sale of a business. Such
clauses are valid if reasonable. Is this clause reasonable? If it is unreasonable, what
might a court do? (See the “Result” at the end of this section.)
5. EXCULPATORY CLAUSES These clauses are generally void if the activity
involved is in the public interest, the parties are greatly unequal in bargaining power,
or the clause is unclear. In other cases, they are generally enforced. (pp. 284–286)
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290 U N I T 2 Contracts
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6. UNCONSCIONABILITY Oppression and surprise may create an unconscionable
bargain. An adhesion contract is especially suspect when it is imposed by a corporation
on a consumer or small company. Under the UCC, a limitation of liability is less likely
to be unconscionable when both parties are sophisticated corporations. (pp. 287–289)
2. Result: This statute was designed to protect the public. Wagner was unlicensed
and cannot enforce the contract. Graham wins.
3. Result: By selling at $80,000 and repurchasing at $120,000, McElroy would
be paying $40,000 in interest on an $80,000 loan. The 50 percent rate is usurious.
The court prohibited Graham from collecting the interest.
4. Result: “Anywhere else on earth”? This is almost certainly unreasonable. It
is hard to imagine a purchaser who would legitimately need such wide-ranging
protection. In some states, a court might rewrite the clause, limiting the effect
to the seller’s state, or some reasonable area. However, in other states, a court
finding a clause unreasonable will declare it void in its entirety—enabling the
seller to open a competing business next door.
MULTIPLE-CHOICE QUESTIONS
1. At a fraternity party, George mentions that he is going to learn to hang-glide during
spring break. Vicki, a casual friend, overhears him, and the next day she purchases a
$100,000 life insurance policy on George’s life. George has a happy week of hang-
gliding. But on the way home, he is bitten by a parrot and dies of a rare tropical illness.
Vicki files a claim for $100,000. The insurance company refuses to pay.
(a) Vicki will win $100,000, but only if she mentioned animal bites to the insurance
agent.
(b) Vicki will win $100,000 regardless of whether she mentioned animal bites to the
insurance agent.
(c) Vicki will win $50,000.
(d) Vicki will win nothing.
2. Now assume that Vicki has loaned George $50,000. George again mentions that he is
going to learn to hang-glide during spring break, so Vicki purchases the $100,000 life
insurance policy on George’s life. If George dies and the insurance company refuses
to pay …
(a) Vicki will win $100,000, but only if she mentioned animal bites to the insurance
agent.
(b) Vicki will win $100,000 regardless of whether she mentioned animal bites to the
insurance agent.
(c) Vicki will win $50,000.
(d) Vicki will win nothing.
CHAPTER 12 Legality 291
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3. KwikFix, a Fortune 500 company, contracts with Allied Rocket, another huge company,
to provide the software for Allied’s new Jupiter Probe rocket for $14 million.
The software is negligently designed, and when the rocket blasts off from Cape
Kennedy, it travels only as far as Fort Lauderdale before crashing to Earth. Allied
Rocket sues for $200 million and proves that as a result of the disaster, it lost a huge
government contract, worth at least that much, which KwikFix was aware of. KwikFix
responds that its contract with Allied included a clause limiting its liability to the value
of the contract. Is the contract clause valid?
(a) The clause is unenforceable because it is unconscionable.
(b) The clause is unenforceable because it is exculpatory.
(c) The clause is enforceable because both parties are sophisticated corporations.
(d) The clause is enforceable because $200 million is an unconscionable claim.
4. Ricki goes to a baseball game. The back of her ticket clearly reads: “Fan agrees to
hold team blameless for all injuries pay attention to the game at all
times for your own safety!” In the first inning, a foul ball hits Ricki in the elbow.
She sue the team over the foul ball. Ricki spends the next several
innings riding the opposing team’s first baseman. The nicest thing she says to him
is, “You suck, Franklin!” In the eighth inning, Franklin has had enough. He grabs
the ballboy’s chair and throws it into the stands, injuring Ricki’s other elbow.
Ricki sue the team over the thrown chair.
(a) can; can
(b) can; cannot
(c) cannot; can
(d) cannot; cannot
5. Jim, about to start a pickup soccer game, asks Desiree if she will hold his wallet while
he plays. Desiree, a law student, says, “Sure, if you’ll sign this exculpatory clause
holding me blameless for negligence.” Jim is very surprised, but he signs the paper
that Desiree holds out for him. A bailment been created. If Desiree is
careless and loses the wallet, she be liable to Jim.
(a) has; will
(b) has; will not
(c) has not; will
(d) has not; will not
ESSAY QUESTIONS
1. For 20 years, Art’s Flower Shop relied almost exclusively on advertising in the yellow
pages to bring business to its shop in a small West Virginia town. One year, the yellow
pages printer accidentally did not print Art’s ad, and Art’s suffered an enormous drop in
business. Art’s sued for negligence and won a judgment of $50,000 from the jury, but the
printing company appealed, claiming that under an exculpatory clause in the contract,
the company could not be liable to Art’s for more than the cost of the ad, about $910.
Art’s claimed that the exculpatory clause was unconscionable. Please rule.
292 U N I T 2 Contracts
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2. Brockwell left his boat to be repaired at Lake Gaston Sales. The boat contained
electronic equipment and other personal items. Brockwell signed a form stating that
Lake Gaston had no responsibility for any loss to any property in or on the boat.
Brockwell’s electronic equipment was stolen and other personal items were damaged,
and he sued. Is the exculpatory clause enforceable?
3. Guyan Machinery, a West Virginia manufacturing corporation, hired Albert Voorhees
as a salesman and required him to sign a contract stating that if he left Guyan, he
would not work for a competing corporation anywhere within 250 miles of West
Virginia for a two-year period. Later, Voorhees left Guyan and began working at
Polydeck Corp., another West Virginia manufacturer. The only product Polydeck
made was urethane screens, which comprised half of 1 percent of Guyan’s business.
Is Guyan entitled to enforce its noncompete clause?
4. 810 Associates owned a 42-story skyscraper in midtown Manhattan. The building
had a central station fire alarm system, which was monitored by Holmes
Protection. A fire broke out and Holmes received the signal. But Holmes’s
inexperienced dispatcher misunderstood the signal and failed to summon the fire
department for about nine minutes, permitting tremendous damage. 810 sued
Holmes, which defended based on an exculpatory clause that relieved Holmes of
any liability caused in any way. Holmes’s dispatcher was negligent. Does it matter
how negligent he was?
5. YOU BE THE JUDGE WRITING PROBLEM Oasis Waterpark, located in
Palm Springs, California, sought out Hydrotech Systems, Inc., a New York
corporation, to design and construct a surfing pool. Hydrotech replied that it could
design the pool and sell all the necessary equipment to Oasis, but it could not
build the pool because it was not licensed in California. Oasis insisted that
Hydrotech do the construction work because Hydrotech had unique expertise in
these pools. Oasis promised to arrange for a licensed California contractor to
“work with” Hydrotech on the construction; Oasis also assured Hydrotech that it
would pay the full contract price of $850,000, regardless of any licensing issues.
Hydrotech designed and installed the pool as ordered. But Oasis failed to make
the final payment of $110,000. Hydrotech sued. Can Hydrotech sue for either
breach of contract or fraud (trickery)? Argument for Oasis: The licensing law
protects the public from incompetence and dishonesty. The legislature made the
section strict: no license, no payment. If the court were to start picking and
choosing which unlicensed contractors could win a suit, it would be inviting
incompetent workers to endanger the public and then come into court and try
their luck. That is precisely the danger the legislature seeks to avoid. Argument
for Hydrotech: This is not the kind of case the legislature was worried about.
Hydrotech has never solicited work in California. Hydrotech went out
of its way to avoid doing any contracting work, informing Oasis that it was
unlicensed in the state. Oasis insisted on bringing Hydrotech into the state to do
work. If Oasis has its way, word will go out that any owner can get free work done
by hiring an unlicensed builder. Make any promises you want, get the work done to
your satisfaction, and then stiff the contractor—you’ll never have to pay.
CHAPTER 12 Legality 293
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DISCUSSION QUESTIONS
1. ETHICS Richard and Michelle Kommit traveled to
New Jersey to have fun in the casinos. While in
Atlantic City, they used theirMasterCard towithdraw
cash from an ATM conveniently located in the
“pit”—the gambling area of a casino. They ran up
debts of $5,500 on the credit card and did not pay.
The Connecticut National Bank sued for the money.
Law aside, who has the moral high ground? Is it
acceptable for the casino to offer ATM services in the
gambling pit? If a credit card company allows
customers to withdraw cash in a casino, is it
encouraging them to lose money? Do the Kommits
have any ethical right to use the ATM, attempt to win
money by gambling, and then seek to avoid liability?
2. The Justice Department shut down three of the
most popular online poker websites (Poker Stars,
Absolute Poker, and Full Tilt Poker). State
agencies take countless actions each year to stop
illegal gaming operations. Do you believe that
gambling by adults should be regulated? If so,
which types? Rate the following types of gambling
from most acceptable to least acceptable:
3. Van hires Terri to add an electrical outlet to his
living room for his new HDTV. Terri does an
excellent job, and the new outlet works
perfectly. She presents Van with a bill for $200.
But Terri is not a licensed electrician. Her state
sets licensing standards in the profession to
protect the public. And so, Van can refuse to pay
Terri’s bill. Is this reasonable? Should he be able
to avoid payment?
4. Should noncompete agreements in employment
contracts be illegal altogether? Is there equality of
bargaining power between the company and the
employee? Should non-competes be limited to top
officers of a company? Would you be upset if a
prospective employer asked you to agree to a one
year covenant not to compete?
5. Revisit the Gail Waters example on page 287.
Imagine now that Beauchemin was not her
boyfriend, and that he had not introduced her to
the drugs to which she became addicted. If all
other facts in the case remain the same, would the
purchase of the annuity for $50,000 still be
unconscionable, in your opinion?
– online poker – state lotteries – horse racing
– casino gambling – bets on pro sports – bets on college
sports
294 U N I T 2 Contracts
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CHAPTER13
CAPACITY AND
CONSENT
Katie, age 17, visits her local electronics store to
buy a new laptop. At the register, she pays $400
in cash for the machine. No one is with her, and
the cashier does not ask her to show her ID.
Out in the parking lot, Katie’s cell phone
rings. As she fumbles for it, she loses her grip
on the new laptop. It falls to the pavement—
crack!—bounces once, and comes to rest a few
feet away from her.
Just then, a Hummer rounds the corner. It runs over Katie’s new laptop. “Ugg …” she
says, feeling nauseous. The SUV stops, and the reverse lights come on. It backs slowly over
the laptop again. The driver, oblivious, rolls down his
window and asks Katie, “Say, is there a gas station
around here?”
“That way,” a shocked Katie says, pointing to a sign
in the distance. “But you just …”
“Oh, I see it! Thanks a million!” The driver puts the
Hummer in gear and drives over the laptop a third time.
The small jolt loosens the one lug nut securing the spare
tire to the back of the SUV. The heavy spare falls
directly on top of what remains of Katie’s new laptop.
Scooping up wires, bits of plastic, and pieces of metal, she goes back inside the store.
Dumping the pieces on the customer service desk, she says, “I’ve changed my mind about
this computer.”
The clerk looks at the collection of laptop parts, shakes his head, and points to a sign
behind him. “Look, I can’t take merchandise back if it’s damaged. And this laptop is
definitely damaged.”
“Too bad,” Katie says. “I want my money back. Now.”
Is Katie entitled to a full refund? In most states, the answer is yes.
This chapter examines voidable contracts. When a contract is voidable, one party has
the option either to enforce or terminate the agreement. Two specific issues are presented.
Just then, a Hummer
rounds the corner.
It runs over Katie’s
new laptop.
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Capacity concerns the legal ability of a party to enter a contract in the
first place. Someone may lack capacity because of his young age or mental
infirmity. Consent refers to whether a contracting party truly understood
what she was getting into and whether she made the agreement voluntarily.
Consent issues arise in cases of fraud, mistake, duress, and undue influence.
13-1 CAPACITY
Capacity is the legal ability to enter into a contract. An adult of sound mind has capacity.
Generally, any deal she enters into will be enforced if all elements on the Contracts Checklist—
agreement, consideration, and so forth—are present. But two groups of people usually lack legal
capacity: minors and those with a mental impairment.
13-1a Minors
In contract law, a minor is someone under the age of 18. Because a minor lacks legal
capacity, she normally can create only a voidable contract. A voidable contract may be canceled
by the party who lacks capacity. Notice that only the party lacking capacity may cancel the
agreement. So a minor who enters into a contract generally may choose between enforcing
the agreement or negating it. The other party—an adult, or perhaps a store—has no such right.
Voidable contracts are very different from those that are void, which we examined in Chapter
12, on legality. A void contract is illegal from the beginning and may not be enforced by either
party. A voidable contract is legal but permits one party to escape, if he so wishes.
DISAFFIRMANCE
A minor who wishes to escape from a contract generally may disaffirm it; that is, he may
notify the other party that he refuses to be bound by the agreement. There are several ways
a minor may disaffirm a contract. He may simply tell the other party, orally or in writing, that
he will not honor the deal. Or he may disaffirm a contract by refusing to perform his
obligations under it. A minor may go further—he can undo a contract that has already been
completed by filing a suit to rescind the contract; that is, to have a court formally cancel it.
Kevin Green was 16 when he signed a contract with Star Chevrolet to buy a used
Camaro. Because he was a minor, the deal was voidable. When the Camaro blew a gasket
and Kevin informed Star Chevrolet that he wanted his money back, he was disaffirming the
contract. He happened to do it because the car suddenly seemed a poor buy, but he could
have disaffirmed for any reason at all, such as deciding that he no longer liked Camaros.
When Kevin disaffirmed, he was entitled to his money back.
RESTITUTION
A minor who disaffirms a contract must return the consideration he has received, to the
extent he is able. Restoring the other party to its original position is called restitution. The
consideration that Kevin Green received in the contract was, of course, the Camaro.
What happens if theminor is not able to return the consideration because he no longer has it or
it has been destroyed?Most states hold that theminor is still entitled to his money back. Aminority
of states follow the status quo rule, which provides that, if a minor cannot return the consideration,
the adult or store is only required to return its profit margin to the minor.
In the opening scenario, Katie attempted to return a destroyed laptop for the full
purchase price of $400. Assume that the store paid a computer manufacturer $350 for the
laptop and then marked it up $50.
Disaffirm
To give notice of refusal to be
bound by an agreement.
Rescind
To cancel a contract.
Restitution
Restoring an injured party to its
original position.
Offer
Acceptance
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In most states, Katie would be entitled to the full $400 purchase price, even though the
laptop is now worthless. The sign at the customer service desk would have no effect, and
the store would have to absorb the loss. But, if Katie lives in a state with the status quo rule,
then the store will have to refund only $50 to Katie. It is permitted to keep the other $350
so that it breaks even on the transaction, or is “returned to the status quo.”
Ethics The rule permitting a minor to disaffirm a contract is designed to
discourage adults from making deals with innocent children, and it is
centuries old. Is this rule still workable in our modern consumer society? There are entire
industries devoted to (and dependent upon) minors. Think of children’s films, music,
sneakers, and toys. Does this rule imperil retailers? Is it right to give a 17-year-old high
school senior so much power to cancel agreements? In the opening scenario, is it
reasonable for Katie to seek a full refund, or is she taking advantage of the system?
TIMING OF DISAFFIRMANCE/RATIFICATION
A minor may disaffirm a contract anytime before she reaches age 18. She also may disaffirm
within a reasonable time after turning 18. Suppose that 17-year-old Betsy signs a contract to
buy a $3,000 stereo. The following week, she picks up the system and pays for it in full.
Four months later, she turns 18, and two months after that, she disaffirms the contract. Her
disaffirmance is effective. In most states, she gets 100 percent of her money back. In some
cases, minors have been entitled to disaffirm a contract several years after turning 18. But the
minor’s right to disaffirm ends if she ratifies the contract. Ratification is made by any words
or action indicating an intention to be bound by the contract. Suppose Betsy, age 17, buys
her stereo on credit, promising to pay $150 per month. She has made only four payments by
the time she turns 18, but after reaching her majority, she continues to pay every month for
six more months. Then she attempts to disaffirm. Too late. Her actions—payment of the
monthly bill for six months as an adult—ratified the contract she entered into as a minor.
She is now fully obligated to pay the entire $3,000, on the agreed-upon schedule.
EXCEPTION: NECESSARIES
A necessary is something essential to the minor’s life and welfare. On a contract for
necessaries, a minor must pay for the value of the benefit received. In other words, the
minor may still disaffirm the contract and return whatever is unused. But he is liable to pay
for whatever benefit he obtained from the goods while he had them. Food, clothing,
housing, and medical care are necessaries. Thus a 16-year-old who buys and eats a 99-cent
cheeseburger cannot later seek his 99 cents from the fast food restaurant.
EXCEPTION: MISREPRESENTATION OF AGE
The rules change somewhat if a minor lies about his age. Sixteen-year-old Dan is delighted to
learn from his friend Betsy that a minor can buy a fancy stereo system, use it for a year or so,
and then get his money back. Dan drops into SoundBlast and asks to buy a $4,000 surround-
sound system. The store clerk says that the store no longer sells expensive systems to
underage customers. Dan produces a fake driver’s license indicating that he is 18, and the
clerk sells him the system. A year later, Dan drives up to SoundBlast and unloads the system,
now in shambles. He asks for his $4,000 back. Is he still permitted to disaffirm?
States have been troubled by this problem, and there is no clear rule. A few states will
still permit Dan to disaffirm the contract entirely. The theory is that a minor must be saved
from his own poor judgment, including his foolish lie. Many states, though, will prohibit
Ratification
Words or actions indicating an
intention to be bound by a
contract.
CHAPTER 13 Capacity and Consent 297
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Dan from disaffirming the contract. They take the reasonable position that the law was
intended to protect childhood innocence, not calculated deceit.
13-1b Mentally Impaired Persons
You are a trial court judge. Don wants you to rule that his father, Cedric, is mentally
incompetent and, on behalf of Cedric, to terminate a contract he signed.
Here is the evidence.
Cedric isa75-year-oldmillionairewhokeeps$300,000stuffedinpillowcasesintheattic.Helives
in a filthy house with a parrot whom he calls the Bishop, an iguana named Orlando, and a tortoise
knownasMrs.Sedgely.Allof thepetshavesmallbeds inCedric’sgrungybedroom,andeachoneeats
at the dining table with its master. Cedric pays college students $50 an hour to read poetry to the
animals, but he forbids the reading of sonnets, which he regards as “the devil’s handiwork.”
Don has been worried about Cedric’s bizarre behavior for several years and has urged his
father to enter a nursing home. Last week, when Don stopped in to visit, Cedric became angry
at him, accusing his son of disrespecting the Bishop and Mrs. Sedgely, who were enjoying a
15th-century Castilian poem that Jane, a college student, was reading. Don then blurted out
that Cedric was no longer able to take care of himself. Cedric snapped back, “I’ll show you how
capable I am.”On the back of a 40-year-old menu, he scratched out a contract promising to give
Jane “$100,000 today and $200,000 one year from today if she agrees to feed, house, and care
for the Bishop, Orlando, and Mrs. Sedgely for the rest of their long lives.” Jane quickly signed
the agreement. Don urges that the court, onCedric’s behalf, declare the contract void. Howwill
you rule? Courts often struggle when deciding cases of mental competence.
A person suffers from a mental impairment if, by reason of mental illness or defect, he is
unable to understand the nature and consequences of the transaction.1 The mental impair-
ment can be due to some mental illness, such as schizophrenia, or to mental retardation,
brain injury, senility, or any other cause that renders the person unable to understand the
nature and consequences of the contract.
A party suffering a mental impairment usually creates only a voidable contract. The
impaired person has the right to disaffirm the contract just as a minor does. But again, the
contract is voidable, not void. The mentally impaired party generally has the right to full
performance if she wishes.
The law creates an exception: If a person has been adjudicated insane, then all of his
future agreements are void. “Adjudicated insane” means that a judge has made a formal
finding that a person is mentally incompetent and has assigned the person a guardian.
How will a court evaluate Cedric’s mental status? Of course, if there had already been a
judicial determination that he was insane, any contract he signed would be void. Since no
judge has issued such a ruling about Cedric, the court will listen to doctors or therapists who
have evaluated him and to anyone else who can testify about Cedric’s recent conduct. The
court may also choose to look at the contract itself, to see if it is so lopsided that no competent
person would agree to it.
How will Don fare in seeking to preserve Cedric’s wealth? Poorly. Unless Don has more
evidence than we have heard thus far, he is destined to eat canned tuna while Jane and the
Bishop dine on caviar. Cedric is decidedly eccentric, and perhaps unwise. But those
characteristics do not prove mental impairment. Neither does leaving a fortune to a poetry
reader. If Don could produce evidence from a psychiatrist that Cedric, for example, was
generally delusional or could not distinguish a parrot from a religious leader, that would
persuade a court of mental impairment. But on the evidence presented thus far, Mrs.
Sedgely and friends will be living well.2
1Restatement (Second) of Contracts §15.
2For a similar case, see Harwell v. Garrett, 239 Ark. 551, 393 S.W.2d 256, 1965 Ark. LEXIS 1033
(1965).
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INTOXICATION
Similar rules apply in cases of drug or alcohol intoxication. When one party is so intoxicated that
he cannot understand the nature and consequences of the transaction, the contract is voidable.
We wish to stress that courts are highly skeptical of intoxication arguments. If you go out
drinking and make a foolish agreement, you are probably stuck with it. Even if you are too
drunk to drive, you are probably not nearly too drunk to
make a contract. If your blood alcohol level is, say, .08, your
coordination and judgment are poor. Driving in such a
condition is dangerous. But you probably have a fairly clear
awareness of what is going on around you.
To back out of a contract on the grounds of intoxica-
tion, you must be able to provide evidence that you did not
understand the “nature of the agreement,” or the basic deal
that you made.
The following landmark case is a rare exception, and
the defendant was able to escape the deal. The defendant
had lots of witnesses who testified that he had no idea what
he was doing.
Did he understand what
he was doing? Did he
know where and who he
was?
Landmark Case
Facts: While Charles
Engel’s wife was out
of town, he sat home
alone, drinking migh-
tily. During this period,
he made the following
agreement with G. M.
Babcock: Engel traded his 320-acre farm and $2,000
worth of personal property for Babcock’s hotel. Engel’s
property was worth approximately twice the value of the
hotel. Engel later refused to honor the deal on the
grounds that he had been intoxicated when he made
the agreement. Babcock sued, but the jury sided with
Engel and dismissed the complaint. Babcock appealed.
Issue: Did Engel’s intoxication make his agreement with
Babcock voidable?
Decision: Yes. Engel’s inability to understand the nature
and consequences of his act made the contract voidable.
Reasoning: The main question here was not whether
Engel was drunk. The facts indicated that he was
completely wasted and the jury agreed. Engel testified
that as soon as his wife left town, he binged on whisky
for two days. (Let’s just say he missed her …) After
stumbling into town, he
downed four or five more
drinks of whisky and black-
berry before negotiating a
bad deal with Babcock.
The law was only
concerned with the ugly
details of Engel’s drunkenness because they described
his mental capacity when he entered into the contract.
Could Engel have freely consented in his condition?
Did he understand what he was doing? Did he
know where and who he was? Four credible witnesses
testified that the befuddled Engel had no idea what
he was doing and did not look qualified to transact
business.
Traditionally, the law refused to give a “free pass” to
the drunk, opting instead to make them liable for the
consequences of their overindulgence. But alcohol
intoxication is just one of many causes of incapacity, all
of which are subject to the same rule. If a party is unable to
understand the nature and consequences of his act, the
resulting contract is voidable at his option when he regains
capacity. The trial court’s decision was affirmed.
BABCOCK V. ENGEL
58 Mont. 597; 194 P. 137
Supreme Court of Montana, 1920
CHAPTER 13 Capacity and Consent 299
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RESTITUTION
Amentally infirm party who seeks to void a contract must make restitution. If a party succeeds
with a claim of mental impairment, the court will normally void the contract but will require
the impaired party to give back whatever she got. Suppose Danielle buys a Rolls-Royce and
promises in writing to pay $4,000 per month for five years. Three weeks later, she seeks to
void the contract on the grounds of mental impairment. She must return the Rolls. If the car
has depreciated, Danielle normally will have to pay for the decrease in value. What happens
if restitution is impossible? Generally, courts require a mentally infirm person to make full
restitution if the contract is to be rescinded. If restitution is impossible, the court will not
rescind the agreement unless the infirm party can show bad faith by the other. This is
because, unlike minority, which is generally easy to establish, mental competence may not
be so apparent to the other person negotiating.
13-2 REALITY OF CONSENT
Smiley offers to sell you his house for $300,000, and you agree in writing to buy it. After you
move in, you discover that the house is sinking into the earth at the rate of six inches per
week. In twelve months, your only access to the house may be through the chimney. You
sue, seeking to rescind. You argue that when you signed the contract, you did not truly consent
because you lacked essential information. In this section we look at four claims that parties make
in an effort to rescind a contract based on lack of valid consent: (1) fraud, (2) mistake, (3) duress,
and (4) undue influence.
13-2a Fraud
Fraud begins when a party to a contract says something that is factually wrong. “This house
has no termites,” says a homeowner to a prospective buyer. If the house is swarming with
the nasty pests, the statement is a misrepresentation. But does it amount to fraud? An
injured person must show the following:
1. The defendant knew that his statement was false, or that he made the statement
recklessly and without knowledge of whether it was false.
2. The false statement was material.
3. The injured party justifiably relied on the statement.
ELEMENT ONE: INTENTIONAL OR RECKLESS
MISREPRESENTATION OF FACT
The injured party must show a false statement of fact. Notice that this does not mean the
statement was a necessarily a “lie.” If a homeowner says that the famous architect Stanford
White designed her house, but Bozo Loco actually did the work, it is a false statement.
Now, if the owner knows that Loco designed the house, she has committed the first
element of fraud. And, if she has no idea who designed the house, her assertion that it was
“Stanford White” also meets the first element.
But the ownermight have a good reason for the error. Perhaps a local history book identifies the
house as a StanfordWhite. If shemakes the statementwith a reasonable belief that she is telling the
truth, she has made an innocent misrepresentation (discussed in the next section) and not fraud.
Opinions and “puffery” do not amount to fraud. An opinion is not a statement of fact. A
seller says, “I think land values around here will be going up 20 or 30 percent for the
foreseeable future.” That statement is pretty enticing to a buyer, but it is not a false
Offer
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statement of fact. The maker is clearly stating her own opinion, and the buyer who relies on
it does so at his peril. A close relative of opinion is something called “puffery.”
Get ready for one of the most astonishing experiences you’ve ever had! This section on
puffery is going to be the finest section of any textbook you have ever read! You’re going to
find the issue intriguing, the writing dazzling, and the legal summary unforgettable!
“But what happens,” you might wonder, “if this section fails to astonish? What if I find the
issue dull, the writing mediocre, and the legal summary incomprehensible? Can I sue for fraud?”
No. The promises wemade were mere puffery. A statement is puffery when a reasonable person
would realize that it is a sales pitch, representing the exaggerated opinion of the seller. Puffery is
not a statement of fact. Because puffery is not factual, it is never a basis for rescission.
Consumers filed a class action against Intel Corporation, claiming fraud. They asserted
that Intel advertised its “Pentium 4” computer chip as the “best” in the market when in fact
it was no faster than the Pentium III chip. The Illinois Supreme Court dismissed the claims,
asserting that no reasonable consumer would make a purchase relying solely on the name
“Pentium 4.” Even if the consumers could show that Intel plotted to persuade the market
that the Pentium 4 was the finest processor, they are demonstrating nothing but puffery.
Saying that the Pentium 4 is “better” or “best” could mean that the Pentium 4 is cheaper,
smaller, more reliable, of higher quality, better for resale, more durable, creates less heat, uses less
electricity, is more compatible with some versions of software, or is simply the latest in a temporal
line of processors. Because the term “better” as a mere suggestion in the name “Pentium 4” is not
capable of precise measuring, it is mere puffery and therefore not actionable. That is true even if
Intel specifically set out to show the market that the Pentium 4 was the best processor to date.3
Courts have found many similar phrases to be puffery, including “high-quality,”
“expert workmanship,” and “you’re in good hands with us.”
ELEMENT TWO: MATERIALITY
The injured party must demonstrate that the statement was material, or important. A minor
misstatement does not meet this second element of fraud. Was the misstatement likely to
influence the decision of the misled party significantly? If so, it was material.
Imagine a farmer selling a piece of his land. He measures the acres himself, and
calculates a total of 200. If the actual acreage is 199, he has almost certainly not made a
material misstatement. But if the actual acreage is 150, he has.
ELEMENT THREE: JUSTIFIABLE RELIANCE
The injured party also must show that she actually did rely on the false statement and that
her reliance was reasonable. Suppose the seller of a gas station lies through his teeth about
the structural soundness of the building. The buyer believes what he hears but does not
much care because he plans to demolish the building and construct a day-care center. There
was a material misstatement but no reliance, and the buyer may not rescind.
The reliance must be justifiable—that is, reasonable. If the seller of wilderness land
tells Lewis that the area is untouched by pollution, but Lewis can see a large lake on the
property covered with six inches of oily red scum, Lewis is not justified in relying on the
seller’s statements. If he goes forward with the purchase, he may not rescind.
No Duty to Investigate In the previous example, Lewis must act reasonably and
keep his eyes open if he walks around the “wilderness” property. But he has no duty to
undertake an investigation of what he is told. In other words, if the seller states that the
countryside is pure and the lake looks crystal clear, Lewis is not obligated to take water
samples and have them tested by a laboratory. A party to a contract has no obligation to
investigate the other party’s factual statements.
3Barbara’s Sales, Inc. v. Intel Corp., 879 N.E.2d 910 (Ill. 2007).
CHAPTER 13 Capacity and Consent 301
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PLAINTIFF’S REMEDIES FOR FRAUD
In the case of fraud, the injured party generally has a choice of rescinding the contract or
suing for damages or, in some cases, doing both. The contract is voidable, which meant that
injured party is not forced to rescind the deal but may if he wants. Fraud permits the injured
party to cancel. Alternatively, the injured party can sue for damages—the difference
between what the contract promised and what it delivered.
Nancy learns that the building she bought has a terrible heating system. A new one will
cost $12,000. If the seller told her the system was “like new,” Nancy may rescind the deal.
But it may be economically harmful for her to do so. She might have sold her old house,
hired a mover, taken a new job, and so forth. What are her other remedies? She could move
into the new house and sue for the difference between what she got and what was
promised, which is $12,000, the cost of replacing the heating system.
In some states, a party injured by fraud may both rescind and sue for damages. In these
states, Nancy could rescind her contract, get her deposit back, and then sue the seller for
any damages she has suffered. Her damages might be, for example, a lost opportunity to buy
another house or wasted moving expenses.
In fact, this last option—rescinding and still suing for damages—is available in all states
when a contract is for the sale of goods. UCC §2-721 permits a party to rescind a contract
and then sue for damages when fraud is committed.
INNOCENT MISREPRESENTATION
If all elements of fraud are present except the misrepresentation of fact was not made
intentionally or recklessly, then innocent misrepresentation has occurred. So, if a person
misstates a material fact and induces reliance, but he had good reason to believe that his
statement was true, then he has not committed fraud. Most states allow rescission of a
contract, but not damages, in such a case.
SPECIAL PROBLEM: SILENCE
We know that a party negotiating a contract may not misrepresent a material fact. The house
seller may not say that “the roof is in great shape” when she sleeps under an umbrella to
avoid rain. But what about silence? Suppose the seller knows the roof is in dreadful
condition but the buyer never asks. Does the seller have an affirmative obligation to disclose
what she knows?
This is perhaps the hottest topic today in the law of misrepresentation. In 1817, the
United States Supreme Court laid down the general rule that a party had no duty to
disclose, even when he knew that the other person was negotiating under a mistake.4 In
other words, the Court was reinforcing the old rule of caveat emptor, “let the buyer beware.”
But social attitudes about fairness have changed. Today, a seller who knows something that
the buyer does not know is often required to divulge it.
Nondisclosure of a fact amounts to misrepresentation in these four cases: (1) where
disclosure is necessary to correct a previous assertion; (2) where disclosure would correct a
basic mistaken assumption that the other party is relying on; (3) where disclosure would
correct the other party’s mistaken understanding about a writing; or (4) where there is a
relationship of trust between the two parties.5
To Correct a Previous Assertion During the course of negotiations, one party’s
perception of the facts may change. When an earlier statement later appears inaccurate, the
change generally must be reported.
4Laidlaw v. Organ, 15 U.S. 178, 1817 U.S. LEXIS 396 (1817).
5Restatement (Second) of Contracts §161.
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W. R. Grace & Co. wanted to buy a natural-gas field in Mississippi. An engineer’s report
indicated the presence of large gas reserves. On the basis of the engineering report, the
Continental Illinois National Bank committed to a $75 million nonrecourse production loan.
A “nonrecourse loan” meant that Continental would be repaid only with revenues from the
gas field. After Continental committed, but before it had closed on the loan, Grace had an
exploratory well drilled and struck it rich—with water. The land would never produce any
gas. Without informing Continental of the news, Grace closed the $75 million loan. When
Grace failed to repay, Continental sued and won. A party who learns new information
indicating that a previous statement is inaccurate must disclose the bad news.6
To Correct a Basic Mistaken Assumption When one party knows that the other
is negotiating with a mistaken assumption about an important fact, the party who knows of
the error must correct it. Jeffrey Stambovsky agreed to buy Helen Ackley’s house in Nyack,
New York, for $650,000. Stambovsky signed a contract and made a $32,500 down payment.
Before completing the deal, he learned that in several newspaper articles, Ackley had
publicized the house as being haunted. Ackley had also permitted the house to be featured
in a walking tour of the neighborhood as “a riverfront Victorian (with ghost).” Stambovsky
refused to go through with the deal and sued to rescind. He won. The court ruled that
Ackley sold the house knowing Stambovsky was ignorant of the alleged ghosts. She also knew
that a reasonable buyer might avoid a haunted house, fearing grisly events—or diminished
resale value. Stambovsky could not have discovered the apparitions himself, and Ackley’s
failure to warn permitted him to rescind the deal.7
A seller generally must report any latent defect he
knows about that the buyer should not be expected to
discover himself. As social awareness of the environment
increases, a buyer potentially worries about more and more
problems. We now know that underground toxic waste,
carelessly dumped in earlier decades, can be dangerous or
even lethal. Accordingly, any property seller who realizes
that there is toxic waste underground, or any other hidden
hazard, must reveal that fact.
To Correct a Mistaken Understanding about a
Writing Suppose the potential buyer of a vacation
property has a town map showing that the land he wants to buy has a legal right of way
to a beautiful lake. If the seller of the land knows that the town map is out of date and that
there is no such right of way, she must disclose her information.
A Relationship of Trust Maria is planning to sell her restaurant to her brother Ricardo.
Maria has a greater duty to reveal problems in the business because Ricardo assumes she will
be honest. When one party naturally expects openness and honesty, based on a close relation-
ship, the other party must act accordingly. If the building’s owner has told Maria he will not
renew her lease, she must pass that information on to Ricardo.
What happens if an owner, rather than disclosing hidden defects, sells the property “as
is”? The following case provides insight.
She also knew that a
reasonable buyer might
avoid a haunted house,
fearing grisly events …
6FDIC v. W.R. Grace & Co., 877 F.2d 614, 1989 U.S. App. LEXIS 8905 (7th Cir. 1989).
7Stambovsky v. Ackley, 169 A.D.2d 254, 572 N.Y.S.2d 672, 1991 N.Y. App. Div. LEXIS 9873 (N.Y. App.
Div. 1991).
CHAPTER 13 Capacity and Consent 303
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EXAM Strategy
Question: Mako is selling his country house for $400,000. Guppy, an interested
buyer, asks whether there is sufficient water from the property’s well. Mako replies,
“Are you kidding? Watch this.” He turns on the tap, and the water flows bountifully.
Mako then shows Guppy the well, which is full. Guppy buys the property, but two
weeks later, the well runs dry. In fact, Mako knew the water supply was inadequate,
and he had the well filled by a tanker truck while the property was being sold. A
hydrologist tells Guppy it will cost $100,000 to dig a better well, with no guarantee of
success. Guppy sues Mako. What remedy should Guppy seek? Who will win?
Strategy: Is this a case of innocent misrepresentation or fraud? Fraud. Therefore,
Guppy may seek two remedies: damages or rescission. Make sure that you understand
the difference. To win, Guppy must show he relied on a fact that was both false and
material.
HESS V. CHASE MANHATTAN BANK, USA, N.A.
220 S.W.3d 758
Missouri Supreme Court, 2007
C A S E S U M M A R Y
Facts: Billy Stevens owned a paint company. On sev-
eral occasions, he ordered employees to load a trailer
with 55-gallon paint drums, and pallets of old paint cans, and
dump them on property he owned. This illegal dumping
saved Stevens the cost of proper disposal. Later, employees
notified the Environmental Protection Agency of what Ste-
vens had done, and the EPAbegan an investigation. (Stevens
later served time for environmental crimes.)
Stevens defaulted on his mortgage to the land. While
Chase Manhattan Bank was in the process of foreclosing, it
learned that the EPA was investigating the property for
contamination. Chase foreclosed and put the property up
for sale “as is.” Several buyers expressed interest. The bank
did not inform any of them of the ongoing EPA investiga-
tion. Dennis Hess bought the property for $52,000.
After Hess bought the land, he discovered the illegal
waste and sued Chase for failing to disclose the EPA’s
investigation. The jury awarded Hess $52,000 and Chase
appealed.
Issue: Did Chase have a duty to disclose to Hess the ongoing
investigation?
Decision: Yes. Chase had a duty to disclose the investi-
gation. Affirmed.
Reasoning: Buyers of “as-is” properties must exercise
ordinary diligence before making the purchase. Sellers of
such properties need not disclose anything that buyers
could discover during a reasonable inspection. Chase argued
that because old paint cans were strewn about the property,
Hess should have known that the previous owner had
dumped hazardous waste there.
Hess responded that even though the paint cans were
visible, he had no way of knowing that the EPA was
investigating the land. He claimed that he would not have
purchased the property if Chase had notified him of the
government inquiry. Hess also presented evidence that
two other potential buyers who were aware of the paint
cans had made offers on the land. But both testified that
they would not have done so if they had known about the
EPA investigation.
Chase was wrong to conceal its superior knowledge
because Hess had no reasonable chance to discover the
EPA action during his inspection of the property. Chase’s
silence amounted to fraud, and Missouri law does not
allow a disclaimer like “as is” to protect a defendant from
liability for fraud.
Hess may rescind the contract and recover the
$52,000 purchase price.
304 U N I T 2 Contracts
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Result: When Mako responded to Guppy’s question by demonstrating the apparent
abundance of water, he made a false statement. This was fraud (not innocent
misrepresentation), because Mako knew the well was inadequate. That was a material
fact. Guppy reasonably relied on the demonstration. Guppy will win. He can elect to
rescind the contract (return the property to Mako and get his money back) or choose
damages (the cost of digging a proper well). Given the uncertain nature of well
digging, he would be wise to rescind.
13-2b Mistake
Contract law principles come from many sources, and in the area of “legal mistake,” a cow
significantly influenced the law. The cow was named Rose. She was a gentle animal that
lived in Michigan in 1886. Rose’s owner, Hiram Walker & Sons, bought her for $850. After a
few years, the company concluded that Rose could have no calves. As a barren cow, she was
worth much less than $850, so Walker contracted to sell her to T. C. Sherwood for a mere
$80. But when Sherwood came to collect Rose, the parties realized that (surprise!) she was
pregnant. Walker refused to part with the happy mother, and Sherwood sued. Walker
defended, claiming that both parties had made a mistake and that the contract was voidable.
A mistake can take many forms. It may be a basic error about an essential characteristic
of the thing being sold, as in Rose’s case. It could be an erroneous prediction about future
prices, such as an expectation that oil prices will rise. It might be a mechanical error, such as
a builder offering to build a new home for $300 when he clearly meant to bid $300,000.
Some mistakes lead to voidable contracts, others create enforceable deals. The first distinc-
tion is between bilateral and unilateral mistakes.
BILATERAL MISTAKE
A bilateral mistake occurs when both parties negotiate based on the same factual error.
Sherwood and Walker both thought Rose was barren, both negotiated accordingly, and both
were wrong. The Michigan Supreme Court gave judgment for Walker, the seller, permitting
him to rescind the contract because the parties were both wrong about the essence of what
they were bargaining for.
If the parties contract based on an important factual error, the contract is voidable by
the injured party. Sherwood and Walker were both wrong about Rose’s reproductive ability,
and the error was basic enough to cause a tenfold difference in price. Walker, the injured
party, was entitled to rescind the contract. Note that the error must be factual. Suppose
Walker sold Rose thinking that the price of beef was going to drop, when in fact the price
rose 60 percent in five months. That would be simply a prediction that proved wrong, and
Walker would have no right to rescind.
Conscious Uncertainty No rescission is permitted where one of the parties knows he is
taking on a risk; that is, he realizes there is uncertainty about the quality of the thing being
exchanged. Rufus offers 10 acres of mountainous land to Priscilla. “I can’t promise you
anything about this land,” he says, “but they’ve found gold on every adjoining parcel.” Priscilla,
eager for gold, buys the land, digs long and hard, and discovers—mud. She may not rescind the
contract. She understood the risk she was assuming, and there was no mutual mistake.
UNILATERAL MISTAKE
Sometimes only one party enters a contract under a mistaken assumption, a situation called
unilateral mistake. In these cases, it is more difficult for the injured party to rescind a
contract. This makes sense since in a bilateral error, neither side really knew what it was
getting into, and rescission seems a natural remedy. But with unilateral mistakes, one side
Bilateral mistake
Occurs when both parties
assume the same factual
error.
Unilateral mistake
Occurs when only one party
enters a contract under a
mistaken assumption.
CHAPTER 13 Capacity and Consent 305
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may simply have made a better bargain than the other. As we have seen throughout this unit
on contracts, courts are unwilling to undo an agreement merely because someone made a
foolish deal. Nonetheless, if her proof is strong, the injured party in a case of unilateral
mistakes still may sometimes rescind a contract.
To rescind for unilateral mistake, a party must demonstrate that she entered the
contract because of a basic factual error and that either (1) enforcing the contract would be
unconscionable or (2) the nonmistaken party knew of the error.8
A town obtains five bids for construction of a newmunicipal swimming pool. Four are between
$100,000 and $111,000. Fred’s bid is for $82,000. His offer includes a figure of $2,000 for excavation
work, while the others have allotted about $20,000 for that work. Fred has inadvertently dropped a
zero, resulting in a bid that is $18,000 too low. Town officials accept Fred’s offer. When he sues to
rescind, Fredwins. Town officials knew that thework could not be done that cheaply, and it would
be unfair to hold Fred to a mathematical error that the other side perceived.9
In contrast, suppose that Rebecca sues Pierce, whose bad driving caused an accident, and
Amy, who owned the car that Pierce was driving. While the case is pending, Amy’s insurance
company, Risknaught, pays Rebecca a $70,000 settlement. Later, the state supreme court rules
that Pierce was an unauthorized driver, and an owner’s insurer is never liable in such a case.
Risknaught seeks to rescind its settlement, claiming unilateral mistake as to its liability. The
company loses. Risknaught was aware that an appellate ruling might establish new precedent.
The insurer settled based on a decision calculated to minimize its risk.10
In the following case an automobile dealer made a mistake—how often does this
happen?—in the customer’s favor.
DONOVAN V. RRL CORPORATION
26 Cal. 4th 261, 27 P.3d 702, 109 Ca. Rptr. 2d 807
Supreme Court of California, 2001
C A S E S U M M A R Y
Facts: Brian Donovan was in the market for a used car.
As he scanned the Costa Mesa Daily Pilot, he came upon a
“Pre-Owned Coup-A-Rama Sale!” at Lexus of Westmin-
ster. Of the 16 cars listed in the ad (with vehicle identifica-
tion numbers), one was a sapphire blue Jaguar XJ6 Vanden
Plas, priced at $25,995.
Brian drove to a Jaguar dealership to do some compar-
ison shopping. Jaguars of the same year and mileage cost
about $8,000 to $10,000 more than the auto at the Lexus
agency. The next day, Brian and his wife hurried over to the
Coup-A-Rama event, spotted the Jaguar (which had the
correct VIN) and asked a salesperson if theymight test drive
it. Pleased with the ride, Brian said to the salesman, “O.K.
We will take it at your price, $26,000.” This figure startled
the sales representative, who glanced at the newspaper ad
Brian showed him, and responded, “That’s a mistake.”
As indeed it was. The Lexus agency had paid $35,000
for the Jaguar and intended to sell it for about $37,000.
Brian was adamant. “No, I want to buy it at your adver-
tised price, and I will write you a check right now.” The
sales manager was called in, and he refused to sell the car
for less than $37,000.
It turned out that the Daily Pilot’s typographical and
proofreading errors had caused the mistake, although the
Lexus dealership had failed to review the proof sheet, which
would have revealed the error before the ad went to press.
Brian sued. The trial court found that unilateral mistake
prevented enforcement of the contract. The appellate court
reversed, and Donovan appealed to the state’s highest
court.
The state supreme court first ruled that therewas in fact
a contract between the parties. Generally, a newspaper
8Restatement (Second) of Contracts §153.
9See examples provided in Restatement (Second) of Contracts §153.
10See, for example AID Hawai’i Ins. Co. v. Bateman, 82 Haw. 453, 923 P.2d 395 (Haw. 1996).
306 U N I T 2 Contracts
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EXAM Strategy
Question: Joe buys an Otterhound named Barky, from Purity Dog Shop. He pays
$2,500 for the puppy. The high cost is a result of the certificate Purity gives him,
indicating that the puppy’s parents were both AKC champions (elite dogs). Two
months later, Joe sells the hound to Emily for $2,800. Joe and Emily both believe that
Barky is descended from champions. Then a state investigation reveals that Purity has
been cheating and its certificates are fakes. Barky is just a regular dog, worth about
$100. Emily sues Joe. Who wins?
Strategy: Both parties are mistaken about the kind of dog Joe is selling, so this is an
instance of bilateral mistake. What is the rule in such cases?
Result: If the two sides agree based on an important factual error, the contract is
voidable by the injured party. A mutt is entirely different from a dog that might
become a champion. The parties erred about the essence of their deal. Joe’s good
faith does not save him, and Emily is entitled to rescind.
13-2c Duress
True consent is also lacking when one party agrees to a contract under duress. If kindly
Uncle Hugo signs over the deed to the ranch because Niece Nelly is holding a gun to his
head, Hugo has not consented in any real sense, and he will have the right to rescind the
contract. If one party makes an improper threat that causes the victim to enter into a
contract, and the victim had no reasonable alternative, the contract is voidable.11
On a Sunday morning, Bancroft Hall drove to pick up his daughter Sandra, who had
slept at a friend’s house. The Halls are black and the neighborhood was white. A suspicious
advertisement is merely a solicitation for an offer, and does
not permit the customer to form a contract by accepting.
(See Chapter 10, on agreement.) However, a California
statute generally holds automobile dealers to the terms of
their offers. The court then went on to examine
the mistake.
Issue: Did the Lexus dealer’s mistake entitle it to rescind the
contract?
Decision: Yes, themistakeentitled thedealership to rescind.
Reasoning: The price is a “basic assumption” of a con-
tract. A significant mistake about that price may permit
one party to rescind an agreement. The injured party
must show that the error is so severe that it would be
unfair to enforce the bargain.
Measured by this standard, the Lexus dealership’s
price error was a material mistake. A sales price of
$25,995 would require the dealer to sell the Lexus for
$12,000 less than it intended. That is a 32% error, creating
a bonanza for Donovan and a large loss for the seller.
Donovan argues that a dealer is able to monitor its ads
and must be strictly held to the terms that it publishes.
However, if a court were to enforce this rule, it would mean
that a dealer who inadvertently advertised a $75,000 car for
$75 would be stuck with the bargain. That is too harsh.
There is no evidence that the Lexus dealership knew
of the misprint or intended to mislead customers. Nothing
indicated that the dealer routinely permitted such errors to
appear in thepress. Itwas theDailyPilot thatmade themistake.
The dealership should not suffer a large loss because of that
error. The judgment in favor of the dealership is affirmed.
11Restatement (Second) of Contracts §175(1).
Duress
An improper threat made to
force another party to enter
into a contract.
CHAPTER 13 Capacity and Consent 307
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You Be the Judge
Facts: Amy Maida sued
her employer, RLS Legal
Solutions, for various claims
relating to her job. RLS
asked that the case be dis-
missed because Maida had
signed an arbitration agree-
ment. Maida had in fact signed the contract while already
working at RLS. However, she responded that the agreement
should not be enforced because she had signed it under eco-
nomicduress.At trial, shewasaskedwhether shehad found the
agreement acceptable:
I did not. The arbitration clause was going to allow me not
to be able to be in a position that I needed to be in now,
and that is, to have someone represent me to help me
where I feel like the company did me wrong.
After I refused to agree
to this arbitration clause, I
was told that my payroll
checks would not be
direct deposited into my
account until I signed the
agreement and that I
would not be paid until I signed the agreement. I had received
my paychecks by direct deposit for three years. [RLS did in
fact stop the direct deposit payment of Maida’s salary.]
I needed my paycheck to meet my financial responsibil-
ities since I am a single family income household provider. I
had no way to pay my mortgage, vehicle note, car and
homeowner’s insurance as well as any household bills.
Maida testified that after signing and returning the
agreement, she received a manual check. Maida said
neighbor called the police, who arrived, aggressively prevented the Halls from getting into
their own car, and arrested the father. The Halls had not violated any law or done anything
wrong whatsoever. Later an officer told Hall that he could leave immediately if he signed a
full release (stating that he had no claims of any kind against the police), but that if he
refused to sign it, he would be detained for a bail hearing. Hall signed the release but later
filed suit. The police defended based on the release.
The court held that the release was voidable because Hall had signed it under duress.
The threat to detain Hall for a bail hearing was clearly improper because he had committed
no crime. He also had no reasonable alternative to signing. A jury awarded the Halls over
half a million dollars.12
Can “improper threats” take other forms? Does economic intimidation count? Many plain-
tiffs have posed that question over the last half century, and courts have grudgingly yielded.
Today, in most states, economic duress can also be used to void a contract. But
economic duress sounds perilously close to hard bargaining—in other words, business.
The free market system is expected to produce tough competition. A smart, aggressive
executive may bargain fiercely. How do we distinguish economic duress from legal, success-
ful business tactics? Courts have created no single rule to answer the question, but they do
focus on certain issues.
In analyzing a claim of economic duress, courts look at these factors:
• Acts that have no legitimate business purpose
• Greatly unequal bargaining power
• An unnaturally large gain for one party
• Financial distress to one party
Is the following case one of duress or hard bargaining?
12Halls v. Ochs, 817 F.2d 920, U. S. App. LEXIS 5822 (1st Cir. 1987).
IN RE RLS LEGAL SOLUTIONS,
LLC
2005 WL 171381
Texas Court of Appeals, 2005
308 U N I T 2 Contracts
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13-2d Undue Influence
She was single and pregnant. A shy young woman in a large city with no family nearby,
she needed help and support. She went to the Methodist Mission Home of Texas
where she found room and board, support—and a lot of counseling. Her discussions
with a minister and a private counselor stressed one point: that she should give up her
baby for adoption. She signed the adoption papers, but days later, she decided she
wanted the baby after all. Was there any ground to rescind? She claimed undue influence,
in other words, that the Mission Home so dominated her thinking that she never truly
consented. Where one party has used undue influence, the contract is voidable at the
option of the injured party. There are two elements to the plaintiff’s case. To prove undue
influence, the injured party must demonstrate:
• A relationship between the two parties either of trust or of domination, and
• Improper persuasion by the stronger party.13
In the Methodist Mission case, the court held that the plaintiff had been young and
extremely vulnerable during the days following the birth of her child. The mission’s
counselor, to whom she turned for support, had spent day after day forcefully insisting that
the young woman had no moral or legal right to keep her child. This amounted to undue
influence. The court voided the adoption agreement.14 In the following case, the age
difference is reversed.
that when she asked why she had not been paid by direct
deposit as usual, she was told her paycheck would be held
until she signed the agreement.
RLS argued that Maida had eventually received
every paycheck to which she was entitled, had suffered
no losses, and was free to leave RLS at any time if she
found her employment terms unacceptable.
The trial court refused to dismiss the case or order
arbitration, and RLS appealed.
You Be the Judge: Did Maida sign the arbitration under
economic duress?
Argument for RLS: Your honors, it is hard to take
seriously a claim of economic duress when the plain-
tiff has not lost one cent and was never forced to
sign anything. RLS runs a business, not a commu-
nity center. To stay competitive, we constantly
revise our commercial practices, and this was one
such change. We did not ask for a bizarre or inap-
propriate change: Arbitration is a widely favored
method of settling disputes, quicker and cheaper for all parties.
Maida signed. Yes, we stopped direct deposit of her check, but
in the end, we paid her all she was due.Wewere not obligated
to pay her in any particular fashion, or even to continue her
employment. If she wanted to stay with us, she had to play by
our rules.
Argument for Maida: The company could offer an
arbitration contract to all workers. But that is distinct
from forcing such agreements down employee throats,
which is what they did here. RLS knows that its
workers depend on prompt payment of payroll checks
to avoid falling quickly into debt. The company
offered Maida the arbitration agreement, she rejected
it, and they responded by stopping direct deposit of
her check. Knowing that she was the sole provider for
her family, the firm intended to subject her to intol-
erable economic pressure. It worked. However, the
court should have no part of this coercion. The two
sides had hugely differing bargaining power, and RLS
attempted to use financial distress to obtain what it
could not by persuasion.
13Restatement (Second) of Contracts §177.
14Methodist Mission Home of Texas v. N A B, 451 S.W.2d 539, 1970 Tex. App. LEXIS 2055 (Tex. Civ.
App. 1970).
CHAPTER 13 Capacity and Consent 309
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Chapter Conclusion
An agreement between two parties may not be enough to make a contract enforceable. A
minor or a mentally impaired person may generally disaffirm contracts. Even if both parties
are adults of sound mind, courts will insist that consent be genuine. Misrepresentation,
mistake, duress, and undue influence all indicate that at least one party did not truly
consent. As the law evolves, it imposes an increasingly greater burden of good faith negotiating
on the party in the stronger position.
SEPULVEDA V. AVILES
762 N.Y.S.2d 358, 308 A.D.2d 1
New York Supreme Court, Appellate Division, 2003
C A S E S U M M A R Y
Facts: Agnes Seals owned and lived in a ten-unit
apartment building on East 119th Street in New York
City. When she was 80 years old, a fire damaged much
of the building’s interior, leaving Seals physically and
mentally unable to care for the property. Shortly after
the fire, she met David Aviles, a 35-year-old neighbor.
Aviles convinced Seals to sell him the building, promis-
ing to care for her for the rest of her life. She sold him
the building for $50,000, taking a down payment of
$10,000, with the rest to be paid over time. At the
closing, Seals was represented by an attorney, Martin
Freedman, whom she had never met before, and who
had been referred to her by Aviles’s lawyer (with whom
he shared office space).
Three years later, Seals died. Her will left her entire
estate to Elba and Victor Sepulveda, but the building had
been Seals’s principal asset. The Sepulvedas sued Aviles,
asking the court to set aside the sale of the building,
claiming that Aviles had used undue influence to trick
Seals into a sale that was not in her interest. The jury
found that Aviles had not used undue influence, and the
Sepulvedas appealed.
Issue: Did Aviles use undue influence to obtain the apart-
ment building?
Decision: Yes, Aviles used undue influence.
Reasoning: The jury’s verdict was completely at odds
with the evidence. A social worker testified that at the
time of the sale, Seals was traumatized by the fire, house-
bound, and utterly dependent on others for her daily
needs. Sister Lachapelle, a second neutral witness, con-
firmed this. They both stated that Aviles promised to take
care of Seals if she would sell him the building. At the
closing, Seals was represented by a lawyer she had never
met before, recommended to her by Aviles.
A medical expert testified that in his opinion, Seals
suffered from severe Alzheimer’s disease at the time of
the sale. Aviles testified that at the time of the sale, Seals
was coherent and lucid, but the expert testimony is far
more persuasive than Aviles’s self-serving, lay opinion.
At trial, Aviles admitted that he made unfettered use of
Seals’s funds and credit cards. In a particularly brazen exam-
ple, he wrote Seals monthly checks for payment on the
house, and then had her endorse the checks back to him.
Aviles deposited the checks in his account, having effec-
tively paid nothing for the house. The sale was a sham.
Aviles clearly and repeatedly used undue influence to
bring about the sale and then avoid his payments for the
building. The jury’s verdict that there was no undue
influence was based on a wildly unreasonable interpreta-
tion of the evidence. The case is reversed and remanded
for a new trial.
310 U N I T 2 Contracts
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EXAM REVIEW
1. VOIDABLE CONTRACT Capacity and consent are different contract issues that
can lead to the same result: a voidable contract. A voidable agreement is one that can be
canceled by a party who lacks legal capacity or who did not give true consent. (p. 296)
2. MINORS Aminor (someone under the age of 18) generally may disaffirm any contract
while she is still a minor or within a reasonable time after reaching age 18. (pp. 296–298)
Question: John Marshall and Kirsten Fletcher decided to live together. They
leased an apartment, each agreeing to pay one-half of the rent. When he signed the
lease, Marshall was 17. Shortly after signing the lease, Marshall turned 18, and two
weeks later, he moved into the apartment. He paid his half of the rent for twomonths
and then moved out because he and Fletcher were not getting along. Fletcher sued
Marshall for one-half of the monthly rent for the remainder of the lease. Who wins?
Strategy: Marshall was clearly a minor when he signed the lease, and he could
have rescinded the agreement at that time. However, after he turned 18, he
moved in and began to pay rent. What effect did that have on his contract
obligation? (See the “Result” at the end of this section.)
3. MENTAL IMPAIRMENT A mentally impaired person may generally disaffirm a
contract. In such a case, though, he generally must make restitution. (pp. 298–299)
4. INTOXICATION A person who is so intoxicated that he fails to understand the
nature of an agreement may disaffirm a contract. (p. 299)
5. FRAUD Fraud is grounds for rescinding a contract. The injured party must prove
all of the following:
a. A false statement of fact made intentionally or recklessly
b. Materiality
c. Justifiable reliance (pp. 300–305)
6. INNOCENT MISREPRESENTATION Innocent misrepresentation also allows
an injured party to rescind a contract, but it does not allow a plaintiff to sue for damages.
It has the same elements as fraud, but it does not require intent or recklessness. (p. 302)
Question: Ron buys 1,000 “Smudgy Dolls” for his toy store. Karen, the seller, tells
him the dolls are in perfect condition, even though she knows their heads are defectively
attached. Ron sells all of the products, but then he has to face 1,000 angry customers with
headless dolls. Ron sues Karen seeking rescission. What is the likely outcome?
(a) This is fraud, and Ron will be able to rescind.
(b) This is an innocent misrepresentation, and Ron will be able to rescind.
(c) This is fraud, but Ron will not be able to rescind.
E
X
A
M
S
tr
a
te
g
y
E
X
A
M
S
tr
a
te
g
y
CHAPTER 13 Capacity and Consent 311
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d. This is an innocent misrepresentation, but Ron will not be able to rescind.
e. This is neither fraud nor an innocent misrepresentation.
Strategy: Karen knew her statement was false, so this is a case of fraud if all
elements can be met. Ron must prove a false statement of fact, materiality, and
reliance. Can he do so? (See the “Result” at the end of this section.)
7. SILENCE Silence amounts to misrepresentation only in four instances:
• Where disclosure is necessary to correct a previous assertion;
• Where disclosure would correct a basic mistaken assumption on which the other party
is relying;
• Where disclosure would correct the other party’s mistaken understanding about a
writing; or
• Where there is a relationship of trust between the two parties. (pp. 302–305)
8. MISTAKE In a case of bilateral mistake, either partymay rescind the contract. In a case
of unilateral mistake, the injured party may rescind only upon a showing that enforcement
would be unconscionable or that the other party knew of her mistake. (pp. 302–304)
9. DURESS If one party makes an improper threat that causes the victim to enter into a
contract, and the victim had no reasonable alternative, the contract is voidable. (pp. 307–309)
Question: Andreini’s nerve problem diminished the use of his hands. Dr. Beck
operated, but the problem grew worse. A nurse told the patient that Beck might have
committed a serious error that exacerbated the problem. Andreini returned for a
second operation, which Beck assured him would correct the problem. But after
Andreini had been placed in a surgical gown, shaved, and prepared for surgery, the
doctor insisted that he sign a release relieving Beck of liability for the first operation.
Andreini did not want to sign it, but Beck refused to operate until he did. Later,
Andreini sued Beck for malpractice. A trial court dismissed Andreini’s suit based on
the release. You are on the appeals court. Will you affirm the dismissal or reverse?
Strategy: Andreini is claiming physical duress. Did Beck act improperly in
demanding a release? Did Andreini have a realistic alternative? (See the “Result” at
the end of this section.)
10. UNDUE INFLUENCE Once again the injured party may rescind a contract, but
only upon a showing of a special relationship and improper persuasion. (pp. 309–310)
2. Result: A minor can disaffirm a contract. However, if he turns 18 and then
ratifies the agreement, he is fully liable. When he paid the rent, Marshall ratified
the contract, and thus he is fully liable.
E
X
A
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tr
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312 U N I T 2 Contracts
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5. Result: Karen made a false statement of fact, knowing it was wrong. It was
material, and Ron reasonably relied on her. Karen has committed fraud. Ron is
entitled to rescind the agreement. The correct answer is “a.”
8. Result: The Utah Supreme Court reversed the trial court, so you probably
should as well. Beck forced Andreini to sign under duress. The threat to withhold
surgery was improper, and Andreini had no reasonable alternative.
MULTIPLE-CHOICE QUESTIONS
1. Kerry finds a big green ring in the street. She shows it to Leroy, who says, “Wow.
That could be valuable.” Neither Kerry nor Leroy knows what the ring is made of or
whether it is valuable. Kerry sells the ring to Leroy for $100, saying, “Don’t come
griping if it turns out to be worth two dollars.” Leroy takes the ring to a jeweler who
tells him it is an unusually perfect emerald, worth at least $75,000. Kerry sues to
rescind.
(a) Kerry will win based on fraud.
(b) Kerry will win based on mutual mistake.
(c) Kerry will win based on unilateral mistake.
(d) Kerry will lose.
2. Veronica has a beer and then makes a contract. She continues drinking, and her blood
alcohol level eventually rises to .09, which is just above her state’s threshold for drunk
driving. She makes a second contract while in this condition. Veronica’s first contract
is , and her second contract is .
(a) valid; valid
(b) valid; voidable
(c) voidable; voidable
(d) voidable; void
3. Jerry is so mentally ill that he is unable to understand the nature and consequences of
his transactions, but he has not been adjudicated insane. Penny has been adjudicated
insane, and a court has appointed a guardian to handle her affairs. Jerry’s contracts
are , and Penny’s contracts are .
(a) valid; valid
(b) valid; voidable
(c) valid; void
(d) voidable; voidable
(e) voidable; void
4. Angela makes a material misstatement of fact to Lance, which he relies on when he
signs Angela’s contract. Fraud exists if Angela made the misstatement .
(a) intentionally
(b) recklessly
CHAPTER 13 Capacity and Consent 313
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(c) carelessly
(d) (a) and (b) only
(e) (a), (b), and (c)
5. Scarborough’s Department Store opens for business on a busy shopping day just
before Christmas. A hurried clerk places a sign in the middle of a table piled high with
red cashmere sweaters. The sign reads, “SALE—100% Cashmere—$0.99 Each.” The
sign, of course, was supposed to read “$99 each.”
This is a mistake, and customers be able to demand that
Scarborough’s sell the sweaters for 99 cents.
(a) unilateral; will
(b) unilateral; will not
(c) bilateral; will
(d) bilateral; will not
ESSAY QUESTIONS
1. Raymond Barrows owned a 17-acre parcel of undeveloped land in Seaford, Delaware.
For most of his life, Mr. Barrows had been an astute and successful businessman, but by
the time he was 85 years old, he had been diagnosed as “very senile and confused 90
percent of the time.” Glenn Bowen offered to buy the land. Barrows had no idea of its
value, so Bowen had it appraised by a friend, who said it was worth $50,000. Bowen
drew up a contract, which Barrows signed. In the contract, Barrows agreed to sell the
land for $45,000, of which Bowen would pay $100 at the time of closing; the remaining
$44,900 was due whenever Bowen developed the land and sold it. There was no time
limit on Bowen’s right to develop the land nor any interest due on the second payment.
Comment.
2. On television and in magazines, Maurine and Mamie Mason saw numerous
advertisements for Chrysler Fifth Avenue automobiles. The ads described the car as
“luxurious,” “quality-engineered,” and “reliable.” When they went to inspect the car,
the salesman told them the warranty was “the best … comparable to Cadillacs and
Lincolns.” After the Masons bought a Fifth Avenue, they began to have many problems
with it. Even after numerous repairs, the car was unsatisfactory and required more work.
The Masons sued, seeking to rescind the contract based on the ads and the dealer’s
statement. Will they win?
3. The McAllisters had several serious problems with their house, including leaks in the
ceiling, a buckling wall, and dampness throughout. They repaired the buckling wall by
installing I-beams to support it. They never resolved the leaks and the dampness. When
they decided to sell the house, they said nothing to prospective buyers about the problems.
They stated that the I-beam had been added for reinforcement. The Silvas bought the
house for $60,000. Soon afterwards, they began to have problems with leaks, mildew, and
dampness. Are the Silvas entitled to any money damages? Why or why not?
4. Roy Newburn borrowed money and bought a $49,000 truck from Treadwell Ford. A
few months later, the truck developed transmission problems. Newburn learned that
the truck had 170,000 more miles on it than the odometer indicated. The company
admitted the mileage error and promised to install a new transmission for free.
314 U N I T 2 Contracts
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Treadwell did install the new transmission, but when Newburn came to pick up the
truck, Treadwell demanded that he sign a general release absolving the dealership of
any claims based on the inaccurate mileage. Treadwell refused to turn over the truck
until Newburn finally signed. The truck broke down again, and delays cost Newburn
so much income that he fell behind on his loan payments and lost the truck. He sued
Treadwell, which defended based on the release. Is the release valid?
5. Morell bought a security guard business from Conley, including the property on
which the business was located. Neither party knew that underground storage tanks
were leaking and contaminating the property. After the sale, Morell discovered the
tanks and sought to rescind the contract. Should he be allowed to do so?
DISCUSSION QUESTIONS
1. Sixteen-year-old Travis Mitchell brought his
Pontiac GTO into M&M Precision Body and Paint
for body work and a paint job. M&M did the work
and charged $1,900, which Travis paid. When
Travis later complained about the quality of the
work, M&M did some touching up, but Travis was
still dissatisfied. He demanded his $1,900 back,
but M&M refused to refund it because all of the
work was “in” the car and Travis could not return
it to the shop. The state of Nebraska, where this
occurred, follows the majority rule on this issue.
Does Travis get his money? Is this a fair result?
2. Contract law gives minors substantial legal
protection. But does a modern high school student
need so much protection? Older teens may have
been naive in the 1700s, but today, they are quite
savvy. Should the law change so that only younger
children—perhaps those aged 14 and under—have
the ability to undo agreements?
3. In the old Michigan case featuring Rose the
Cow, the court refused to enforce the
agreement. Was this a fair result? Should
bilateral mistakes create voidable contracts, or
should Walker have been required to sell the
cow for $80?
4. Susan drops by Dean’s garage sale. She buys a
painting for $10. Both she and Dean think that the
painting is a copy of a Matisse. Later, Susan is
delighted to discover that the painting is actually a
Matisse and is worth $50,000,000. Dean hears the
news, and wants the painting back. Will he get it?
Why or why not?
5. Do you have sympathy for intoxicated people who
make agreements? Should the law ever let them
back out of deals when they sober up? After all, no
one forced them to get drunk. Should the law be
more lenient, or is it reasonable as it currently exists?
CHAPTER 13 Capacity and Consent 315
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CHAPTER14
WRITTEN
CONTRACTS
Oliver and Perry were college roommates, two
sophomores with contrasting personalities. They
were sitting in the cafeteria with some friends,
Oliver chatting away, Perry slumped on a plastic
bench. Oliver suggested that they buy a lottery
ticket, as the prize for that week’s drawing was
$13 million. Perry muttered, “Nah. You never
win if you buy just one ticket.” Oliver bubbled
up, “O.K., we’ll buy a ticket every week. We’ll
keep buying them from now until we graduate. Come
on, it’ll be fun. This month, I’ll buy the tickets. Next
month, you will, and so on.” Other students urged Perry
to do it and, finally, he agreed.
The two friends carefully reviewed their deal.
Each party was providing consideration—namely,
the responsibility for purchasing tickets during his
month. The amount of each purchase was clearly
defined at one dollar. They would start that week and
continue until graduation day, two and a half years down
the road. Finally, they would share equally any money
won. As three witnesses looked on, they shook hands on the bargain. That month, Oliver
bought a ticket every week, randomly choosing numbers, and won nothing. The next
month, Perry bought a ticket with equally random numbers—and won $52 million. Perry
moved out of their dorm room into a suite at the Ritz and refused to give Oliver one red
cent. Oliver sued, seeking $26 million, and the return of his Nintendo Wii U console. If the
former friends had understood the Statute of Frauds, they would never have gotten into
this mess.1
Perry moved out of their
dorm room into a suite at
the Ritz and refused to
give Oliver one red cent.
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1Based loosely on Lydon v. Beauregard (Middlesex Sup. Ct., Mass., Dec. 22, 1989), reported in Paul Langher, “Couple
Lose Suit to Share $2.8M Prize,” Boston Globe, December 23, 1989, p. 21.
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

The rule we examine in this chapter is not exactly news. Originally passed by the British
Parliament in 1677, the Statute of Frauds has changed little over the centuries. The purpose
was to prevent lying (fraud) in civil lawsuits. Jury trials of that era invited perjury. Neither the
plaintiff nor the defendant was permitted to testify, meaning that the jury never heard from
the people who really knew what had happened. Instead, the court heard testimony from
people who claimed to have witnessed the contract being created. Knowing that he would
never be subjected to aggressive cross-examination, a plaintiff might easily allege that a fake
contract was real, and then bribe witnesses to support his case. A powerful earl, seeking to
acquire 300 acres of valuable land owned by a neighboring commoner, might claim that the
neighbor had orally promised to sell his land. Although the claim was utterly false, the earl
would win if he could bribe enough “reputable” witnesses to persuade the jury.
To provide juries with more reliable evidence that a contract did or did not exist, Parlia-
ment passed the Statute of Frauds. It required that in several types of cases, a contract would be
enforced only if it was in writing. Contracts involving interests in land were first on the list.
In the days before the Revolutionary War, when Pennsylvania was still a British
possession, the colony’s supreme court heard the following case, which centered on the
Statute of Frauds. Notice the case citation. This is very nearly the first case reported in
United States history, further evidence that the Statute of Frauds is not news. Back then,
rulings were expressed quite differently (and they seemed to enjoy capitalization), but you
will be able to see Judge Coleman’s point.
Almost all states of this country have passed their own version of the Statute of Frauds.
It is important to remember, as we examine the rules and exceptions, that Parliament and
the state legislatures all had a commendable, straightforward purpose in passing their
Landmark Case
Facts: A tenant had
rented land from Richard-
son. However, Campbell
claimed the property was
really his. To stay there,
the tenant had to prove that
Richardson owned the land.
Richardson’s tenant
offered a deed (which was then called a patent) to support
his claim; Campbell provided receipts as evidence that he
had bought the property years prior.
To prove that the receipts were for the disputed
property, Campbell wanted to introduce statements
from an important person—Thomas Penn, whose father,
William, had founded the Pennsylvania colony. Obvi-
ously, the tenant did not want that evidence admitted in
court.
Issue: Was oral evidence
about the ownership of land
admissible in court?
Decision: No. Oral evi-
dence was not admissible in
court to prove ownership of
land.
Excerpts from Justice
Coleman’s Decision: PLAINTIFF supported his Title
by a Patent. The Defendant produced Receipts several
Years prior to Plaintiff’s Patent; but the Plaintiff contend
[ed] that the Receipts were only for Money paid on an
adjacent Tract; the Defendant produced a Witness to
prove a parol Declaration of Mr. Thomas Penn that the
Land in dispute was sold to Defendant.
This piece of Evidence was opposed by the Plaintiff,
and refused BY THE COURT.
THE LESSEE OF RICHARDSON
V. CAMPBELL
1 U.S. 10
Supreme Court of Pennsylvania, 1764
CHAPTER 14 Written Contracts 317
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respective statutes of fraud: to provide a court with the best possible evidence of whether the parties
intended to make a contract. Ironically, the British government has repealed the writing
requirement for most contracts. Parliament concluded that the old statute, far from prevent-
ing wrongdoing, was helping people commit fraud. A wily negotiator could orally agree to
terms and then, if the deal turned unprofitable, walk away from the contract, knowing it was
unenforceable without written evidence.
Thus far, no state in this country has entirely repealed its Statute of Frauds. Instead,
courts have carved exceptions into the original statute to prevent unfairness. Some scholars
have urged state legislatures to go further and repeal the law altogether. Other commenta-
tors defend the Statute of Frauds as a valuable tool for justice. They argue that, among other
benefits, the requirement of a writing cautions people to be careful before making—or
relying on—a promise. For now, the Statute of Frauds is a vital part of law. Sadly, Oliver
from the opening scenario will learn this the hard way.
According to the Statute of Frauds, a plaintiff may not enforce any of the following
agreements unless the agreement, or some memorandum of it, is in writing and signed by
the defendant.
The agreements that must be in writing are those:
• For any interest in land;
• That cannot be performed within one year;
• To pay the debt of another;
• Made by an executor of an estate;
• Made in consideration of marriage; and
• For the sale of goods worth $500 or more.
In other words, when two parties make an agreement covered by any one of these six
topics, it must be in writing to be enforceable. Oliver and Perry made a definite agreement
to purchase lottery tickets during alternate months and share the proceeds of any winning
ticket. But their agreement was to last two and a half years. As the second item on the list
indicates, a contract must be in writing if it cannot be performed within one year. The good
news is that Oliver gets back his Wii U. The bad news is he gets none of the lottery money.
Even though three witnesses saw the deal made, it is unlikely to be enforced in any state.
Perry will walk away with all $52 million.
Note that although theOliver-Perry agreement is unenforceable, it is not void. Suppose that
Perry does the right thing, agreeing to share the winnings with Oliver. Over the next 20 years, as
he receives thewinnings, Perry gives one-half to his friend. But then, having squandered his own
fortune, Perry demands the money back fromOliver, claiming that the original contract violated
the Statute of Frauds. Perry loses.Once a contract is fully executed, it makes no difference that it
was unwritten.The Statute of Frauds prevents the enforcement of an executory contract; that is,
one in which the parties have not fulfilled their obligations. But the contract is not illegal. Once
both parties have fully performed, neither party may demand rescission. The Statute of Frauds
allows a party to cancel future obligations but not undo past actions.
Ethics The law permits Perry to keep all of the lottery money. But does Perry have
amoral right to deny Oliver his half-share? Is the Statute of Frauds serving a
useful purpose here? Remember that Parliament passed the original Statute of Frauds
believing that a written document would be more reliable than the testimony of alleged
witnesses. If we permitted Oliver to enforce the oral contract, based on his testimony and
that of the witnesses, would we simply be inviting other plaintiffs to invent lottery “contracts”
that had never been made?
318 U N I T 2 Contracts
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14-1 COMMON LAW STATUTE OF FRAUDS:
CONTRACTS THAT MUST BE IN WRITING
14-1a Agreements for an Interest in Land
A contract for the sale of any interest in land must be in writing to be enforceable. Notice
the phrase “interest in land.” This means any legal right regarding land. A house on a lot is an
interest in land. A mortgage, an easement, and a leased apartment are all interests in land.
As a general rule, leases must therefore be in writing, although most states have created an
exception for short-term leases. A short-term lease is often one for a year or less, although
the length varies from state to state.
Kary Presten and Ken Sailer were roommates in a rental apartment in New Jersey that
had a view of the Manhattan skyline. The lease was in Sailer’s name, but the two split all
expenses. Then the building became a “cooperative,” meaning that each tenant would have
the option of buying the apartment.2 Sailer learned he could buy his unit for only $55,800 if he
promptly paid a $1,000 fee to maintain his rights. He mentioned to Presten that he planned to
buy the unit, and Presten asked if he could become half-owner. Sailer agreed and borrowed
the $1,000 from Presten to pay his initial fee. But as the time for closing on the purchase came
nearer, Sailer realized that he could sell the apartment for a substantial profit. He placed an ad
in a paper and promptly received a firm offer for $125,000. Sailer then told Presten that their
deal was off, and that he, Sailer, would be buying the unit alone. He did exactly that, and
Presten filed suit. Regrettably, the outcome of Presten’s suit was only too easy to predict.
A cooperative apartment is an interest in land, said the court. This agreement could be
enforced only if put in writing and signed by Sailer. The parties had put nothing in writing,
and therefore Presten was out of luck. He was entitled to his $1,000 back, but nothing more.
The apartment belonged to Sailer, who could live in it or sell it for a large, quick profit.3
Suppose that you are interested in buying five expensive acres in a fast-growing rural area.
There is no water on the property, and the only way to bring public water to it is through land
owned by the neighbor, Joanne, who agrees to sell you an easement through her property. An
easement is a legal right that an owner gives to another person to make some use of the owner’s
land. In other words, Joanne will permit you to dig a 200-foot trench through her land and lay a
water pipe there in exchange for $15,000. May you now safely purchase the five acres? Not
until Joanne has signed the written easement. You might ignore this “technicality,” since
Joanne seems friendly and honest. But you could then spend $300,000 buying your property
only to learn that Joanne has changed her mind. She might refuse to go through with the deal
unless you pay $150,000 for the easement. Without her permission to lay the pipe, your new
land is worthless. Avoid such nightmares: Get it in writing.
EXCEPTION: FULL PERFORMANCE BY THE SELLER
If the seller completely performs her side of a contract for an interest in land, a court is likely
to enforce the agreement even if it was oral. Adam orally agrees to sell his condominium to
Maggie for $150,000. Adam delivers the deed to Maggie and expects his money a week
later, but Maggie fails to pay. Most courts will allow Adam to enforce the oral contract and
collect the full purchase price from Maggie.
2Technically, the residents of a “co-op” do not own their apartments. They own a share of the
corporation that owns the building. Along with their ownership shares, residents obtain a right to
occupy their units for a modest fee.
3Presten v. Sailer, 225 N.J. Super. 178, 542 A.2d 7, 1988 N.J. Super. LEXIS 151 (N.J. Super. Ct. App.
Div. 1988).
CHAPTER 14 Written Contracts 319
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EXCEPTION: PART PERFORMANCE BY THE BUYER
The buyer of land may be able to enforce an oral contract if she paid part of the purchase
price and either entered upon the land or made improvements to it. Suppose that Eloise sues
Grover to enforce an alleged oral contract to sell a lot in Happydale. She claims they struck a
bargain in January. Grover defends based on the Statute of Frauds, saying that even if the two did
reach an oral agreement, it is unenforceable.Eloise proves that shepaid 10percent of thepurchase
price, that she began excavating on the lot in February to build a house, and that Grover knew of
the work. Eloise has established part performance and will be allowed to enforce her contract.
This exception makes sense if we recall the purpose of the Statute of Frauds: to provide
the best possible evidence of the parties’ intentions. The fact that Grover permitted Eloise to
enter upon the land and begin building on it is compelling evidence that the two parties had
reached an agreement. But be aware that most claims of part performance fail. Merely paying
a deposit on a house is not part performance. A plaintiff seeking to rely on part performance
must show partial payment and either entrance onto the land or physical improvements to it.
EXCEPTION: PROMISSORY ESTOPPEL
The other exception to the writing requirement is our old friend promissory estoppel. If a
promisor makes an oral promise that should reasonably cause the promisee to rely on it, and
the promisee does rely, the promisee may be able to enforce the promise, despite the Statute
of Frauds, if that is the only way to avoid injustice. This exception potentially applies to any
contract that must be written, such as those for land, those that cannot be performed within
one year, and so forth.
Maureen Sullivan and James Rooney lived together for seven years, although they never
married. They decided to buy a house. The two agreed that they would be equal owners, but
Rooney told Sullivan that in order to obtain Veterans Administration financing, he would have to
be the sole owner on the deed. They each contributed to the purchase and maintenance of the
house, and Rooney repeatedly told Sullivan that he would change the deed to joint ownership.
He never did. When the couple split up, Sullivan sued, seeking a 50 percent interest in the
house. She won. The agreement was for an interest in land and should have been in writing, said
the court. But Rooney had clearly promised Sullivan that she would be a half-owner, and she had
relied by contributing to the purchase and maintenance. The Statute of Frauds was passed to
prevent fraud, not to enable one person to mislead another and benefit at her expense.4
EXAM Strategy
Question: Aditi and Danielle, MBA students, need an apartment for next September.
They find a lovely two-bedroom unit that the owner is rehabbing. The students can
see that the owner is honest, his workmanship excellent. The owner agrees to rent
them the apartment beginning September 1, for $1,200 per month for one year. “Come
back at the end of August. By then, my work will be done and I’ll have the papers to
sign.” Aditi asks, “Should we sign something now, to be sure?” The landlord laughs
and replies, “I trust you. You don’t trust me?” They both trust him, and they shake
hands on the deal. When the students return in August, the landlord has rented it to
Danielle’s former boyfriend for $1,400 per month. Aditi and Danielle sue. Who wins?
Strategy: Under the Statute of Frauds, a contract for the sale of any interest in land
must be in writing to be enforceable. What does “any interest” mean? Does the
Statute of Frauds apply to this case?
4Sullivan v. Rooney, 404 Mass. 160, 533 N.E.2d 1372, 1989 Mass. LEXIS 49 (1989).
320 U N I T 2 Contracts
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Result: An “interest” means any legal right. A lease is an interest in land, meaning
that the students cannot enforce this agreement unless it is in writing, signed by the
owner—and it is not. The students need to look for a new apartment.
14-1b Agreements That Cannot Be Performed within
One Year
Contracts that cannot be performed within one year are unenforceable unless they are in
writing. This one-year period begins on the date the parties make the agreement. The critical
word here is “cannot.” If a contract could possibly be completed within one year, it need not be
in writing. Betty gets a job at Burger Brain, throwing fries in oil. Her boss tells her she can
have Fridays off for as long as she works there. That oral contract is enforceable whether Betty
stays one week or twenty years. “As long as she works there” could last for less than one year.
Betty might quit the job after six months. Therefore, it does not need to be in writing.5
If an agreement will necessarily take longer than one year to finish, it must be in writing to be
enforceable. If Betty is hired for a term of three years as manager of Burger Brain, the agreement
is unenforceable unless put in writing. She cannot perform three years of work in one year.
Or, if you hire a band to play at your wedding 15 months from today, the agreement
must be in writing. The gig may take only a single day, but that day will definitely not fall in
the next 12 months.
The following case starts with a notorious diet pill and ends with a paralegal suing her
boss. Which argument carries greater weight?
5This is the majority rule. In most states, for example, if a company hires an employee “for life,” the
contract need not be in writing because the employee could die within one year. “Contracts of
uncertain duration are simply excluded [from the Statute of Frauds]; the provision covers only those
contracts whose performance cannot possibly be completed within a year.” Restatement (Second) of
Contracts §130, Comment a, at 328 (1981). See, for example Mackay v. Four Rivers Packing Co., 2008
WL 427789 (Id. 2008). However, a few states disagree. The Illinois Supreme Court ruled that a
contract for lifetime employment is enforceable only if written. McInerney v. Charter Golf, Inc., 176 Ill.
2d 482, 680 N.E.2d 1347, 1997 Ill. LEXIS 56 (Ill. 1997).
You Be the Judge
Facts: Barbara Sawyer, a
paralegal, worked for attor-
neyMelbourneMills, assist-
ing him in a class action
lawsuit against the makers
of a popular diet drug called
Fen-Phen. Mills promised
Sawyer a large bonus “when the ship comes in,” but he never
specified howmuchhewould pay her.Mills successfully settled
the Fen-Phen case for millions of dollars, and he later met with
Sawyer and her husband to
discuss her bonus. The Saw-
yers secretly recorded the
conversation.
The Sawyers asked
Mills for a $1 million
bonus, to be paid as a
lump sum. Mills refused. However, the parties kept talk-
ing and Mills eventually agreed to pay Sawyer $1 million,
plus $65,000 for a luxury automobile. Payments were to
SAWYER V. MILLS
2007 WL 1113038
Kentucky Court of Appeals, 2007
CHAPTER 14 Written Contracts 321
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14-1c Promise to Pay the Debt of Another
When one person agrees to pay the debt of another as a favor to that debtor, it is called a
collateral promise, and it must be in writing to be enforceable. D. R. Kemp was a young
entrepreneur who wanted to build housing in Tuscaloosa, Alabama. He needed $25,000 to
complete a project he was working on, so he went to his old college professor, Jim Hanks, for
help. The professor said he would see what he could do about getting Kemp a loan. Professor
Hanks spokewith his good friendTravis Chandler, telling him that Kempwas highly responsible
and would be certain to repay any money loaned. Chandler trusted Professor Hanks but wanted
to be sure of his money. Professor Hanks assured Chandler that if for any reason Kemp did not
repay the loan, he, Hanks, would pay Chandler in full. With that assurance, Chandler wrote out a
check for $25,000, payable to Kemp, never having met the young man.
Kemp, of course, never repaid the loan. (Thank goodness he did not; this textbook has
no use for people who do what they promise.) Kemp exhausted the cash trying to sustain his
business, which failed anyway, so he had nothing to give his creditor. Chandler approached
Professor Hanks, who refused to pay, and Chandler sued. The outcome was easy to predict.
Professor Hanks had agreed to repay Kemp’s debt as a favor to Kemp, making it a collateral
promise. Chandler had nothing in writing, and that is exactly what he got from his lawsuit—
nothing.
EXCEPTION: THE LEADING OBJECT RULE
There is one major exception to the collateral promise rule. When the promisor guarantees
to pay the debt of another and the leading object of the promise is some benefit to the promisor
himself, then the contract will be enforceable even if unwritten. In other words, if the
promisor makes the guarantee not as a favor to the debtor, but primarily out of self-interest,
the Statute of Frauds does not apply.
be made in monthly installments of $10,000, for 10 years.
Mills also agreed to sign a document confirming his
promise. Sawyer’s lawyer drafted the writing, but Mills
never signed it. He did pay nine monthly installments,
along with an extra payment of $100,000.
At trial, jurors heard the tape recording, which confirmed
the oral agreement. The jury concluded that the parties had
reached a binding agreement and awarded Sawyer $900,000.
However, the court granted a judgment notwithstanding the
verdict for Mills. He ruled that the agreement was barred by
the Statute of Frauds. Sawyer appealed.
You Be the Judge: Does the Statute of Frauds prevent
enforcement of Mills’s promise?
Argument for Sawyer: The Statute of Frauds exists to
make sure that a plaintiff does not come into court and
allege an oral promise that never existed. The fear of
fraudulent claims is legitimate, but obviously it does not
apply in this case. We know that Mills agreed to pay a
million dollars because we can hear him make the promise.
We know the exact terms of the agreement, and we know it
was a reasonable arrangement based on years of work and a
massive settlement. We even hear Mills agree to sign a
document confirming his promise.
The Statute of Frauds was designed to prevent fraud
—not encourage it. Mills’s tiresome, technical arguments
did not fool the jurors. After hearing—literally—the evi-
dence, the jury knew there had been a deal and awarded
Sawyer her fair share. Let’s stop playing legal games, start
doing justice, and restore the verdict.
Argument for Mills: This is a simple case. The
plaintiffs allege an oral contract for 10 years’ worth of
installment payments. In other words, if there was an
agreement, it was for 10 years’ duration. Sawyer’s own
lawyer drafted a contract—never signed—for compensa-
tion lasting a full decade. Under the Statute of Frauds, an
agreement that cannot be performed within one year is
unenforceable unless written and signed. End of case.
If our legislature wanted to encourage secret tape
recordings and deception, it could have included an
exception to the Statute of Frauds, giving tricky plaintiffs
a reward for bad-faith negotiating. However, the legisla-
tors wisely have made no such exception. The alleged oral
contract is worthless.
322 U N I T 2 Contracts
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Robert Perry was a hog farmer in Ohio. He owed $26,000 to Sunrise Cooperative, a
supplier of feed. Because Perry was in debt, Sunrise stopped giving him feed on credit and
began selling him feed on a cash-only basis. Perry also owed money to Farm Credit
Services, a loan agency. Perry promised Farm Credit he would repay his loans as soon as
his hogs were big enough to sell. But Perry couldn’t raise hogs without feed, which he
lacked the money to purchase. Farm Credit was determined to bring home the bacon, so it
asked Sunrise Cooperative to give Perry the feed on credit. Farm Credit orally promised to
pay any debt that Perry did not take care of. When Perry defaulted on his payments to
Sunrise, the feed supplier sued Farm Credit based on its oral guarantee. Farm Credit
claimed the promise was unenforceable, based on the Statute of Frauds. But the court
found in favor of Sunrise. The leading object of Farm Credit’s promise to Sunrise was self-
interest, and the oral promise was fully enforceable.6
14-1d Promise Made by an Executor of an Estate
This rule is merely a special application of the previous one, concerning the debt of another
person. An executor is the person who is in charge of an estate after someone dies. The
executor’s job is to pay debts of the deceased, obtain money owed to him, and disburse the
assets according to the will. In most cases, the executor will use only the estate’s assets to
pay those debts. The Statute of Frauds comes into play when an executor promises to pay
an estate’s debts with her own funds. An executor’s promise to use her own funds to pay a
debt of the deceased must be in writing to be enforceable.
Suppose Esmeralda dies penniless, owing Tina $35,000. Esmeralda’s daughter, Sap-
phire, is the executor of her estate. Tina comes to Sapphire and demands her $35,000.
Sapphire responds, “There is no money in mamma’s estate, but don’t worry, I’ll make it up
to you with my own money.” Sapphire’s oral promise is unenforceable. Tina should get it in
writing while Sapphire is feeling generous.
14-1e Promise Made in Consideration of Marriage
Barney is a multimillionaire with the integrity of a gangster and the charm of a tax collector.
He proposes to Li-Tsing, who promptly rejects him. Barney then pleads that if Li-Tsing
will be his bride, he will give her an island he owns off the coast of California. Li-Tsing
begins to see his good qualities and accepts. After they are married, Barney refuses to
deliver the deed. Li-Tsing will get nothing from a court either, because a promise made in
consideration of marriage must be in writing to be enforceable.
14-2 THE COMMON LAW STATUTE OF
FRAUDS: WHAT THE WRITING MUST
CONTAIN
Each of the types of contract described above must be in writing in order to be enforceable.
What must the writing contain? It may be a carefully typed contract, using precise legal
terminology, or an informal memo scrawled on the back of a paper napkin at a business
lunch. The writing may consist of more than one document, written at different times, with
6Sunrise Cooperative v. Robert Perry, 1992 Ohio App. LEXIS 3913 (Ohio Ct. App. 1992).
CHAPTER 14 Written Contracts 323
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each document making a piece of the puzzle. But there are some general requirements: the
writing
• Must be signed by the defendant, and
• Must state with reasonable certainty the name of each party, the subject matter of the
agreement, and all of the essential terms and promises.7
14-2a Signature
A state’s Statute of Frauds typically requires that the writing be “signed by the party to be
charged therewith”; that is, the party who is resisting enforcement of the contract. Through-
out this chapter, we refer to that person as the defendant because when these cases go to
court, it is the defendant who is disputing the existence of a contract.
Judges define “signature” very broadly. Using a pen to write one’s name certainly
counts, but it is not required. A secretary who stamps an executive’s signature on a letter
fulfills this requirement. In fact, any mark or logo placed on a document to indicate
acceptance, even an “X,” will generally satisfy the Statute of Frauds. And electronic
commerce, as we discuss below, creates new methods of signing.
14-2b Reasonable Certainty
Suppose Garfield and Hayes are having lunch, discussing the sale of Garfield’s vacation
condominium. They agree on a price and want to make some notation of the agreement even
before their lawyers work out a detailed purchase and sales agreement. A perfectly adequate
memorandum might say, “Garfield agrees to sell Hayes his condominium at 234 Baron
Boulevard, Apartment 18, for $350,000 cash, payable on June 18, 2015, and Hayes promises
to pay the sum on that day.” They should make two copies of their agreement and sign both.
Notice that although Garfield’s memo is short, it is certain and complete. This is critical because
problems of vagueness and incompleteness often doom informal memoranda.
VAGUENESS
Ella Hayden owned valuable commercial property on a highway called Route 9. She wrote a
series of letters to her stepson Mark, promising that several of the children, including Mark,
would share the property. One letter said, “We four shall fairly divide the Route 9 property.”
Other letters said, “When the Route 9 Plaza is sold, you can take a long vacation,” and “The
property will be sold. You and Dennis shall receive the same amount.” Ella Hayden died
without leaving Mark anything. He sued, but got nothing. The court ruled:
The above passages written by Ms. Hayden do not recite the essential elements of the alleged
contract with reasonable certainty. The writings do not state unequivocally or with sufficient
particularity the subject matter to which the writings relate, nor do they provide the terms and
conditions of alleged promises made which constitute a contract. The alleged oral contract
between Ms. Hayden and Mr. Hayden cannot be identified from the passages from Ms. Hayden’s
letters quoted above when applied to existing facts. In sum, Mr. Hayden’s cause of action seeking
an interest in the Route 9 property is foreclosed by the Statute of Frauds.8
INCOMPLETENESS
During Ronald McCoy’s second interview with Spelman Memorial Hospital, the board of
directors orally offered him a three-year job as assistant hospital administrator. McCoy
accepted. Spelman’s CEO, Gene Meyer, sent a letter confirming the offer, which said:
7Restatement (Second) of Contracts §131.
8Hayden v. Hayden, Mass. Lawyers Weekly No. 12-299-93 (Middlesex Sup. Ct. 1994).
324 U N I T 2 Contracts
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To reconfirm the offer, it is as follows: (1) We will pay for your moving expenses. (2) I would like
you to pursue your Master’s Degree at an area program. We will pay 100 percent tuition
reimbursement. (3) Effective September 26, you will be eligible for all benefits. (4) A starting
salary of $48,000 annually with reviews and eligibility for increases at 6 months, 12 months, and
annually thereafter. (5) We will pay for the expenses of 3 trips, if necessary, in order for you to
find housing. (6) Vacation will be for 3 weeks a year after one year; however, we do allow for this
to be taken earlier. [Signed] Gene Meyer.
Spelman Hospital fired McCoy less than a year after he started work, and McCoy sued.
The hospital’s letter seems clear, and it is signed by an authorized official. The problem is,
it is incomplete. Can you spot the fatal omission? The court did.
McCoy wanted to hold the hospital’s board to its spoken promise that he would have a
job for a term of three years. To be enforceable, a contract for a term of over one year must
be in writing under the Statute of Frauds.
To satisfy the Statute of Frauds, an employment contract—[or] its memorandum or
note—must contain all essential terms, including duration of the employment relationship.
Without a statement of duration, an employment-at-will arrangement is created, which is
terminable at any time by either party with no liability for breach of contract. McCoy’s
argument that the letter constituted a memorandum of an oral contract fails because the
letter does not state an essential element: duration. The letter did not state that Spelman
was granting McCoy employment for any term—only that his salary would be reviewed at
6 months, 12 months, and “annually thereafter.”9
The lawsuits in this section demonstrate the continuing force of the Statute of
Frauds. If the promisor had truly wanted to make a binding commitment, he or she
could have written the appropriate contract or memorandum in a matter of minutes.
Great formality and expense are unnecessary. But the written document must be clear
and complete, or it will fail.
EXAM Strategy
Question: Major Retailer and Owner negotiated a lease of a strip mall, the tenancy
to begin August 1. Retailer’s lawyer then drafted a lease accurately reflecting all terms
agreed to, including the parties, exact premises, condition of the store, dates of the
lease, and monthly rent of $18,000. Retailer signed the lease and delivered it to
Owner on July 1. On July 20, Owner leased the same space to a different tenant for
$23,000 per month. Retailer sued, claiming that the parties had a binding deal, and
the Owner had breached his agreement in order to obtain higher rent. Who will win?
Strategy: To comply with the Statute of Frauds, a writing must state all essential
terms. This lease appears to do that. However, the writing must contain one other
thing. What is it?
Result: The writing must be signed by the party claiming that there is no contract;
that is, by the defendant. Owner never signed the lease. This lease does not comply
with the Statute of Frauds, and the Retailer will lose his case.
9McCoy v. Spelman Memorial Hospital, 845 S.W.2d 727, 1993 Mo. App. LEXIS 105 (Mo. Ct. App. 1993).
CHAPTER 14 Written Contracts 325
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14-2c Electronic Contracts and Signatures
E-commerce has grown at a dazzling rate—each year, U.S. enterprises buy and sell tens of
billions of dollars worth of goods and services over the Internet. What happens to the
writing requirement, though, when there is no paper? The present Statute of Frauds
requires some sort of “signature” to ensure that the defendant committed to the deal.
Today, an “electronic signature” could mean a name typed (or automatically included) at
the bottom of an email message, a retinal or vocal scan, or a name signed by electronic pen
on a writing tablet, among others.
E-signatures are valid in all 50 states. Almost all states have adopted the Uniform
Electronic Transactions Act (UETA).10 UETA declares that electronic contracts and signa-
tures are as enforceable as those on paper. In other words, the normal rules of contract law
apply, and neither party can avoid such a deal merely because it originated in cyberspace. A
federal statute, the Electronic Signatures in Global and National Commerce Act (E-SIGN),
also declares that contracts cannot be denied enforcement simply because they are in
electronic form, or signed electronically. It applies in states that have not adopted UETA.
Note that, in many states, certain documents still require a traditional (non-electronic)
signature. Wills, adoptions, court orders, and notice of foreclosure are common exceptions. If
in doubt, get a hard copy, signed in ink.
14-3 THE UCC’S STATUTE OF FRAUDS
We have reached another section dedicated to the Uniform Commercial Code (UCC).
Remember that UCC rules govern only contracts involving a sale of goods. Because some
merchants make dozens or even hundreds of oral contracts every year, the drafters of the
UCC wanted to make the writing requirement less onerous for the sale of goods.
The UCC requires a writing for the sale of goods
worth $500 or more. The Code’s requirements are easier
to meet than those of the common law. UCC §2-201, the
Statute of Frauds section, has three important elements:
1. The basic rule
2. The merchants’ exception
3. Special circumstances
14-3a UCC §2-201(1)—The Basic
Rule
A contract for the sale of goods worth $500 or more is not
enforceable unless there is some writing, signed by the
defendant, indicating that the parties reached an agree-
ment. The key difference between the common law rule
and the UCC rule is that the Code does not require all of
the terms of the agreement to be in writing. The Code looks for something simpler: an
indication that the parties reached an agreement. Only two things are required: the signature of
the defendant and the quantity of goods being sold. Suppose a short memorandum between
The key difference
between the common
law rule and the UCC
rule is that the Code
does not require all of
the terms of the
agreement to be in
writing.
10The states that have not adopted the Uniform Electronic Transactions Act, at the time of this
writing, are Illinois, New York, and Washington.
326 U N I T 2 Contracts
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textile dealers indicates that Seller will sell to Buyer “grade AA 100 percent cotton, white
athletic socks.” If the writing does not state the price, the parties can testify at court about
what the market price was at the time of the deal. If the writing says nothing about the
delivery date, the court will assume a reasonable delivery date, say, 60 days. But how many
socks were to be delivered? 100 pairs or 100,000? The court will have no objective evidence,
and so, the quantity must be written.
Writing Result
“Confirming phone conversation today, I
will send you 1,000 reams of paper for
laser printing, usual quality & price.
[Signed,] Seller.”
This memorandum satisfies UCC
§2-201(1), and the contract may be
enforced against the seller. The buyer
may testify as to the “usual” quality
and price between the two parties,
and both sides may rely on normal
trade usage.
“Confirming phone conversation today, I
will send you best quality paper for laser
printing, $3.25 per ream, delivery date
next Thursday.[Signed,] Seller.”
This memorandum is not enforceable
because it states no quantity.
14-3b UCC §2-201(2)—The Merchants’ Exception
When both parties are “merchants,” that is, businesspeople who routinely deal in the
goods being sold, the Code will accept an even more informal writing. Within a
reasonable time of making an oral contract, if a merchant sends a written confirmation
to another, and if the confirmation is definite enough to bind the sender herself, then the
merchant who receives the confirmation will also be bound by it unless he objects in
writing within 10 days. This exception dramatically changes the rules from the common
law, but it applies only between two merchants. The drafters of the Code assumed that
experienced merchants are able to take care of themselves in fast-moving negotiations.
The critical difference is this: A writing may create a binding contract even when it is not
signed by the defendant.
Madge manufactures “beanies,” that is, silly caps with plastic propellers on top. Rachel, a
retailer, telephones her, and they discuss the price of the beanies, shipping time, and other
details. Madge then faxes Rachel a memo: “This confirms your order for 2,500 beanies at
$12.25 per beanie. Colors: blue, green, black, orange, red. Delivery date: 10 days. [Signed]
Madge.” Rachel receives the fax, reads it while negotiating with another manufacturer, and
throws it in the wastebasket. Rachel buys her beanies elsewhere, and Madge sues. Rachel
defends, claiming there is no written contract because she, Rachel, never signed anything.
Madge wins under UCC §2-201(2). Both parties were merchants because they routinely dealt
in these goods. Madge signed and sent a confirming memo that could have been used to hold
her, Madge, to the deal. When Rachel read it, she was not free to disregard it. Obviously, the
intelligent business practice would have been to promptly fax a reply saying, “I disagree.We do
not have any deal for beanies.” Since Rachel failed to respond within 10 days, Madge has an
enforceable contract.
For a confirming memo to count, a merchant must send it within a reasonable time. But
how long is that? A few days certainly qualifies. Could 13 months be quick enough?
CHAPTER 14 Written Contracts 327
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14-3c UCC §2-201(3)—Special Circumstances
An oral contract may be enforceable, even without a written memorandum, if:
• The seller is specially manufacturing the goods for the buyer, or
• The defendant admits in court proceedings that there was a contract, or
• The goods have been delivered or they have been paid for.
SPECIALLY MANUFACTURED GOODS
If a seller, specially manufacturing goods for the buyer, begins work on them before the buyer
cancels, and the goods cannot be sold elsewhere, the oral contract is binding. Bernice manu-
factures solar heating systems. She phones Jason and orders 75 special electrical converter units
designed for her heating system, at $150 per unit. Jason begins manufacturing the units, but
SETON CO. V. LEAR CORP.
198 Fed. Appx. 496, 2006 WL 2860774
Sixth Circuit Court of Appeals, 2006
C A S E S U M M A R Y
Facts: GeneralMotors hired Lear Corporation to supply all
of the leather seats for its trucks and SUVs. In October 1998,
Lear reached an agreement with Seton Company to provide
Lear with the actual cut-to-pattern leather, which Lear
would then assemble. Seton agreed to give Lear certain
rebates, based on the size of the orders. Despite the great
value of this contract, the parties initially put nothing in
writing. (Note to students: Later in life, if you negotiate a
multimillion dollar deal and fail to put it in writing, your
grade in this course will be retroactively lowered!)
Both parties performed the contract satisfactorily for
about a year. Then they agreed to a slight modification in
the rebates. All was still well. In the fall of 1999, Lear
asked Seton to send a written summary of the agreement,
including the modified rebates. In November 1999, Seton
sent a one-page memorandum to Lear, summarizing the
agreement. It stated: “Lear is to award Seton the entire
[truck and SUV program] cut to pattern business for the
life of the program.” The letter ended with a request that
Lear “kindly return with acknowledgement signature,”
but Lear did not do so.
For two more years, the parties worked together
amicably. Then Seton became anxious that Lear was
planning to take its business elsewhere. In January 2002,
Seton sent a letter, requesting that Lear affirm its commit-
ment to deal exclusively with Seton for the life of the
GMC program. Lear responded that there had never been
any such agreement. Seton filed suit.
At trial, Lear claimed that no contract had ever been
signed. Seton replied that its memo summarizing the
agreement created a valid contract, under the “merchant
exception” rule. The jury agreed with Seton and awarded
the company $34 million. Lear appealed.
Issue: Did Seton’s memorandum create a contract under the
merchant exception?
Decision: Yes, the confirming memo between merchants
created a contract under the UCC. Affirmed.
Reasoning: Lear argued that the November letter was
not a written confirmation of an existing contract, but
rather an offer of a new contract. The company empha-
sized that the phrase “kindly return with acknowledge-
ment signature” was evidence that there was no final
agreement. But the jury disagreed. It was clearly influ-
enced by Seton’s argument that the letter referred to a
prior agreement between Lear and Seton executives. Also,
although the letter asked for a signature, it did not require
one. For these reasons, the letter amounted to more than a
mere offer.
The UCC does require, however, that merchants
send any confirmatory memo within a reasonable length
of time. Lear contended that the letter could not count as
a written confirmation because it arrived 13 months after
the first discussion of the deal with Seton, but the jury
disagreed, probably because the relationship between the
companies had been casual and friendly for a long time.
328 U N I T 2 Contracts
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then Bernice phones again and says she no longer needs them. Bernice is bound by the contract.
The goods are being manufactured for her and cannot be sold elsewhere. Jason had already
begun work when she attempted to cancel. If the case goes to court, Jason will win.
ADMISSIONS IN COURT
When the defendant admits in court proceedings that the parties made an oral contract, the
agreement is binding. Rex sues Sophie, alleging that she orally agreed to sell him five boa
constrictors that have been trained to stand in a line and pass a full wine glass from one
snake to the next. Sophie defends the lawsuit, but during a deposition, she says, “OK, we
agreed verbally, but nothing was ever put in writing, and I knew I didn’t have to go through
with it. When I went home, the snakes made me feel really guilty, and I decided not to
sell.” Sophie’s admission under oath dooms her defense.
GOODS DELIVERED OR PAID FOR
If the seller has delivered the goods, or the buyer has paid for them, the contract may be
enforced even with nothing in writing. Malik orally agrees to sell 500 plastic chairs to a
university for use in its cafeteria. Malik delivers 300 of the chairs, but then the university
notifies him that it will not honor the deal. Malik is entitled to payment for the 300 chairs,
though not for the other 200. Conversely, if the university had sent a check for one-half of
the chairs, it would be entitled to 250 chairs.
EXAM Strategy
Question: Beasley is a commercial honey farmer. He orally agrees to sell 500,000
pounds of honey to Grizzly at $1 per pound. Grizzly immediately faxes Beasley a
signed confirmation, summarizing the deal. Beasley receives the fax but ignores it,
and he never responds to Grizzly. Five days later, Beasley sells his honey to Brown for
$1.15 per pound. Grizzly sues Beasley for breach of contract. Beasley claims that he
signed nothing and was free to sell his honey anywhere he wanted. Who will win?
Strategy: Honey is a moveable thing, meaning that this contract is governed by the
UCC. Under the Code, contracts for the sale of goods worth $500 or more must be in
writing. However, the merchant exception changes things when both parties are
merchants. Beasley and Grizzly are both merchants. Apply the merchant exception.
Result: Beasley breached the contract. Within a reasonable time after making the
agreement, Grizzly sent a memo to Beasley confirming it. Beasley had 10 days either
to object in writing or be held to the agreement. Beasley will lose this lawsuit because
he ignored the faxed confirmation.
14-4 PAROL EVIDENCE
Tyrone agrees to buy Martha’s house for $800,000. The contract obligates Tyrone to make a
10 percent down payment immediately and pay the remaining $720,000 in 45 days. As the
two parties sign the deal, Tyrone discusses his need for financing. Unfortunately, at the end
of 45 days, he has been unable to get a mortgage for the full amount. He claims that the
parties orally agreed that he would get his deposit back if he could not obtain financing. But
the written agreement says no such thing, and Martha disputes the claim. Who will win?
Probably Martha, because of the parol evidence rule.
CHAPTER 14 Written Contracts 329
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Parol evidence refers to anything (apart from the written contract itself) that was said,
done, or written before the parties signed the agreement or as they signed it. Martha’s
conversation with Tyrone about financing the house was parol evidence because it occurred
as they were signing the contract. Another important term is integrated contract, which
means a writing that the parties intend as the final, complete expression of their agreement.
Now for the rule.
The parol evidence rule: When two parties make an integrated contract, neither one
may use parol evidence to contradict, vary, or add to its terms. Negotiations may last for
hours, weeks, or even months. Almost no contract includes everything that the parties said.
When parties consider their agreement integrated, any statements they made before or while
signing are irrelevant. If a court determines that Martha and Tyrone intended their agreement
to be integrated, it will prohibit testimony aboutMartha’s oral promises. One way to avoid parol
evidence disputes is to include an integration clause.That is a statement clearly proclaiming that
this writing is the “full and final expression” of the parties’ agreement, and that anything said
before signing or while signing is irrelevant. In the following case, learned people learned about
parol evidence the hard way.
MAYO V. NORTH CAROLINA STATE UNIVERSITY
608 S.E.2d 116
North Carolina Court of Appeals, 2005
C A S E S U M M A R Y
Facts: Dr. Robert Mayo was a tenured faculty member of
the engineering department at North Carolina State Univer-
sity (NCSU), and director of the school’s nuclear engineering
program. In July, he informed his department chair, Dr. Paul
Turinsky, that he was leaving NCSU effective September 1.
Turinsky accepted the resignation.
In October, after Mayo had departed, Phyllis Jenn-
ette, the university’s payroll coordinator, informed him
that he had been overpaid. She explained that for employ-
ees who worked 9 months but were paid over 12 months,
the salary checks for July andAugust were in fact prepayments
for the period beginning that September. Because Mayo had
not worked after September 1, the checks for July and August
were overpayment. When he refused to refund the money,
NCSU sought to claim it in legal proceedings. The first step
was a hearing before an administrative agency.
At the hearing, Turinsky and Brian Simet, the univer-
sity’s payroll director, explained that the “prepayment” rule
was a basic part of every employee’s contract. However,
both acknowledged that the prepayment rule was not
included in any of the documents that formed Mayo’s con-
tract, including his appointment letter, annual salary
letter, and policies adopted by the university’s trustees.
The university officials used other evidence, outside
the written documents, to establish the prepayment
policy.
Based on the additional evidence, the agency ruled
that NCSU was entitled to its money. However, Mayo
appealed to court, and the trial judge declared that he
owed nothing, ruling that the university was not per-
mitted to rely on parol evidence to establish its policy.
NCSU appealed.
Issue: Could NCSU have relied on parol evidence to estab-
lish its prepayment rule?
Decision: No, neither party could have used parol evi-
dence to explain the terms of the agreement. Affirmed.
Reasoning: When the parties intend a written document
to be the final, integrated expression of their agreement,
neither side may introduce parol evidence that changes,
adds to, or contradicts any of the written terms. However,
if the writing is not intended as a full integration of the
agreement, or if the writing is ambiguous, then parol
evidence is allowed.
Brian Simet, the university’s payroll director, argued
that the prepayment rule was a basic part of every
employee’s contract. However, during the agency hearing,
Integrated contract
A writing that the parties intend
as the final, complete
expression of their agreement.
330 U N I T 2 Contracts
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14-4a Exception: An Incomplete or Ambiguous
Contract
If a court determines that a written contract is incomplete or ambiguous, it will permit parol
evidence. Suppose that an employment contract states that the company will provide “full
health coverage for Robert Watson and his family,” but does not define family. Three years
later, Watson divorces and remarries, acquiring three stepchildren, and a year later, his
second wife has a baby. Watson now has two children by his first marriage and four by the
second. The company refuses to insure Watson’s first wife or his stepchildren. A court will
probably find a key clause in his health care contract—“coverage for … his family”—is
ambiguous. A judge cannot determine exactly what the clause means from the contract
itself, so the parties will be permitted to introduce parol evidence to prove whether or not
the company must insure Watson’s extended family.11
14-4b Fraud, Misrepresentation, or Duress
A court will permit parol evidence of fraud, misrepresentation, or duress. To encourage
Annette to buy his house, Will assures her that no floodwaters from the nearby river have
ever come within two miles of the house. Annette signs a contract that is silent about
flooding and includes an integration clause stating that neither party is relying on any oral
statements made during negotiations. When Annette moves in, she discovers that the
foundation is collapsing due to earlier flooding and that Will knew of the flooding and the
damage. Despite the integration clause, a court will probably allow Annette to testify about
Will’s misrepresentations.12
Chapter Conclusion
Some contracts must be in writing to be enforceable, and the writing must be clear and
unambiguous. Drafting the contract need not be arduous. The disputes illustrated in this
chapter could all have been prevented with a few carefully crafted sentences. It is worth the
time and effort to write them.
he acknowledged that the rule was “not stated anywhere
specifically.”
The department chair, Dr. Turinsky, testified that
Professor Mayo’s employment agreement consisted only
of his appointment letter, his annual salary letter, and the
policies adopted and amended by the school’s Board of
Governors and its Board of Trustees. The language in
each of these documents was unambiguous and said noth-
ing about the supposed “prepayment rule.” Dr. Turinsky
also stated that he had never heard of the prepayment rule
until September, after Professor Mayo left the school.
It appeared that the parties intended these docu-
ments to be the final, integrated expression of Professor
Mayo’s employment agreement. Because the documents
were complete and unambiguous, parol evidence was
excluded.
Professor Mayo owed the university nothing based on
the alleged overpayment.
11See, for example Eure v. Norfolk Shipbuilding & Drydock Corp., Inc., 561 S.E.2d 663 (Va. 2002).
12Lindberg v. Roseth, 137 Idaho 222, 46 P.3d 518 (Idaho 2002).
CHAPTER 14 Written Contracts 331
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EXAM REVIEW
1. THE STATUTE OF FRAUDS Several types of contract are enforceable only if
written:
• LAND The sale of any interest in land. (pp. 319–320)
• ONE YEAR An agreement that cannot be performed within one year. (pp. 321–322)
CPA Question: Able hired Carr to restore Able’s antique car for $800. The terms
of their oral agreement provided that Carr had 18 months to complete the work.
Actually, the work could be completed within one year. The agreement is:
(a) Unenforceable because it covers services with a value in excess of $500
(b) Unenforceable because it covers a time period in excess of one year
(c) Enforceable because personal service contracts are exempt from the Statute of Frauds
(d) Enforceable because the work could be completed within one year
Strategy: This is a subtle question. Notice that the contract is for a sum greater
than $500. But that is a red herring. Why? The contract also might take 18 months
to perform. But it could be finished in less than a year. (See the “Result” at the
end of this section.)
• DEBT OF ANOTHER A promise to pay the debt of another, including promises
made by executors to pay an estate’s debts. (pp. 322–323)
Question: Donald Waide had a contracting business. He bought most of his
supplies from Paul Bingham’s supply center. Waide fell behind on his bills, and
Bingham told Waide that he would extend no more credit to him. That same day,
Donald’s father, Elmer Waide, came to Bingham’s store, and said to Bingham that
he would “stand good” for any sales to Donald made on credit. Based on Elmer’s
statement, Bingham again gave Donald credit, and Donald ran up $10,000 in
goods before Bingham sued Donald and Elmer. What defense did Elmer make,
and what was the outcome?
Strategy: This was an oral agreement, so the issue is whether the promise had to
be in writing to be enforceable. Review the list of six contracts that must be in
writing. Is this agreement there? (See the “Result” at the end of this section.)
• EXECUTORS A promise made by an executor of an estate. (p. 323)
• MARRIAGE A promise made in consideration of marriage. (p. 323)
• GOODS The sale of goods worth $500 or more. (p. 326)
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332 U N I T 2 Contracts
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Question: James River-Norwalk, Inc., was a paper and textile company that
needed a constant supply of wood. James River orally contracted with Gary Futch
to supply wood for the company, and Futch did so for several years. The deal was
worth many thousands of dollars, but nothing was put in writing. Futch actually
purchased the wood for his own account and then resold it to James River. After a
few years, James River refused to do more business with Futch. Did the parties
have a binding contract?
Strategy: If this is a contract for services, it is enforceable without anything in
writing. However, if it is one for the sale of goods, it must be in writing. Clearly
what James River wanted was the wood, and it did not care where Futch found it.
(See the “Result” at the end of this section.)
2. CONTENTS The writing must be signed by the defendant and must state the name
of all parties, the subject matter of the agreement, and all essential terms and promises.
Electronic signatures usually are valid. (pp. 323–326)
3. UNIFORM COMMERCIAL CODE (UCC) A contract or memorandum for the
sale of goods may be less complete than those required by the common law.
• The basic UCC rule requires only a memorandum signed by the defendant,
indicating that the parties reached an agreement and specifying the quantity of
goods.
• Between merchants, even less is required. If one merchant sends written
confirmation of a contract, the merchant who receives the document must object
within 10 days or be bound by the writing.
• In the following special circumstances, no writing may be required: the goods are
specially manufactured, one party admits in litigation that there was a contract, or
one party pays for part of the goods or delivers some of the goods. (pp. 326–329)
4. PAROL EVIDENCE When an integrated contract exists, neither party may
generally use parol evidence to contradict, vary, or add to its terms. Parol evidence
refers to anything (apart from the written contract itself) that was said, done, or written
before the parties signed the agreement or as they signed it. (pp. 329–331)
1. “One Year” Result: (d) A contract for the sale of goods worth $500 or more must
be in writing—but this is a contract for services, not the sale of goods, so the $800
price is irrelevant. The contract can be completed within one year, and thus it falls
outside the Statute of Frauds. This is an enforceable agreement.
1. “Debt of Another” Result: Elmer made a promise to pay the debt of another. He
did so as a favor to his son. This is a collateral promise. Elmer never signed any
such promise, and the agreement cannot be enforced against him.
1. “Goods” Result: James River was buying wood, and this is a contract for the sale
of goods. With nothing in writing, signed by James River, Futch has no enforceable
agreement.
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MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Two individuals signed a contract that was intended to be their
entire agreement. The parol evidence rule will prevent the admission of evidence
offered to:
(a) Explain the meaning of an ambiguity in the written contract
(b) Establish that fraud had been committed in the formation of the contract
(c) Prove the existence of a contemporaneous oral agreement modifying
the contract
(d) Prove the existence of a subsequent oral agreement modifying the contract
2. Raul wants to plant a garden, and he agrees to buy a small piece of land for $300.
Later, he agrees to buy a table for $300. Neither agreement is put in writing. The
agreement to buy the land enforceable, and the agreement to buy the
table enforceable.
(a) is; is
(b) is; is not
(c) is not; is
(d) is not; is not
3. The common law Statute of Frauds requires that to be “in writing,” an agreement
must be signed by …
(a) the plaintiff
(b) the defendant
(c) both (a) and (b)
(d) none of the above
4. Mandy verbally tells a motorcycle dealer that she will make her son’s motorcycle
payments if he falls behind on them. Will Mandy be legally required to live up to this
agreement?
(a) Yes, absolutely
(b) Yes, if her son is under 18
(c) Yes, if Mandy will be the primary driver of the motorcycle
(d) Yes, if the motorcycle is worth less than $500
(e) No, absolutely not
5. In December 2012, Eric hires a band to play at a huge graduation party he is
planning to hold in May, 2014. The deal is never put into writing. In January
2014, if he wanted to cancel the job, Eric be able to do so. If he
does not cancel, and if the band shows up and plays at the party in May 2014,
Eric have to pay them.
(a) will; will
(b) will; will not
(c) will not; will
(d) will not; will not
334 U N I T 2 Contracts
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ESSAY QUESTIONS
1. Richard Griffin and three other men owned a grain company called Bearhouse, Inc.,
which needed to borrow money. First National Bank was willing to loan $490,000, but
it insisted that the four men sign personal guaranties on the loan, committing
themselves to repaying up to 25 percent of the loan each if Bearhouse defaulted.
Bearhouse went bankrupt. The bank was able to collect some of its money from
Bearhouse’s assets, but it sued Griffin for the balance. At trial, Griffin wanted to
testify that before he signed his guaranty, a bank officer assured him that he would
only owe 25 percent of whatever balance was unpaid, not 25 percent of the total loan.
How will the court decide whether Griffin is entitled to testify about the
conversation?
2. When Deana Byers married Steven Byers, she was pregnant with another man’s child.
Shortly after the marriage, Deana gave birth. The marriage lasted only two months,
and the couple separated. In divorce proceedings, Deana sought child support. She
claimed that Steven had orally promised to support the child if Deana would marry
him. Steven claims he never made the promise. Comment on the outcome.
3. Lonnie Hippen moved to Long Island, Kansas, to work in an insurance company
owned by Griffiths. After he moved there, Griffiths offered to sell Hippen a house he
owned, and Hippen agreed in writing to buy it. He did buy the house and moved in,
but two years later, Hippen left the insurance company. He then claimed that at the
time of the sale, Griffiths had orally promised to buy back his house at the selling
price if Hippen should happen to leave the company. Griffiths defended based on the
Statute of Frauds. Hippen argued that the Statute of Frauds did not apply because the
repurchase of the house was essentially part of his employment with Griffiths.
Comment.
4. Landlord owned a clothing store and agreed in writing to lease the store’s basement
to another retailer. The written lease, which both parties signed, (1) described the
premises exactly, (2) identified the parties, and (3) stated the monthly rent clearly.
But an appeals court held that the lease did not satisfy the Statute of Frauds.
Why not?
5. YOU BE THE JUDGE WRITING PROBLEM Harrison Epperly operated
United Brake Systems in Indianapolis, Indiana, and wanted to open a similar store in
Nashville. He offered Kenneth Jarrett a job as manager, promising six months’
severance pay if the store was not profitable in six months, and 49 percent
ownership if he managed the new store for 10 years. Jarrett agreed, but the two men
never put the deal in writing. Under Jarrett’s management, the Nashville branch
grew dramatically. After four years of renting space, the company purchased the land
and buildings it used. Epperly periodically acknowledged his promise to make
Jarrett 49 percent owner of the Nashville branch, and from time to time, he
mentioned the arrangement to other workers. But after 10 years, Epperly sold
United Brake, which had grown to 23 branches, to another company for $11 million.
Jarrett sued Epperly for 49 percent of the Nashville branch. The trial court awarded
Jarrett $812,000. Epperly appealed. Is Jarrett’s contract with Epperly barred by the
Statute of Frauds? Argument for Epperly: This alleged contract is unenforceable for
two reasons. First, the agreement includes real estate; namely, the valuable land and
buildings the company uses. A contract for the sale of any interest in land is
unenforceable unless written. Second, the contract could not have been performed
CHAPTER 14 Written Contracts 335
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within 1 year. If there was a deal, then by Jarrett’s own words, the parties intended it
to last 10 years. And 10 years’ work cannot be performed in 1 year. Argument for
Jarrett: The agreement had nothing to do with land. Jarrett and Epperly agreed that
Mr. Jarrett would obtain a 49 percent ownership of the Nashville branch. At the time
they made that agreement, the Nashville branch had no real estate. There is no rule
saying that a valid contract becomes invalid because a corporation acquires some
land. The “not in one year” argument also misses the point. The primary obligation
was to open the branch and manage it for six months. If it was not profitable, Mr.
Jarrett would immediately receive six months’ severance pay, and the contract
would be fully performed by both parties in less than a year. Finally, Epperly made
a binding commitment, and Mr. Jarrett relied. Promissory estoppel prohibits Mr.
Epperly from using deceit to profit.
DISCUSSION QUESTIONS
1. ETHICS Jacob Deutsch owned commercial
property. He orally agreed to rent it for six years to
Budget Rent-A-Car. Budget took possession, began
paying monthly rent, and, over a period of several
months, expended about $6,000 in upgrading the
property. Deutsch was aware of the repairs. After a
year, Deutsch attempted to evict Budget. Budget
claimed it had a six-year oral lease, but Deutsch
claimed that such a lease was worthless. Please rule.
Is it ethical for Deutsch to use the Statute of Frauds
in attempting to defeat the lease? Assume that, as
landlord, you had orally agreed to rent premises to a
tenant, but then for business reasons, you preferred
not to carry out the deal. Would you evict a tenant if
you thought the Statute of Frauds would enable
you to do so? How should you analyze the problem?
What values are most important to you?
2. Mast Industries and Bazak International were
two textile firms. Mast orally offered to sell
certain textiles to Bazak for $103,000. Mast
promised to send documents confirming the
agreement, but it never did. Finally, Bazak sent
a memorandum to Mast confirming the
agreement, describing the goods, and specifying
their quantity and the price. Bazak’s officer
signed the memo. Mast received the memo but
never agreed to it in writing. When Mast
failed to deliver the goods, Bazak sued. Who
will win? Why?
3. Is the Statute of Frauds reasonable, or does it
unacceptably allow people to escape their
obligations on a mere technicality?
4. Does the coverage of the Statute of Frauds make
sense as it currently stands? Would it be better to
expand the law and require that all contracts be in
writing? Or should the law be done away with
altogether?
5. Compare the common law Statute of Frauds
to the UCC version. What are the specific
differences? Which is more reasonable? Why?
336 U N I T 2 Contracts
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CHAPTER15
THIRD PARTIES
Morty is 80, and a back injury makes it impos-
sible for him to keep up with his yard work. The
weeds in his front yard are knee-high by the
Fourth of July, when his son John comes to visit
for a week.
Surprised at the condition of the lawn, John
gets the old mower out of the garage and mows
it himself. Later in the visit, John calls a local
landscaping company. He agrees to pay $500 for
the company to send workers to mow Morty’s
lawn every two weeks for the rest of the year.
The company bills John’s credit card, but it
never sends anyone to cut the grass. As the summer
wears on, John and Morty make several angry phone
calls to the landscaper, without result. The owner of the
company seems not to care, and it may take a lawsuit to
motivate him to refund John’s money so that he can hire
someone else to do the job.
But if John is too busy to take legal action, can Morty
do so?
If John is too busy to
take legal action, can
Morty do so?
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The last five chapters examined the Contracts Checklist, so you now know all the elements
that must be present for a valid contract to exist. In this chapter and the next three, we turn
our attention to other contracts issues.
15-1 THIRD PARTY BENEFICIARY
The two parties who make a contract always intend to gain some benefit for themselves. Often,
though, their bargain will also benefit someone else. A third party beneficiary is someone who was
not a party to the contract but stands to benefit from it. Many contracts create third party
beneficiaries. In the opening scenario, Morty is a third party beneficiary of John’s agreement
with the landscaping company. As another example, suppose a Major League Baseball team
contracts to purchase from Seller 20 acres of an abandoned industrial site to be used for a new
stadium. The owner of a pizza parlor on the edge of Seller’s land might benefit enormously,
since 40,000 hungry fans in the neighborhood for 81 home games every season could turn her
once-marginal operation into a gold mine of cheese and pepperoni.
But what if the contract falls apart? What if the team backs out of the deal to buy the land?
Seller can certainly sue because it is a party to the contract. But what about the pizza parlor owner?
Can she sue to enforce the deal and recover lost profits for unsold sausage and green pepper?
The outcome in cases like these depends upon the intentions of the two contracting parties.
If they intended to benefit the third party, she will probably be permitted to enforce their contract.
If they did not intend to benefit her, she probably has no power to enforce the agreement.
15-1a Intended Beneficiaries
A person is an intended beneficiary and may enforce a contract if the parties intended her to
benefit and if either (a) enforcing the promise will satisfy a duty of the promisee to the
beneficiary or (b) the promisee intended to make a gift to the beneficiary. (The promisor is
the one who makes the promise that the third party beneficiary is seeking to enforce. The
promisee is the other party to the contract.)
In other words, a third party beneficiary must show two things in order to enforce a
contract that two other people created. First, she must show that the two contracting parties
were aware of her situation and knew that she would receive something of value from their
deal. Second, she must show that the promisee wanted to benefit her for one of two reasons:
either to satisfy some duty owed or to make her a gift.
If the promisee is fulfilling some duty, the third party beneficiary is called a creditor
beneficiary. Most often, the duty that a promisee will be fulfilling is a debt already owed to
the beneficiary. If the promisee is making a gift, the third party is a donee beneficiary.1 So
long as the third party is either a creditor or a donee beneficiary, she may enforce the
contract. If she is only an incidental beneficiary, she may not.
We will apply this rule to the dispute over Morty’s lawn. Like most contracts, the deal
between John and the landscaping company had two promises: the company’s promise to
mow the lawn every two weeks and John’s agreement to pay $500. The one that interests us
is the promise to mow the lawn. The company is the promisor and John is the promisee.
Did the two parties intend to benefit Morty? Yes, they did. John wanted his father’s
property maintained. Did John owe Morty a legal duty? No. Did John intend to make a gift
to Morty? Yes. So, Morty is an intended, donee beneficiary, and he can sue the landscaping
company to enforce the contract himself.
By contrast, the pizza parlor owner will surely lose. A stadium is a multimillion-dollar
investment, and it is most unlikely that the baseball team and the seller of the land were even
Intended beneficiary
Someone who may enforce a
contract made between two
other parties.
Promisor
Makes the promise that a third
party seeks to enforce.
Promisee
The contract party to whom a
promise is made.
1
“Donee” comes from the word “donate.”
338 U N I T 2 Contracts
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aware of the owner’s existence, let alone that they intended to benefit her. She probably
cannot prove either the first element or the second element, and certainly not both.
In the following case, a dazzling diamond loses its luster. Who is entitled to sue?
EXAM Strategy
Question: Mr. Inspector examines houses and gives its reports to potential buyers.
Mr. Inspector contracts with Greenlawn, a real estate agent, to furnish reports on houses
that Greenlawn is selling. The agreement allows the agent to give the reports to potential
buyers. Greenlawn gives Molly one of Mr. Inspector’s reports and, relying upon it, she
buys a house. Although the report states that the house is structurally sound, it turns out
that chronic roof leaks have caused water to seep into the walls. Molly sues Mr. Inspector.
The inspector requests summary judgment, claiming that he had no contract with Molly.
Strategy: Mr. Inspector is right in saying he had no agreement with Molly. To prevail,
Molly must demonstrate she is a third party beneficiary of the contract between the other
two. A third party beneficiary may enforce a contract if the parties intended to benefit her
and either (a) enforcing the promise will satisfy a duty of the promisee to the beneficiary
or (b) the promisee intended to make a gift to the beneficiary.
SCHAUER V. MANDARIN GEMS OF CALIFORNIA, INC.
2005 WL 5730
Court of Appeal of California, 2005
C A S E S U M M A R Y
Facts: Sarah Schauer and her fiancé, Darin Erstad, went
shopping for an engagement ring, first at Tiffany and Car-
tier, then atMandarin Gems, where they were captivated by
a 3.01 carat diamond with a clarity grading of “S11.” Erstad
bought the ring the same day for $43,121. Later, Mandarin
supplied Erstad with a written appraisal, again rating the
ring as an S11 and valuing it at $45,500. Paul Lam, a
certified gemologist, signed the appraisal.
Diamonds may last forever, but this marriage was
short-lived. The divorce decree gave each party the right
to keep whatever personal property they currently held,
meaning that Schauer could keep the ring. She had the
ring appraised by the Gem Trade Laboratory, which gave
it a poorer clarity rating and a value of $20,000.
Schauer sued Mandarin for misrepresentation and
breach of contract, but the jeweler defended by saying that
it had never contracted with her, and that she was not a third
party beneficiary of the company’s agreement with Erstad.
The trial court dismissed Schauer’s suit, and she appealed.
Issue: Did Schauer have any right to sue for breach of contract?
Decision: Yes, she was entitled to sue. Reversed and
remanded.
Reasoning: A true third party beneficiary may enforce a
contract made by others unless they rescinded the agree-
ment. Persons who expect to incidentally or remotely
benefit from a bargain may not enforce it.
A plaintiff claiming status as a third party beneficiary
must demonstrate that the promisor understood that the
promisee intended to benefit the third party. It is not neces-
sary that both parties intended to benefit the third party.
Schauer alleged that she and Erstad went shopping
for an engagement ring. They were together when they
looked at the ring, and they explained to the jeweler that
Erstad was buying the diamond to give to Schauer as an
engagement ring. The jeweler must have understood that
Erstad was entering into a sales contract intending to
benefit Schauer.
Schauer alleged facts that, if found to be true, estab-
lished her as a third party beneficiary. She was entitled to
proceed with her contract claim against Mandarin Gems.
CHAPTER 15 Third Parties 339
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Result: Greenlawn used the inspection summaries as sales tools. When Greenlawn
assured a potential buyer that she could rely upon a report, the real estate agent took on
a duty to deliver reliable information. Mr. Inspector understood that. The two parties
intended to benefit Greenlawn’s buyers. Molly may sue Mr. Inspector for breach of his
contract with the agent. Mr. Inspector’s motion for summary judgment is denied.
15-1b Incidental Beneficiaries
A person who fails to qualify as a donee beneficiary or a creditor beneficiary is merely an incidental
beneficiary and may not enforce the contract. The pizza parlor owner is an incidental beneficiary.
In an effort to persuade courts, many plaintiffs make creative arguments that they are
intended beneficiaries with enforcement rights. Is every taxpayer an intended beneficiary of a
government contract? Do labor unions have rights if a contract refers to them in general terms?
Or are these plaintiffs incidental beneficiaries? The following case answers these questions.
UNITE HERE LOCAL 30 V. CALIFORNIA DEPARTMENT
OF PARKS AND RECREATION
2011 Cal. App. LEXIS 510
Court of Appeal of California, 2011
C A S E S U M M A R Y
Facts: The California Department of Parks and Recreation
andDelaware North Companies entered into a contract giving
Delaware North the right to operate a concession stand at a
state park in San Diego for 10 years. Four years into the
contract, Delaware North assigned its rights to operate the
stand to another company.
Delaware North fired many of its employees, and the
new operator did not rehire them. Some of these workers
were members of the union Unite Here Local 30. Local
30 sued to block the assignment. It was joined in the suit
by Bridgette Browning, who lived in the area and seemed
to care who provided her hot dogs.
The trial court rejected the plaintiffs’ claims, and the
plaintiffs appealed.
Issue: Did the plaintiffs have the right to enforce the con-
tract between the state and the concession stand company?
Decision: No. The plaintiffs were not intended benefi-
ciaries.
Reasoning: To enforce someone else’s contract, a party
does not have to be specifically named in it. Third parties
may enforce a contract if they are an intended beneficiary,
that is, a member of a class of persons for whose benefit it
was made. But intended beneficiaries must prove that the
contract was actually made for their benefit, not just that
they happened to benefit from the deal.
The plaintiffs argued that they had a right to sue for
breach of contract and block the assignment because the
concession contract was indeed intended for their benefit.
Did the terms of the concession contract reveal an intent
to benefit Bridgette Browning? She argued that state con-
tracts intend to benefit the general public and the taxpayers
and that as a hot-dog-eating, park-going taxpayer of Califor-
nia, she had a right to sue. However, the fact that members
of the public benefit from the contract—a hot pretzel or
friendly service at the park’s concession stand—does not
make them intended beneficiaries. Browning would be an
intended beneficiary only if the point of the contract was
to make a gift to her. That was not the goal of this contract.
Did the terms of the concession contract reveal an
intent to benefit Local 30? To prove this intent, Local 30
pointed to a clause in the contract that prohibited Dela-
ware North from promoting or deterring union organizing.
But that provision hardly revealed an intent to benefit
Local 30, or any union for that matter. At best, it showed
an intent to remain neutral to union organizing, hardly a
gift. Local 30 was no more than an incidental beneficiary.
Since the plaintiffs were not intended beneficiaries,
they had no right to sue to enforce the contract.
Incidental beneficiary
Someone who might have
benefited from a contract
between two others but has
no right to enforce that
agreement.
340 U N I T 2 Contracts
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15-2 ASSIGNMENT AND DELEGATION
After a contract is made, one or both parties may wish to substitute someone else for
themselves. Six months before Maria’s lease expires, an out-of-town company offers her a
new job at a substantial increase in pay. After taking the job, she wants to sublease her
apartment to her friend Sarah.
A contracting party may transfer his rights under the contract, which is called an
assignment of rights. Or a party may transfer her obligations under the contract, which is a
delegation of duties. Frequently, a party will make an assignment and delegation simulta-
neously, transferring both rights (such as the right to inhabit an apartment) and duties (like
the obligation to pay monthly rent) to a third party.
15-2a Assignment
Lydia needs 500 bottles of champagne. Bruno agrees to sell them to her for $10,000, payable
30 days after delivery. He transports the wine to her.
Bruno owesDoug $8,000 fromaprevious deal.He says toDoug,“I don’t have yourmoney, but
I’ll give you my claim to Lydia’s $10,000.” Doug agrees. Bruno then assigns to Doug his rights to
Lydia’s money, and in exchange Doug gives up his claim against Bruno for $8,000. Bruno is the
assignor, the onemaking an assignment, andDoug is the assignee, the one receiving an assignment.
Why would Bruno offer $10,000 when he owed Doug only $8,000? Because all he has is
a claim to Lydia’s money. Cash in hand is often more valuable. Doug, however, is willing to
assume some risk for a potential $2,000 gain.
Bruno notifies Lydia of the assignment. Lydia, who owes the money, is called the
obligor; that is, the one obligated to do something. At the end of 30 days, Doug arrives at
Lydia’s doorstep, asks for his money, and gets it, since Lydia is obligated to him. Bruno has
no claim to any payment. See Exhibit 15.1.
EXAM Strategy
Question: Hasannah, an art dealer, signs a contract with Jason. Hasannah will deliver
a David Hockney painting to Jason’s house. Jason may keep it for 30 days and then
either return it or pay Hasannah $2 million. Hasannah delivers the painting. Hasannah
finds a better building to house her gallery and agrees to buy it from Shannon. She
and Shannon sign a contract allowing Shannon to receive Jason’s payment if he keeps
the picture. Hasannah then notifies Jason to pay Shannon the $2 million. Identify the
obligor, the assignor, and the assignee.
Strategy: The obligor is the one obligated to do something. The assignor makes an
assignment and the assignee receives it.
Result: Jason is obligated either to return the picture or pay $2 million for it. He is
the obligor. Hasannah is entitled to the money, but she assigns her right to Shannon.
Hasannah is the assignor and Shannon the assignee.
Assignment
Transferring contract rights.
Delegation
Transferring contract duties.
Obligor
The party obligated to do
something.
CHAPTER 15 Third Parties 341
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WHAT RIGHTS ARE ASSIGNABLE?
Most contract rights are assignable, but not all. Disputes sometimes arise between the two
contracting parties about whether one of the parties could legally assign her rights to a third
party. Any contractual right may be assigned unless assignment
(a) would substantially change the obligor’s rights or duties under the contract;
(b) is forbidden by law or public policy; or
(c) is validly precluded by the contract itself.2
Substantial Change An assignment is prohibited if it would substantially change the
obligor’s situation. For example, Bruno is permitted to assign to Doug his rights to payment
from Lydia because it makes no difference to Lydia whether she writes a check to one person
or another. But suppose that, before delivery, Lydia had wanted to assign her rights to the
shipment of 500 bottles of champagne to a business in another country. In this example, Bruno
would be the obligor, and his duties would substantially change. Shipping heavy items over
long distances adds substantial costs, so Lydia would not be able to make the assignment.
Assignment is also prohibited when the obligor is agreeing to perform personal services.
The close working relationship in such agreements makes it unfair to expect the obligor to
work with a stranger. Warner, a feature film director, hires Mayer to be his assistant on a film
Bruno
(Assignor)
Doug
(Assignee)
Lydia
(Obligor)
Has a
Previous
Debt of
$8,000
Assigns All Rights
to the Contract
The Parties Make a Contract:
Agrees to Sell
Champagne
Agrees to Pay
$10,000 for
Champagne
Delivers Champagne
Makes Payment of $10,000
s 1 At4
3
s Make
2
5
y
5
EXHIB IT 15.1 The Anatomy of an Assignment
2Restatement (Second) of Contracts §317(2). And note that UCC §2-210 is, for our purposes, nearly
identical.
©
C
en
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342 U N I T 2 Contracts
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to be shot over the next 10 weeks. Warner may not assign his right to Mayer’s work to another
director.
Public Policy Some assignments are prohibited by public policy. For example, someone
who has suffered a personal injury may not assign her claim to a third person. Vladimir is
playing the piano on his roof deck when the instrument rolls over the balustrade and drops 35
stories before smashing Wanda’s foot. Wanda has a valid tort claim against Vladimir, but she
may not assign the claim to anyone else. As a matter of public policy, all states have decided
that the sale of personal injury claims could create an unseemly and unethical marketplace.
Contract Prohibition Finally, one of the contracting parties may try to prohibit assign-
ment in the agreement itself. For example, most landlords include in the written lease a clause
prohibiting the tenant from assigning the tenancy without the landlord’s written permission.
Subleasing disputes between landlord and tenant are common. How much leeway
does a landlord have in rejecting a proposed assignment? The following case provides the
answer.
TENET HEALTHSYSTEM SURGICAL, L.L.C. V.
JEFFERSON PARISH HOSPITAL SERVICE DISTRICT NO. 1
426 F.3d 738
Fifth Circuit Court of Appeals, 2005
C A S E S U M M A R Y
Facts: MSC, Inc., owned the Marrero Shopping Center,
and leased space to Tenet HealthSystem for use in out-
patient surgery and general medical practice. The lease
allowed Tenet to assign the lease with the consent of the
lessor and stated that consent would not be unreasonably
withheld.
Two years later, Marrero sold the shopping center to
West Jefferson Medical Center, which owned an adjacent
hospital and wanted the space for expansion. A few months
after that, Tenet went out of business and requested
permission fromWest Jefferson to assign its lease to Pelican
Medical, which intended to use the space for an occupa-
tional medicine clinic. Pelican’s clinic would offer
workmen’s compensation-related medical services, includ-
ing physical examinations, drug and alcohol testing, and
minor surgical procedures. West Jefferson denied permis-
sion, stating that Pelican would be performing work not
permitted under the original lease, and also because Pelican
would compete with West Jefferson.
Tenet sued, claiming that West Jefferson was unrea-
sonably withholding permission to assign. The trial court
granted summary judgment for West Jefferson. Tenet
appealed.
Issue: Did West Jefferson unreasonably withhold permission
to assign the lease?
Decision: Yes, West Jefferson withheld consent for an
improper reason. Reversed and remanded.
Reasoning: Tenet, the tenant, used the office space for
nothing more than minor surgery. Pelican proposed to offer
many medical services in the space, but none were unusual.
West Jefferson objected primarily because it did not want to
lose patients to Pelican.This is a reasonable economic concern,
but nonetheless it is not a factor that a landlordmay consider in
approving a lease assignment. In this situation, a landlordmust
make an objective assessment that is not related to its own
personal circumstances. Thus, it may consider only whether
the new tenant is financially responsible, will adequatelymain-
tain the property, andwill use the premises for a legal business.
Tenet’s lease allowed for “general medical and phy-
sician’s offices.” Pelican did not propose to provide any
services not covered by that definition. There was no
indication that Pelican would miss lease payments or
damage the property. West Jefferson may have acted as
a reasonable business in defending its own interests, but it
acted wrongfully in its role as landlord.
CHAPTER 15 Third Parties 343
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HOW RIGHTS ARE ASSIGNED
Writing In general, an assignment may be written or oral, and no particular formalities
are required. However, when someone wants to assign rights governed by the Statute of
Frauds, she must do it in writing. Suppose City contracts with Seller to buy Seller’s land and
then brings in Investor to complete the project. If City wants to assign to Investor its rights
to the land, it must do so in writing.
Consideration An assignment can be valid with or without consideration, but the lack
of consideration may have consequences. Two examples should clarify this. Recall Bruno,
who sells champagne to Lydia and then assigns to Doug his right to payment. In that case,
there is consideration for the assignment. Bruno assigns his rights only because Doug
cancels the old debt, and his agreement to do that is valid consideration. An assignment
for consideration is irrevocable. Once the two men agree, Bruno may not telephone Doug
and say, “I’ve changed my mind, I want Lydia to pay me after all.” Lydia’s $10,000 now
belongs to Doug.
But suppose that Bruno assigns his contract rights to his sister Brunhilde as a
birthday present. This is a gratuitous assignment; that is, one made as a gift, for no
consideration. A gratuitous assignment is generally revocable if it is oral and generally
irrevocable if it is written. If Bruno verbally assigns his rights to Brunhilde, but then
changes his mind, telephones Lydia, and says, “I want you to pay me after all,” that
revocation is effective, and Brunhilde gets nothing. But if Bruno puts his assignment in
writing and Brunhilde receives it, Bruno has given up his right to receive Lydia’s
payment.
Notice to Obligor The assignment is valid from the moment it is made, regardless of
whether the assignor notifies the obligor. But an assignor with common sense will immedi-
ately inform the obligor of the assignment. Suppose Maude has a contract with Nelson, who
is obligated to deliver 700 live frogs to her shop. If Maude (assignor) assigns her rights to
Obie (assignee), Maude should notify Nelson (obligor) the same day. If she fails to inform
Nelson, he may deliver the frogs to Maude. Nelson will have no further obligations under
the contract, and Maude will owe Obie 700 frogs.
RIGHTS OF THE PARTIES AFTER ASSIGNMENT
Once the assignment is made and the obligor notified, the assignee may enforce her
contractual rights against the obligor. If Lydia fails to pay Doug for the champagne she
gets from Bruno, Doug may sue to enforce the agreement. The law will treat Doug as
though he had entered into the contract with Lydia.
But if a lawsuit arises, the reverse is also true. The obligor may generally raise all
defenses against the assignee that she could have raised against the assignor. Suppose Lydia
opens the first bottle of champagne—silently. “Where’s the pop?” she wonders. There is no
pop because all 500 bottles have gone flat. Bruno has failed to perform his part of the
contract, and Lydia may use Bruno’s nonperformance as a defense against Doug. If the
champagne was indeed worthless, Lydia owes Doug nothing.
Assignor’s Warranty The law implies certain warranties, or assurances, on the part of
the assignor. Unless the parties expressly agree to exclude them, the assignor warrants that
(1) the rights he is assigning actually do exist, and (2) there are no defenses to the rights
other than those that would be obvious, like nonperformance. But the assignor does not
warrant that the obligor is solvent. Bruno is impliedly warranting to Doug that Lydia has no
defenses to the contract, but he is not guaranteeing Doug that she has the money to pay, or
that she will pay.
Gratuitous assignment
An assignment made as a gift,
for no consideration.
344 U N I T 2 Contracts
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SPECIAL ISSUE: THE UNIFORM COMMERCIAL CODE
AND ASSIGNMENTS OF SECURITY INTERESTS
The provisions of the Uniform Commercial Code (UCC) regarding assignments in contracts
for the sale of goods are very similar to common law rules.3 However, Article 9 of the Code
has special rules about the assignment of security interests, which are the legal rights in
personal property that assure payment. When an automobile dealer sells you a new car on
credit, the dealer will keep a security interest in your car. If you do not make your monthly
payments, the dealer retains a right to repossess the vehicle. That authority is called a
security interest. (See Chapter 23 for a full discussion.)
Companies that sell goods often prefer to assign their security interests to some other
firm, such as a bank or finance company. The bank is the assignee. Just as we saw with
the common law, the assignee of a security interest generally has all of the rights that the
assignor had. And the obligor (the buyer) may also raise all of the defenses against
the assignee that she could have raised against the assignor.
Under UCC §9-404, the obligor on a sales contract may generally assert any defenses
against the assignee that arise from the contract, and any other defenses that arose before
notice of assignment. The Code’s reference to any defenses that arise from the contract
means that if the assignor breached his part of the deal, the obligor may raise that as a
defense. Suppose a dealer sells you a new Porsche on credit, retaining a security interest. He
assigns the security interest to the bank. The car is great for the first few weeks, but then
the roof slides onto the street and both doors fall off. You refuse to make any more monthly
payments. When the bank sues you, you may raise the automobile’s defects as a defense,
just as you could have raised them against the dealer itself. Where the Code talks about
other defenses that arose before notice of assignment, it refers, for example, to fraud.
Suppose the dealer knew that before you bought the Porsche, it had been smashed up
and rebuilt. If the dealer told you it was fresh from the factory, that would be fraud, and you
could raise the defense against the bank.
A contract may prohibit an obligor from raising certain defenses against an assignee.
Sometimes a seller of goods will require the buyer to sign a contract that permits the
seller to assign and prohibits the buyer from raising defenses against the assignee that he
could have raised against the seller. University wants to buy a computer system on credit
from Leland for $85,000. Leland agrees to the deal but insists that the contract permit
him to assign his rights to anyone he chooses. He also wants this clause: “University
agrees that it will not raise against an assignee any defenses that it may have had against
Leland.” This clause is sometimes called a waiver clause because the obligor is waiving
(giving up) rights. Courts may also refer to it as an exclusion clause since the parties are
excluding potential defenses. Leland wants a waiver clause because it makes his con-
tract more valuable. As soon as University signs the agreement, Leland can take his
contract to Krushem Collections, a finance company. Krushem might offer Leland
$70,000 cash for the contract. Leland can argue, “You have to pay $85,000 for this.
You are guaranteed payment by University since they cannot raise any defenses against
you, even if the computer system collapses in the first half-hour.” Leland gets cash and
need not worry about collecting payments. Krushem receives the full value of the
contract, with interest, spread out over several years.
Under UCC §9-403, an agreement by a buyer (or lessee) that he will not assert against an
assignee any claim or defense that he may have against the seller (or lessor) is generally enforce-
able by the assignee if he took the assignment in good faith, for value, without notice of the
potential defenses. In other words, Leland’s waiver clause with University is enforceable. If
Leland assigns the contract to KrushemCollections and the system proves worthless, Krushem
3UCC §2-210.
Security interests
Rights in personal property that
assure payment or the
performance of some
obligation.
CHAPTER 15 Third Parties 345
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is still entitled to its monthly payments from University. The school must seek its damages
against Leland—a far more arduous step than simply withholding payment.
These waiver clauses are generally not valid in consumer contracts. If Leland sold a
computer system to a consumer (an individual purchasing it for her personal use), the waiver
would generally be unenforceable.
In the following case, one side pushes the waiver rule to its extreme. Can an assignee
recover for money advanced … when the money was never advanced? You be the judge.
You Be the Judge
Facts: Michael Brooks
desperately needed finan-
cing for his company,
BrooksAmerica, so he
agreed to a sale-leaseback
agreement with Terminal
Marketing Company. Ter-
minal would pay Brooks-
America $250,000, and in
exchange it would obtain
title to BrooksAmerica’s
computers and office equipment. BrooksAmerica would then
lease theequipment for threeyears, for $353,000.Theequipment
would never leave BrooksAmerica’s offices.
The contract included a “hell or high water clause”
stating that BrooksAmerica’s obligation to pay was “abso-
lute and unconditional.” Another clause permitted Term-
inal to assign its rights without notice to BrooksAmerica
and stated that the assignee took its rights “free from all
defenses, setoffs, or counterclaims.”
Brooks also signed a “Delivery and Acceptance Certifi-
cate” stating that BrooksAmerica had received the $250,000
(even though no money had yet changed hands) and reaf-
firming BrooksAmerica’s absolute obligation to pay an
assignee, despite any defenses BrooksAmerica might have.
Terminal assigned its rights to Wells Fargo, which had
taken about 2,000 other equipment leases from Terminal.
Terminal never paid any portion of the promised $250,000.
Brooks refused to make the required payments (about
$10,000 per month) and Wells Fargo sued. Brooks acknowl-
edged that Wells Fargo paid Terminal for the assignment.
Both parties moved for summary judgment. The
trial court ruled in favor of Wells Fargo, and Brooks appealed.
You Be the Judge: Is Wells Fargo entitled to its monthly
lease payments despite the fact that BrooksAmerica never
received financing?
Argument for BrooksAmerica: We acknowledge the
general validity of UCC §9-403. However, in this case,
Wells Fargo makes an
absurd argument. Neither
Terminal nor any assignee
has a right to enforce a
financing contract when
Terminal failed to deliver
the financing. There is no
valid contract to enforce
here because Terminal
never paid the $250,000
owed to BrooksAmerica.
“Good faith” required Wells Fargo to make sure that
Terminal had performed. A simple inquiry would have
informed Wells Fargo that Terminal was entitled to no
money. This entire transaction is a sham, and §9-403 was
never drafted to encourage financial swindles.
The trial court penalized BrooksAmerica for acting in
good faith. Mr. Brooks signed the Delivery Certificate
assuming that any reasonable company would promptly
deliver the money it had promised. Unfortunately, Term-
inal does not operate at the same ethical level—a fact that
Wells Fargo should know from its earlier assignments.
Argument for Wells Fargo: Under UCC §9-403, an
assignee such as Wells Fargo may enforce a waiver of
defenses clause if the assignment was taken in good faith,
for value, and free of knowledge of any claims or defenses.
Wells Fargo meets that test.
The“simple inquiry” argumenthas two flaws.First, §9-403
does not require one. The UCC requires good faith, not an
investigation. Second, Wells Fargo did investigate by checking
the contract and the Delivery Certificate. We have done more
than required.Wehave taken thousands of equipment leases as
assignees. In this case, we examined the contract and theDeliv-
ery Certificate, and assumed that BrooksAmerica had received
its money. If Terminal had not paid, why didMr. Brooks sign a
certificate stating he had received his cash? We are entitled to
payment.AnydisputebetweenBrooksAmerica andTerminal is
for those parties to resolve.
WELLS FARGO BANK
MINNESOTA V.
BROOKSAMERICA MORTGAGE
CORPORATION
419 F.3d 107
Second Circuit Court of Appeals, 2005
346 U N I T 2 Contracts
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15-2b Delegation of Duties
Garret has always dreamed of racing stock cars. He borrows $250,000 from his sister,
Maybelle, in order to buy a car and begin racing. He signs a promissory note, which is
a document guaranteeing that he will repay Maybelle the full amount, plus interest, on a
monthly basis over 10 years. Regrettably, during his first race, Garret discovers that he has
a speed phobia and quits the business. Garret transfers the car and all of his equipment to
Brady, who agrees in writing to pay all money owed to Maybelle. Brady sends a check for a
few months, but then the payments stop. Maybelle sues Garret, who defends based on the
transfer to Brady. Will his defense work?
Garret has assigned his rights in the car and business to Brady, and that is entirely legal.
But more important, he has delegated his duties to Brady. Garret was the delegator and Brady
was the delegatee. In other words, the promissory note he signed was a contract, and the
agreement imposed certain duties on Garret, primarily the obligation to pay Maybelle
$250,000 plus interest. Garret had a right to delegate his duties to Brady, but delegating
those duties did not relieve Garret of his own obligation to perform them. When Maybelle
sues, she will win. Garret, like many debtors, would have preferred to wash his hands of his
debt, but the law is not so obliging.
Most duties are delegable. But delegation does not by itself relieve the delegator of his
own liability to perform the contract.
Garret’s delegation to Brady was typical in that it included an assignment at the same
time. If he had merely transferred ownership, that would have been only an assignment. If
he had convinced Brady to pay off the loan without getting the car, that would have been
merely a delegation. He did both at once. See Exhibit 15.2.
1
Assigns
Rights
to the
Business
Delegates
Duty to
Repay
the Loan
The Parties Make a Contract:
Promises to
Repay the
$250,000 Loan
In Full, with
Interest
Loans
$250,000
Remains Obligated to Repay the Loan
Becomes Obligated to Repay the Loan
Garret
(Obligor)
(Assignor)
(Delegator)
Maybelle
(Obligee)
Brady
(Assignee)
(Delegatee)
s
2
D
D
R
t
3
4
ated to R
5
4
©
C
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EXHIB IT 15.2 The Anatomy of a Delegation
CHAPTER 15 Third Parties 347
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WHAT DUTIES ARE DELEGABLE?
The rules concerning what duties may be delegated mirror those about the assignment of rights.
And once again, the common law agrees with the UCC. An obligor may delegate his duties unless:
1. delegation would violate public policy, or
2. the original contract prohibits delegation, or
3. the obligee has a substantial interest in personal performance by the obligor.4
Public Policy Delegation may violate public policy, such as in a public works contract. If
City hires Builder to construct a subway system, state law may prohibit Builder from
delegating his duties to Beginner. The theory is that a public agency should not have to
work with parties that it never agreed to hire.
Contract Prohibition It is very common for a contract to prohibit delegation. We saw
in the “Assignment” section that courts may refuse to enforce a clause that limits one party’s
ability to assign its contract rights. That does not hold true with delegation. The parties may
forbid almost any delegation, and the courts will enforce the agreement. Hammer, a
contractor, is building a house and hires Spot as his painter, including in his contract a
clause prohibiting delegation. Just before the house is ready for painting, Spot gets a better
job elsewhere and wants to delegate his duties to Brush. Hammer may refuse the delega-
tion, even if Brush is equally qualified.
Substantial Interest in Personal Performance Suppose Hammer had omitted
the “nondelegation” clause from his contract with Spot. Could Hammer still refuse the
delegation on the grounds that he has a substantial interest in having Spot do the work? No.
Most duties are delegable, so long as they do not violate public policy or a clause in a
contract. There is nothing so special about painting a house that one particular painter is
required to do it. But some kinds of work do require personal performance, and obligors may
not delegate these tasks. The services of lawyers, doctors, dentists, artists, and performers
are considered too personal to be delegated. There is no single test that will perfectly define
this group, but generally when the work will test the character, skill, discretion, and good faith
of the obligor, she may not delegate her job.
EXAM Strategy
Question: Parker is a well-known actress. She agrees to act in Will’s play for four
weeks, for $30,000 per week. A week before rehearsals are to begin, Parker notifies
Will that she cannot appear because a film producer has offered her over $1 million to
start shooting immediately. She has arranged for Claire, another well-known actress,
to appear in her place. Will objects. Parker claims, correctly, that their agreement does
not prohibit her from making this substitution. Is Parker allowed to do this?
Strategy: Parker is attempting to delegate her duties. Under the Restatement, delegation
is allowed unless (1) it would violate public policy, (2) it is prohibited by the contract, or
(3) the obligee has a substantial interest in the obligor’s personal performance.
Result: This is hardly a matter of public concern, and the contract does not speak to
the issue. However, acting is a very personal kind of work. The actor must be right for
the part, interact smoothly with other cast members, work well with the director, and
help draw the audience. Will is entitled to have Parker perform the work, and she may
not delegate her role.
4Restatement (Second) of Contracts §318. And see UCC §2-210, establishing similar limits.
348 U N I T 2 Contracts
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Improper Delegation and Repudiation Sometimes parties delegate duties they
should not. Suppose Spot, having agreed not to delegate his painting job, is so tempted by
the higher offer from another contractor that he delegates the work anyway. Hammer informs
Spot he will not allow Brush on the job site. If Spot still refuses to work, he has repudiated the
agreement; in other words, he has formally notified the other side that he will not perform his
side of the contract. Hammer will probably sue him. On the other hand, if Hammer allows
Brush up the ladder and Brush completes the job, Hammer has no claim against anybody.
NOVATION
As we have seen, a delegator does not automatically get rid of his duties merely by
delegating them. But there is one way a delegator can do so. A novation is a three-way
agreement in which the obligor transfers all rights and duties to a third party. The obligee
agrees to look only to that third party for performance.
Recall Garret, the forlorn race car driver. When he wanted to get out of his obligations to
Maybelle, he should have proposed a novation. Were one created, he would assign all rights
and delegate all duties to Brady, andMaybelle would agree that only Bradywas obligated by the
promissory note, releasing Garret from his responsibility to repay. Why would Maybelle do
this? She might conclude that Brady was a better bet than Garret and that this was the best way
to get her money.Maybelle would prefer to have both people liable. But Garret might refuse to
bring Brady into the deal until Maybelle permits a novation. In the example given, Garret failed
to obtain a novation, and hence he and Brady were both liable on the promissory note.
Since a novation has the critical effect of releasing the obligor from liability, you will not
be surprised to learn that two parties to a contract sometimes fight over whether some event
was a simple delegation of duties or a novation. Here is one such contest.
It appears that Mary Pratt, moving to Arizona, honestly thought she was not only out of
the ice cream business but relieved of any debt to the Rosenbergs. This lawsuit undoubt-
edly came as a cold shock. What should she have done to avoid the dispute?
ROSENBERG V. SON, INC.
491 N.W.2d 71, 1992 N.D. LEXIS 202
Supreme Court of North Dakota, 1992
C A S E S U M M A R Y
Facts: The Rosenbergs owned a Dairy Queen in Grand
Forks, North Dakota. They agreed in writing to sell the
Dairy Queen to Mary Pratt. The contract required her
to pay $10,000 down and $52,000 over 15 years, at 10 percent
interest. Two years later, Pratt assigned her rights and
delegated her duties under the sales contract to Son, Inc.
The agreement between Pratt and Son contained a
“Consent to Assignment” clause that the Rosenbergs
signed. Pratt then moved to Arizona and had nothing further
to do with the Dairy Queen. The Rosenbergs never
received full payment for theDairy Queen. They suedMary
Pratt.
The trial court gave summary judgment for Pratt,
finding that she was no longer obligated on the original
contract. The Rosenbergs appealed.
Issue: Did Pratt obtain a novation relieving her of her
duties under the original sales contract?
Decision: No. Pratt did not obtain a novation. Reversed
and remanded.
Reasoning: One party to a contract does not escape
liability simply by delegating duties and assigning rights.
To relieve itself of all responsibility, a party must obtain a
novation, meaning an agreement from the other side that
all liability has now passed on to a third person.
It was apparent from the language of this agree-
ment that the parties intended only an assignment,
not a novation. The document made no mention of
discharging Pratt from her duties. In fact, the agreement
included a clause in which Son indemnified Pratt; the
Novation
A three-way agreement in
which the obligor transfers all
rights and duties to a third
party.
CHAPTER 15 Third Parties 349
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Chapter Conclusion
A moment’s caution! It is important to remember that the parties to a contract may not have
the right to substitute someone else into the contract. The parties to a contract always have
legal rights themselves, but when outsiders enter the picture, subtle differences in key areas
determine whether additional rights exist.
EXAM REVIEW
1. THIRD PARTY BENEFICIARY A third party beneficiary is an intended
beneficiary and may enforce a contract if the parties intended her to benefit from the
agreement and if either (1) enforcing the promise will satisfy a debt of the promisee
to the beneficiary, or (2) the promisee intended to make a gift to the beneficiary. The
intended beneficiary described in (1) is a creditor beneficiary, while (2) describes a
donee beneficiary. Any beneficiary who meets neither description is an incidental
beneficiary and has no right to enforce the contract. (pp. 338–340)
2. ASSIGNMENT AND DELEGATION An assignment transfers the assignor’s
contract rights to the assignee. A delegation transfers the delegator’s duties to the
delegatee. (pp. 341–350)
3. RIGHTS ASSIGNABLE A party generally may assign contract rights unless
doing so would substantially change the obligor’s rights or duties, is forbidden by law,
or is validly precluded by the contract. (pp. 342–344)
Question: Angelo Zavarella and Yvette Rodrigues were injured in an automobile
accident allegedly caused by a vehicle belonging to Truck Equipment of Boston.
Travelers Insurance Co. paid insurance benefits to Zavarella and Rodrigues, who then
assigned to Travelers their claims against Truck Equipment. Travelers sued Truck
Equipment, which moved to dismiss. What is Truck Equipment’s claim that the case
should be dismissed, and how would you rule?
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only reason for such a provision was that Pratt remained
liable to the Rosenbergs.
The assignment did not become a novation merely
because Rosenberg signed it. A creditor may permit
assignment without releasing the original obligor. That is
what happened here, and Pratt remained liable to the
Rosenbergs.
350 U N I T 2 Contracts
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Strategy: Travelers is claiming to be the assignee of the plaintiffs’ claims. Any
contractual right may be assigned except in the three instances listed above. Does
one of those prohibitions apply? (See the “Result” at the end of this section.)
4. ENFORCEMENT Once the assignment is made and the obligor notified, the
assignee may enforce her contractual rights against the obligor. The obligor, in turn,
may generally raise all defenses against the assignee that she could have raised against
the assignor. (p. 344)
5. THE UCC AND SECURITY INTERESTS Article 9 of the UCC governs security
interests, which are the legal rights to personal property that assure payment of a debt.
Under Article 9, obligors may assert defenses against assignees that arise from contracts,
and agreements not to enforce such defenses are generally valid. (pp. 345–346)
6. DUTIES DELEGABLE Duties are delegable unless delegation would violate
public policy, the contract prohibits delegation, or the obligee has a substantial
interest in personal performance by the obligor. (pp. 347–350)
Question: Pizza of Gaithersburg, Maryland, owned five pizza shops. Pizza
arranged with Virginia Coffee Service to install soft drink machines in each of its
stores and maintain them. The contract made no mention of the rights of either
party to delegate. Virginia Coffee delegated its duties to the Macke Co., leading to
litigation between Pizza and Macke. Pizza claimed that Virginia Coffee was barred
from delegating because Pizza had a close working relationship with the president
of Virginia Coffee, who personally kept the machines in working order. Was the
delegation legal?
Strategy: Any contractual duty may be delegated except in the three instances listed
above.Does one of thoseprohibitions apply? (See the “Result” at the endof this section.)
7. DISCHARGE Unless the obligee agrees otherwise, delegation does not discharge
the delegator’s duty to perform. (p. 347)
8. NOVATION A novation is a three-way agreement in which the obligor delegates all
duties to the delegatee and the obligee agrees to hold only the delegatee responsible.
(pp. 349–350)
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CHAPTER 15 Third Parties 351
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Question: Mardy, a general contractor, is building a house. He contracts with
Plumbco to do all plumbing work for $120,000. Before Plumbco begins the work,
it notifies Mardy in writing that Leo will be doing the work instead. Mardy does
not respond. When Leo fails to perform, Mardy sues Plumbco. Plumbco is
(a) Liable
(b) Liable only if Plumbco agreed to remain responsible for the job
(c) Not liable because Mardy failed to repudiate the delegation
(d) Not liable because Plumbco validly delegated its duties
(e) Not liable because the parties entered into a novation
Strategy: Delegation does not by itself relieve the delegator of his own liability
to perform the contract. In a novation, the obligee agrees to look only to the third
party for performance. Was this a delegation or a novation? (See the “Result” at
the end of this section.)
3. Result: Truck Equipment’s winning argument was one sentence long: Claims
for personal injury may not be assigned. Such assignments would transform acci-
dent claims into commercial commodities and encourage assignees to exaggerate
the gravity of the harm.
6. Result: There is no public policy issue involved. The contract is silent as to
delegation. And Pizza’s only legitimate interest was in seeing that installation and
maintenance were adequate. There is no reason to believe that Virginia Coffee
would perform the work better than others. The duty was delegable, and Virginia
Coffee wins.
8. Result: When Plumbco announced that Leo would do the work, Mardy did not
respond. Mardy certainly did not agree to look exclusively to Leo for performance.
There has not been a novation, and Plumbco remains liable on the contract. The
correct answer is (a).
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Yost contracted with Egan for Yost to buy certain real property. If
the contract is otherwise silent, Yost’s rights under the contract are:
(a) Assignable only with Egan’s consent
(b) Nonassignable because they are personal to Yost
(c) Nonassignable as a matter of law
(d) Generally assignable
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352 U N I T 2 Contracts
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2. CPA QUESTION One of the criteria for a valid assignment of a sales contract to a
third party is that the assignment must:
(a) Not materially increase the other party’s risk or duty
(b) Not be revocable by the assignor
(c) Be supported by adequate consideration from the assignee
(d) Be in writing and signed by the assignor
3. Amanda agrees to pay Jennifer $300 for a pair of tickets to see Jerry Seinfeld.
“Seinfeld is my boyfriend Octavio’s favorite comedian, and the tickets will be a great
birthday present for him,” she tells Jennifer. Amanda pays up and tells a delighted
Octavio about the tickets, but Jennifer never delivers them. Octavio is a(n)
beneficiary of the agreement, and as such, he have a right to
enforce the contract himself.
(a) donee; does
(b) donee; does not
(c) incidental; does
(d) incidental; does not
4. A novation completely releases an from any further liability. To be
effective, it require the agreement of both the obligor and obligee.
(a) obligor; does
(b) obligor; does not
(c) obligee; does
(d) obligee; does not
5. Will misses three straight payments on his SUV, and his bank repossesses it. The right
to repossess a security interest. Security interests are governed by
Article of the Uniform Commercial Code.
(a) is; 2
(b) is; 9
(c) is not; 2
(d) is not; 9
ESSAY QUESTIONS
1. Intercontinental Metals Corp. (IMC) contracted with the accounting firm of Cherry,
Bekaert, & Holland to perform an audit. Cherry issued its opinion about IMC, giving
all copies of its report directly to the company. IMC later permitted Dun & Bradstreet
to examine the statements, and Raritan River Steel Co. saw a report published by
Dun & Bradstreet. Relying on the audit, Raritan sold IMC $2.2 million worth of steel
on credit, but IMC promptly went bankrupt. Raritan sued Cherry, claiming that IMC
was not as sound as Cherry had reported and that the accounting firm had breached its
contract with IMC. Comment on Raritan’s suit.
CHAPTER 15 Third Parties 353
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2. Woodson Walker and Associates leased computer equipment from Park Ryan
Leasing. The lease said nothing about assignment. Park Ryan then assigned the lease
to TCB as security for a loan. Park Ryan defaulted on its loan, and Walker failed to
make several payments on the lease. TCB sued Walker for the lease payments. Was
the assignment valid, given the fact that the original lease made no mention of it? If
the assignment was valid, may Walker raise defenses against TCB that it could have
raised against Park Ryan?
3. C. Gaston Whiddon owned Gaston’s LP Gas Co., Inc. Curtis Dufour purchased the
company. Since Whiddon had personally operated the company for many years,
Dufour was worried about competition from him and insisted on a noncompetition
clause in the sales contract. The clause stated that Whiddon would not “compete with
Gaston’s LP Gas Co. anywhere south of Interstate Highway 20 for nine years.” Three
years later, the Herring Gas Co. offered to buy all of Dufour’s gas business, assuming
that Whiddon would not be a competitor for six more years. Dufour sold all of the
assets to Herring, keeping the actual corporation “Gaston’s LP Gas Co.” for himself.
What mistake in drafting have Dufour and Herring made?
4. YOU BE THE JUDGE WRITING PROBLEM David Ricupero suspected his
wife Polly of having an affair, so he taped her phone conversations and, based on what
he heard, sued for divorce. David’s lawyer, William Wuliger, had the recorded
conversations transcribed for use at trial. The parties settled the divorce out of court
and signed an agreement that included this clause:
Except as herein otherwise provided, each party hereto completely and forever releases the
other and his attorneys from any and all rights each has or may have … to any property,
privileges, or benefits accruing to either by virtue of their marriage, or conferred by the
Statutory or Common Law of Ohio or the United States of America.
After the divorce was final, Polly sued William Wuliger for invasion of privacy and
violation of federal wiretapping law. Wuliger moved to dismiss the case based on the
clause quoted. Polly argued that Wuliger was not a party to the divorce settlement and
had no right to enforce it. May Wuliger enforce the waiver clause from the Ricuperos’
divorce settlement? Argument for Wuliger: The contract language demonstrates that
the parties intended to release one another and their attorneys from any claims. That
makes Wuliger an intended third party beneficiary, and he is entitled to enforce the
agreement. If Polly did not want to release Wuliger from such claims, she was free not
to sign the agreement. Argument for Polly Ricupero: A divorce agreement settles the
affairs between the couple. That is all it is ever intended to do, and the parties here
never intended to benefit a lawyer. Wuliger is only an incidental beneficiary and
cannot use this contract to paper over his violation of federal wiretapping law.
5. Judith and John Brooks hired Wayne Hayes to build a house. The contract required
Hayes to “provide all necessary labor and materials and perform all work of every
nature whatsoever to be done in the erection of the residence.” Hayes hired
subcontractors to do all of the work. One of Hayes’s employees checked on the work
site daily, but neither Hayes nor any of his employees actively supervised the
building. The Brookses were aware of this working arrangement and consented to it.
The mason negligently installed the fireplace, ultimately leading to a serious fire. The
Brookses sued Hayes for breach of contract. Hayes contended that when the Brookses
approved of his hiring of subcontractors to do all work, that created a novation
relieving him of any liability. Discuss.
354 U N I T 2 Contracts
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DISCUSSION QUESTIONS
1. A century and a half ago, an English judge stated: “All
painters do not paint portraits like Sir Joshua
Reynolds, nor landscapes like Claude Lorraine, nor
do all writers write dramas like Shakespeare or fiction
like Dickens. Rare genius and extraordinary skill are
not transferable.” What legal doctrine is the judge
describing? What is the ethical basis of this rule?
2. Nationwide Discount Furniture hired Rampart
Security to install an alarm in its warehouse. A fire
would set off an alarm in Rampart’s office, and the
security company was then supposed to notify
Nationwide immediately. A fire did break out, but
Rampart allegedly failed to notify Nationwide,
causing the fire to spread next door and damage a
building owned by Gasket Materials Corp.
Gasket sued Rampart for breach of contract, and
Rampart moved for summary judgment. Comment.
3. If a person promises to give you a gift, there
is usually no consideration. The person can change
his mind and decide not to give you the present,
and there is nothing you can do about it. But if a
person makes a contract with someone else and
intends that you will receive a gift under the
agreement, you are a donee beneficiary and you do
have rights to enforce the deal. Are these rules
unacceptably inconsistent? If so, which rule should
change?
4. Imagine that you hire your trusted friend, Fran, to
paint your house, and that you do not include a
nondelegation clause in the agreement. Fran delegates
the job to Sam, who is a stranger to you. The
delegation is legal, but should it be? Is it reasonable
that you must accept the substitute painter?
5. In our society, a person can buy and sell almost
anything. But as this chapter describes, you cannot
sell personal injury claims. Should you be able to?
Imagine that you are injured in a car wreck. You
are told that you might win $100,000 in a lawsuit
eventually, but that you might not receive
payment for years, and you might also lose the case
and recover nothing. If someone is willing to pay
you $20,000 cash-on-the-barrelhead today for the
rights to your claim, is it fair that public policy
concerns prohibit you from taking the money?
CHAPTER 15 Third Parties 355
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CHAPTER16
PERFORMANCE
AND
DISCHARGE
Polly was elated. It was the grand opening of her
new restaurant, Polly’s Folly, and everything
was bubbling. The wait staff hustled, and Cae-
sar, the chef, churned out succulent dishes. Polly
had signed a contract promising him $1,500 per
week for one year, “provided Polly is personally
satisfied with his cooking.” Polly was determined that
her restaurant would be glorious. Her three-year lease
would cost $6,000 per month, and she had signed an
advertising deal with Billboard Bonanza for the same
period. Polly had also promised Eddie, a publicity agent,
a substantial monthly fee, to begin as soon as the res-
taurant was 80 percent booked for one month. Tonight,
with candles flickering at packed tables, Polly beamed.
After a week, Polly’s smiles were a bit forced. Some
of Caesar’s new dishes had been failures, including a
grilled swordfish that was hard to pierce and shrimp
jambalaya that was too spicy. The restaurant was only 60 percent full, and the publicity
agent yelled at Caesar for costing him money. Later that month, Polly disliked a veal dish
and gagged on one of Caesar’s soups. She fired her chef.
Then troubles gushed forth—literally. A water main burst in front of Polly’s restaurant,
flooding the street. The city embarked on a two-month repair job that ultimately took four
times that long. The street was closed to traffic, and no one could park within blocks of
Polly’s restaurant. Patronage dropped steadily as hungry customers refused to deal with the
bad parking and construction noise. After several months, behind on the rent and in debt to
everyone, Polly closed her doors for good.
Shortly, the court doors swung open, offering a full menu of litigation. Polly’s landlord
sued for three years’ rent, and Billboard Bonanza demanded its money for the same period.
Caesar claimed his year’s pay. Eddie, the agent, insisted on some money for his hard work.
Polly defended vigorously, seeking to be discharged from her various contracts.
Polly disliked a veal dish
and gagged on one of
Caesar’s soups. She fired
her chef.
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If a party is discharged, she is “finished,” and has no more duties under a
contract. In each lawsuit, Polly asked a court to declare that her obligations
were terminated and that she owed no money.
Most contracts are discharged by full performance. In other words, the
parties generally do what they promise. Suppose, before the restaurant
opened, Walter had promised to deliver 100 sets of cutlery to Polly and she
had promised to pay $20 per set. Walter delivered the goods on time, and
Polly paid $2,000 on delivery. The parties got what they expected, and that
contract was fully discharged.
Sometimes the parties discharge a contract by agreement. For example,
the parties may agree to rescind their contract, meaning that they terminate
it by mutual agreement.1 If Polly’s landlord believed he could get more rent
from a new tenant, he might agree to rescind her lease. But he was dubious
about the rental market and refused to rescind.
At times, a court may discharge a party who has not performed. When
things have gone amiss, a judge must interpret the contract and issues of
public policy to determine who in fairness should suffer the loss. In the
lawsuits brought by the landlord and Billboard Bonanza, Polly argued a
defense called “commercial impracticability,” claiming that she should not be
forced to rent space that was useless to her or buy advertising for a restaurant
that had closed. From Polly’s point of view, the claim was understandable. But
we can also respect the arguments made by the landlord and the advertiser,
that they did not cause the burst water main. Claims of commercial imprac-
ticability are difficult to win, and Polly lost against both of these opponents.
Though she was making no money at all from the restaurant, the court found
her liable in full for the lease and the advertising contract.2
Polly’s argument against Caesar raised another issue of discharge. Caesar
claimed that his cooking was good professional work and that all chefs have
occasional disasters, especially in a new restaurant. But Polly responded that
they had a “personal satisfaction” contract. Under such contracts, “good”
work may not suffice if it fails to please the promisee. Polly won this
argument, and Caesar recovered nothing.
As to Eddie’s suit, Polly raised a defense called “condition precedent,”
meaning that some event had to occur before she was obligated to pay. Polly
claimed that she owed Eddie money only if and when the restaurant was
1The parties could also decide that one party’s duties will be performed by someone else, a
modification called a novation. Alternatively, they could create an accord and satisfaction, in which
they agree that one party will substitute a new kind of performance in place of his contract obligations.
See Chapter 15, on third parties, and Chapter 11, on consideration.
2Based on Luminous Neon v. Parscale, 17 Kan. App. 2d 241, 836 P.2d 1201, 1992 Kan. App. LEXIS 572
(Kan. Ct. App. 1992).
Discharged
A party is discharged when she
has no more duties under the
contract.
Rescind
To terminate a contract by
mutual agreement.
CHAPTER 16 Performance and Discharge 357
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80 percent full for a month, and that had never happened. The court agreed and
discharged Polly on Eddie’s claim.
We will analyze each of these issues, and begin with a look at conditions.
16-1 CONDITIONS
Parties often put conditions in a contract. A condition is an event that must occur before a
party becomes obligated under a contract. “I’ll agree to do something, but only if something
else happens first.” Polly agreed to pay Eddie, the agent, a percentage of her profits, but
with an important condition: 80 percent of the tables had to be booked for a month. Unless
and until those tables were occupied, Polly owed Eddie nothing. That never happened, or,
in contract language, the condition failed, and so Polly was discharged.
Conditions can take many forms. Alex would like to buy Kevin’s empty lot and build a
movie theater on it, but the city’s zoning law will not permit that kind of business in that
location. Alex signs a contract to buy Kevin’s empty lot in 120 days, provided that within 100
days, the city re-zones the area to permit a movie theater. If the city fails to re-zone the area
by day 100, Alex is discharged and need not complete the deal.
Another example: Friendly Insurance issues a policy covering Vivian’s house, promising to
pay for any loss due to fire, but only if Vivian furnishes proof of her losses within 60 days of the
damage. If the house burns down, Friendly becomes liable to pay. But if Vivian arrives with her
proof 70 days after the fire, she collects nothing. Friendly, though it briefly had a duty to pay,
was discharged when Vivian failed to furnish the necessary information on time.
16-1a How Conditions Are Created
EXPRESS CONDITIONS
The parties may expressly state a condition. Alex’s contract with Kevin expressly discharged all
obligations if the city failed to re-zone within the stated period. Notice that no special language
is necessary to create the condition. Phrases such as “provided that” frequently indicate a
condition, but neither those nor any other specific words are essential. So long as the contract’s
language indicates that the parties intended to create a condition, a court will enforce it.
Because informal language can create a condition, the parties may dispute whether they
intended one or not. Sand Creek Country Club, in Indiana, was eager to expand its clubhouse
facilities and awarded the design work to CSO Architects. The club wanted the work done
quickly but had not secured financing. The architects sent a letter confirming their agreement:
It was our intent to allow Mr. Dan Moriarty of our office to start work on your project as early as
possible in order to allow you to meet the goals that you have set for next fall. Also, it was the
intent of CSO to begin work on your project and delay any billings to you until your financing is
in place. As I explained to you earlier, we will continue on this course until we reach a point
where we can no longer continue without receiving some payment.
The club gave CSO the go-ahead to begin design work, and the architects did their work
and billed Sand Creek for $33,000. But the club, unable to obtain financing, refused to pay.
Sand Creek claimed that CSO’s letter created a condition in their agreement; namely, that the
club would have to pay only if and when it obtained financing. The court was unpersuaded
and ruled that the parties had never intended to create an express condition. The architects
were merely delaying their billing as a convenience to the club. It would be absurd, said the
court, to assume that CSO intended to perform $33,000 worth of work for free.3
3Sand Creek Country Club, Ltd. v. CSO Architects, Inc., 582 N.E.2d 872, 1991 Ind. App. LEXIS 2151 (Ind.
Ct. App. 1991).
Condition
An event that must occur
before a party becomes
obligated under a contract.
358 U N I T 2 Contracts
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Professional sports contracts are often full of conditions. Assume that the San Francisco
Giants want to sign Tony Fleet to play center field. The club considers him a fine defensive
player but a dubious offensive performer. The many conditional clauses in his contract reflect
hard bargaining over an athlete who may or may not become a star. The Giants guarantee Fleet
only $500,000, a very modest salary by Major League Baseball standards. If the speedy
outfielder appears in at least 120 games, his pay increases to $1 million. Winning a Gold Glove
award is worth an extra $200,000 to him. The Giants insist on a team option to re-sign Fleet for
the following season at a salary of $800,000, but if the center-fielder plays in fewer than 100
games, the team loses that right, leaving Fleet free to negotiate for higher pay with other teams.
IMPLIED CONDITIONS
At other times, the parties say nothing about a condition, but it is clear from their agreement
that they have implied one. Charlotte orally rents an apartment to Hakan for one year and
promises to fix any problems in the unit. It is an implied condition that Hakan will promptly
notify Charlotte of anything needing repair. Although the parties have not said anything
about notice, it is only common sense that Hakan must inform his landlord of defects since
she will have no other way to learn of them.
16-1b Types of Conditions
Courts divide conditional clauses into three categories: (1) condition precedent, (2) condi-
tion subsequent, and (3) concurrent conditions.4 But what they have in common is more
important than any of their differences. The key to all conditional clauses is this: If the
condition does not occur, one party will probably be discharged without having to perform
his obligations under a contract.
CONDITION PRECEDENT
In this kind of condition, an event must occur before a duty arises. Polly’s contract with Eddie
concerned a condition precedent. Polly had no obligation to pay Eddie anything unless and
until the restaurant was 80 percent full for a month. Since that never happened, she was
discharged. If the parties agreed to a condition precedent, the plaintiff has the burden to prove
that the condition happened and that the defendant was obligated to perform.
In the following case, the plaintiff claimed that it had met a condition precedent and
was entitled to a payment. Not surprisingly, the defendant had a different point of view.
AMERICAN ELECTRONIC COMPONENTS, INC.
V. AGERE SYSTEMS, INC.
2009 U.S. App. LEXIS 12763
Third Circuit Court of Appeals, 2009
C A S E S U M M A R Y
Facts: American Electronic Components, Inc. (AECI),
agreed to a three-year contract under which it would act as
a non-exclusive sales representative for Agere Systems’s
surplus equipment. The contract said in part, “AECI shall
4The Restatement (Second) of Contracts has officially abandoned the terms condition precedent and
condition subsequent. See Restatement §§224 et seq. But courts routinely use the terms, so it is difficult
to avoid the old distinctions.
CHAPTER 16 Performance and Discharge 359
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CONDITION SUBSEQUENT
This type of condition must occur after a particular duty arises. If the condition does not
occur, the duty is discharged. Vivian’s policy with Friendly Insurance contains a condition
subsequent. As soon as the fire broke out, Friendly became obligated to pay for the damage.
But if Vivian failed to produce her proof of loss on time, Friendly’s obligation ended—it was
discharged. Note that, with a condition subsequent, it is the defendant who must prove that
the condition occurred, relieving him of any obligation.
Condition Precedent and Condition Subsequent Compared
Condition
Created
Does Condition
Occur?
Duty Is Determined Result
Condition
Precedent
“Fee to be paid
when
restaurant is
filled to 80%
capacity for one
month.”
Condition DOES
occur: restaurant is
packed. Condition
DOES NOT occur:
Restaurant is empty.
Duty arises: Polly owes
Eddie his fee. Duty never
arises: Polly is
discharged.
Polly pays the
fee. Polly
pays nothing.
Condition
Created
Duty Is Determined Does Condition
Occur?
Result
Condition
Subsequent
“Vivian must
give proof of
loss within 60
days.”
Fire damages
property, and
Friendly Insurance
becomes obligated to
pay Vivian.
Condition DOES occur:
Vivian proves her losses
within 60 days.
Condition DOES NOT
occur: Vivian fails to
prove her losses within
60 days.
Friendly pays
Vivian for her
losses.
Friendly is
discharged
and owes
nothing.
receive a percentage of the sale price for each item of
equipment sold to a third party by AECI.” The contract
allowed Agere to sell its own equipment.
Agere announced that it planned to close a subsidiary
in Madrid and sell off its surplus equipment. AECI found
potential buyers for the Madrid equipment, but Agere
ultimately sold the items to a different buyer.
AECI sued, arguing that it should be paid a commis-
sion because of its effort in trying to sell the Madrid
equipment. It also argued that when Agere sold the
equipment on its own, it had interfered with AECI’s
ability to fulfill the contract’s condition precedent.
The trial court dismissed the complaint, and AECI
appealed.
Issues: Was a completed sale a condition precedent in this
agreement? Was Agere liable for interfering with AECI’s sales
efforts?
Decision: Yes, a completed sale was a condition prece-
dent for earning a sales commission and no, Agere did not
improperly interfere with AECI’s sales efforts.
Reasoning: AECI relied on two arguments to prove it
deserved a commission on the sale of the Madrid equip-
ment.
First, AECI contended that because it spent substan-
tial time and energy looking for a buyer, it was somehow
owed something. The contract did not support this argu-
ment. The contract clearly set forth when AECI was owed
a commission: when AECI consummated a sale of equip-
ment. Thus, whether or not AECI expended resources to
find a buyer for the Madrid equipment, simply does not
matter. The contract’s condition precedent was finalizing
the sale, not trying really hard to finalize it.
Second, AECI argued that Agere improperly prevented
it from fulfilling the contract’s condition precedent—
consummating the sale. A party may not escape its contrac-
tual duties by wrongfully preventing the performance of a
condition precedent. There was no evidence that Agere
engaged in subterfuge to prevent AECI from earning a
commission. Agere was free to sell its own equipment.
Agere won. It did not owe a commission to AECI on
the sale of the Madrid equipment.
©
C
en
g
ag
e
Le
ar
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in
g
360 U N I T 2 Contracts
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CONCURRENT CONDITIONS
Here, both parties have a duty to perform simultaneously.Renee agrees to sell her condominium
to Tim on July 5. Renee agrees to furnish a valid deed and clear title to the property on that
date, and Tim promises to present a cashier’s check for $200,000. The parties have agreed to
concurrent conditions. Each performance is the condition for the other’s performance. If Renee
arrives at the Registry of Deeds and can say only, “Don’t worry. I’m totally sure I own this
property,” Tim need not present his check; similarly, if Tim arrives with only an “IOU”
scribbled on the back of a candy wrapper, Renee has no duty to hand over a valid deed.
EXAM Strategy
Question: Roberto wants to buy Naomi’s house for $350,000 and is willing to make
a 20 percent down payment, which satisfies Naomi. However, he needs a $280,000
mortgage in order to complete the purchase, and he is not certain he can obtain one.
Naomi is worried that Roberto might change his mind about buying the house and
then use alleged financing problems to skip out of the deal. How can the two parties
protect themselves?
Strategy: Both parties should use conditional clauses in the sales agreement. Naomi
must force Roberto to do his best to obtain a mortgage. How? Roberto’s clause should
protect him if he cannot obtain a sufficient mortgage. How?
Result: Naomi should demand the 20 percent down payment. Further, her
conditional clause should state that Roberto forfeits the down payment unless he
demonstrates that, within two weeks, he has applied in good faith for a mortgage to at
least three banks. Roberto should insist that if he promptly and fully applies to three
banks but fails to obtain a mortgage, his down payment is refunded.
PUBLIC POLICY
At times, a court will refuse to enforce an express condition on the grounds that it is unfair
and harmful to the general public. In other words, a court might agree that the parties
created a conditional clause but conclude that permitting its enforcement would hurt
society. Did the insurance contract in the following case harm society? You be the judge.
You Be the Judge
Facts: On November 26,
a Country Life Insurance
agent went to the house
of Donald and Anna Mae
Anderson. He persuaded
the Andersons to buy a
life insurance policy and
accepted a check for $1,600. He gave the Andersons a
“conditional receipt for medical policy,” dated that day.
The form stated that the Andersons would have a valid
life insurance policy with
Country Life, effective
November 26, but only
when all conditions were
met. The most important
of these conditions was
that the Country Life
home office accepts the Andersons as medical risks. The
Andersons were pleased with the new policy and glad that
it was effective that same day.
ANDERSON V. COUNTRY LIFE
INSURANCE CO.
180 Ariz. 625, 886 P.2d 1381, 1994 Ariz. App. LEXIS
240 Arizona Court of Appeals, 1994
CHAPTER 16 Performance and Discharge 361
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16-2 PERFORMANCE
Caitlin has an architect drawup plans for amonumental newhouse, andDaniel agrees to build it
by September 1. Caitlin promises to pay $900,000 on that date. The house is ready on time, but
Caitlin has some complaints. The living room was supposed to be 18 feet high, but it is only
17 feet; the pool was to be azure, yet it is aquamarine; the maid’s room was not supposed to be
wired for cable television, but it is. Caitlin refuses to pay anything for the house. Is she justified?
Of course not, it would be absurd to give her a magnificent house for free when it has only tiny
defects. But in this easy answer lurks a danger. Technically, Daniel did breach the contract, and
yet the law allows him to recover the full contract price, or virtually all of it. Once that principle is
established, how farwill a court stretch it? Suppose the living room is only 14 feet high, or 12 feet,
or 5 feet? What if the foundation has a small crack? A vast and dangerous split? What if Daniel
finishes the house a month late? Six months late? Three years late? At some point, a court will
conclude that Daniel has so thoroughly botched the job that he deserves little or nomoney. But
where, exactly, is that point? This is a question that businesses—and judges—face often.
The more complex a contract, the more certain that at least one party will perform
imperfectly. Nearly every house ever built has at least some small defects. A delivery of a
thousand bushels of apples is sure to include a few rotten ones. A custom-designed
computer system for a huge airline is likely to have some glitches. The cases raise several
related doctrines, all concerning how well a party performed its contractual obligations.
It was not. Donald Anderson died of a heart attack a few
weeks later.CountryLife declined theAndersons asmedical
risks and refused to issue a policy. AnnaMaeAnderson sued.
Country Life pointed out that medical approval was a
condition precedent. In other words, the company argued
that the policy would be effective as of November 26, but
only if it later decided tomake the policy effective. Based on
this argument, the trial court gave summary judgment for
Country Life. Ms. Anderson appealed, claiming that the
conditional clause was a violation of public policy.
You Be the Judge: Did the conditional clause violate public
policy?
Argument for Ms. Anderson: Your honors, this policy
is a scam. This so-called “conditional receipt for medical
policy” is designed to trick customers and then steal their
money. The company leads people to believe they are
covered as of the day they write the check. But they
aren’t covered until much later, when the insurer gets
around to deciding the applicant’s medical status.
The company gets the customer’s money right away
and gives nothing in exchange. If the company, after
taking its time, decides the applicant is not medically fit,
it returns the money, having used it for weeks or even
months to earn interest. If, on the other hand, the insur-
ance company decides the applicant is a good bet, it then
issues the policy effective for weeks or months in the past,
when coverage is of no use. No one can die retroactively, your
honors. The company is being paid for a period during
which it had no risk. This is a fraud and a disgrace, and
the company should pay the benefits it owes.
Argument for Country Life: Your honors, is Country
Life supposed to issue life insurance policies without
doing a medical check? That is the road to bankruptcy
and would mean that no one could obtain this valuable
coverage. Of course we do a medical inquiry, as quickly as
possible. It’s in our interest to get the policy decided one
way or the other.
The policy clearly stated that coverage was effective
only when approved by the home office, after all inquiries were
made. The Andersons knew that as well as the agent. If
they were covered immediately, why would the company
do a medical check? Country Life resents suggestions that
this policy is a scam, when in reality it is Ms. Anderson
who is trying to profit from a tragedy that the company
had nothing to do with.
The facts of this case are unusual. Obviously, most
insureds do not die between application and acceptance.
It would be disastrous for society to rewrite every insurance
policy in this state based on one very sad fact pattern. The
contract was clear and it should be enforced as written.
362 U N I T 2 Contracts
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16-2a Strict Performance and Substantial
Performance
STRICT PERFORMANCE
When Daniel built Caitlin’s house with three minor defects, she refused to pay, arguing that
he had not strictly performed his obligations. Her assertion was correct, yet she lost anyway.
Courts dislike strict performance because it enables one party to benefit without paying and
sends the other one home empty-handed. A party is generally not required to render strict
performance unless the contract expressly demands it and such a demand is reasonable.
Caitlin’s contract never suggested that Daniel would forfeit all payment if there were minor
problems. Even if Caitlin had insisted on such a clause, few courts would have enforced it
because the requirement would be unreasonable for a project as complicated as the
construction of a $900,000 home.
There are some cases where strict performance does make sense. Marshall agrees to
deliver 500 sweaters to Leo’s store, and Leo promises to pay $20,000 cash on delivery. If Leo
has only $19,000 cash and a promissory note for $1,000, he has failed to perform, andMarshall
need not give him the sweaters. Leo’s payment represents 95 percent of what he promised,
but there is a big difference between getting the last $1,000 in cash and receiving
a promissory note for that amount.
SUBSTANTIAL PERFORMANCE
Daniel, the house builder, won his case against Caitlin because he fulfilled most of his
obligations, even though he did an imperfect job. Courts often rely on the substantial
performance doctrine, especially in cases involving services as opposed to those concerning
the sale of goods or land. In a contract for services, a party that substantially performs its
obligations will generally receive the full contract price, minus the value of any defects. Daniel
receives $900,000, the contract price, minus the value of a ceiling that is 1 foot too low, a pool
the wrong color, and so forth. It will be for the trial court to decide how much those defects are
worth. If the court decides the low ceiling is a $10,000 defect, the pool color is worth $5,000,
and the cable television wiring error is worth $500, then Daniel receives $884,500
On the other hand, a party that fails to perform substantially receives nothing on the
contract itself and will recover only the value of the work, if any. If the foundation cracks in
Caitlin’s house and the walls collapse, Daniel will not receive his $900,000. In such a case,
he collects only the market value of the work he has done, which, since the house is a pile of
rubble, is probably zero.
When is performance substantial? There is no perfect test, but courts look at these issues:
• How much benefit has the promisee received?
• If it is a construction contract, can the owner use the thing for its intended purpose?
• Can the promisee be compensated with money damages for any defects?
• Did the promisor act in good faith?
EXAM Strategy
Question: Jade owns a straight track used for drag racing. She hires Trevor to
resurface it, for $180,000, paying $90,000 down. When the project is completed, Jade
refuses to pay the balance and sues Trevor for her down payment. He counterclaims
for the $90,000 still due. At trial, Trevor proves that all of the required materials were
applied by trained workers in an expert fashion, the dimensions were perfect, and his
Strict performance
Requires one party to perform
its obligations precisely, with no
deviation from the contract
terms.
Substantially performs
Occurs when one party fulfills
enough of its contract
obligations to warrant
payment.
CHAPTER 16 Performance and Discharge 363
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profit margin very modest. The head of the national drag racing association testifies
that his group considers the strip unsafe. He noticed puddles in both asphalt lanes,
found the concrete starting pads unsafe, and believed the racing surface needed to be
ground off and reapplied. His organization refuses to sanction races at the track until
repairs are made. Who wins the suit?
Strategy: When one party has performed imperfectly, we have an issue of substantial
performance. To decide whether Trevor is entitled to his money, we apply four factors:
(1) How much benefit did Jade receive? (2) Can she use the racing strip for its intended
purpose? (3) Can Jade be compensated for defects? (4) Did Trevor act in good faith?
Result: Jade has received no benefit whatsoever. She cannot use her drag strip for
racing. Compensation will not help Jade—she needs a new strip. Trevor’s work must
be ripped up and replaced. Trevor may have acted in good faith, but he failed to
deliver what Jade bargained for. Jade wins all of the money she paid. (As we will see
in the next chapter, she may also win additional sums for her lost profits.)
16-2b Personal Satisfaction Contracts
Sujata, president of a public relations firm, hires Ben to design a huge multimedia project for
her company, involving computer software, music, and live actors, all designed to sell frozen
bologna sandwiches to supermarkets. His contract guarantees him two years’ employment,
provided all of his work “is acceptable in the sole judgment of Sujata.” Ben’s immediate
supervisor is delighted with his work and his colleagues are impressed, but Sujata is not.
Three months later, she fires him, claiming that his work is “uninspired.”Does she have the
right to do that?
This is a personal satisfaction contract, in which the promisee makes a personal,
subjective evaluation of the promisor’s performance. Employment contracts may require
personal satisfaction of the employer; agreements for the sale of goods may demand that the
buyer be personally satisfied with the product; and deals involving a credit analysis of one
party may insist that his finances be satisfactory to the other party. In resolving disputes like
Ben and Sujata’s, judges must decide: When is it fair for the promisee to claim that she is
not satisfied? May she make that decision for any reason at all, even on a whim?
A court applies a subjective standard only if assessing the work involves personal
feelings, taste, or judgment and the contract explicitly demanded personal satisfaction. A
“subjective standard” means that the promisee’s personal views will greatly influence her
judgment, even if her decision is foolish and unfair. Artistic or creative work, or highly
specialized tasks designed for a particular employer, may involve subtle issues of quality and
personal preference. Ben’s work combines several media
and revolves around his judgment. Accordingly, the law
applies a subjective standard to Sujata’s decision. Since
she concludes that his work is uninspired, she may legally
fire him, even if her decision is irrational.
Note that the promisee, Sujata, has to show two things:
that assessing Ben’s work involves her personal judgment
and that their contract explicitly demands personal satisfac-
tion. If the contract were vague on this point, Sujata would lose. Had the agreement merely
said, “Ben will at all times make his best efforts,” Sujata could not fire him.
In all other cases, a court applies an objective standard to the promisee’s decision. In
other words, the objective standard will be used if assessing the work does not involve
personal judgment or if the contract failed to explicitly demand personal satisfaction. An
objective standard means that the promisee’s judgment of the work must be reasonable.
Either the system works
or it does not.
Personal satisfaction
contract
Permits the promisee to make
a subjective evaluation of the
promisor’s performance.
364 U N I T 2 Contracts
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Suppose Sujata hires Leila to install an alarm system for her company, and the contract
requires that Sujata be “personally satisfied.” Leila’s system passes all tests, but Sujata claims,
“It just doesn’t make me feel secure. I know that someday it’s going to break down.” May
Sujata refuse to pay? No. Even though the contract used the phrase “personally satisfied,” a
mechanical alarm system does not involve personal judgment and taste. Either the system
works or it does not. A reasonable person would find that Leila’s system is just fine and
therefore, under the objective standard, Sujata must pay. The law strongly favors the objec-
tive standard because the subjective standard gives unlimited power to the promisee.
16-2c Good Faith
The parties to a contract must carry out their obligations in good faith. The difficulty, of
course, is applying this general rule to the wide variety of problems that may arise when
people or companies do business. How far must one side go to meet its good faith burden?
Marvin Shuster was a physician in Florida. Three patients sued him for alleged malpractice.
Shuster denied any wrongdoing and asked his insurer to defend the claims. But the
insurance company settled all three claims without defending and with a minimum of
investigation. Shuster paid nothing out of his own pocket, but he sued the insurance
company, claiming that it acted in bad faith. The doctor argued that the company’s failure
to defend him caused emotional suffering and meant that it would be impossible for him to
obtain new malpractice insurance. The Florida Supreme Court found that the insurer acted
in good faith. The contract clearly gave all control of malpractice cases to the company. It
could settle or defend as it saw fit. Here, the company considered it more economical to
settle quickly, and Shuster should have known, from the contract language, that the insurer
might choose to do so.5
In the following case, one party to a contract played its cards very close to its chest. Too
close?
BRUNSWICK HILLS RACQUET CLUB INC. V. ROUTE
18 SHOPPING CENTER ASSOCIATES
182 N.J. 210 864 A.2d 387
Supreme Court of New Jersey, 2005
C A S E S U M M A R Y
Facts: Brunswick Hills Racquet Club (Brunswick) owned
a tennis club on property that it leased from Route 18
Shopping Center Associates (Route 18). The lease ran for
25 years, and Brunswick had spent about $1 million in
capital improvements. The lease expired March 30, 2002.
Brunswick had the option of either buying the property or
purchasing a 99-year lease, both on very favorable terms.
To exercise its option, Brunswick had to notify Route 18
no later than September 30, 2001, and had to pay the
option price of $150,000. If Brunswick failed to exercise
its options, the existing lease automatically renewed as of
September 30, for 25 more years, but at more than triple
the current rent.
In February, 2000—19 months before the option
deadline—Brunswick’s lawyer, Gabriel Spector, wrote to
Rosen Associates, the company that managed Route 18,
stating that Brunswick intended to exercise the option for
a 99-year lease. He requested that the lease be sent well
in advance so that he could review it. He did not make
the required payment of $150,000.
5Shuster v. South Broward Hospital Dist. Physicians’ Prof. Liability Ins. Trust, 591 So. 2d 174, 1992 Fla.
LEXIS 20 (Fla. 1992).
CHAPTER 16 Performance and Discharge 365
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EXAM Strategy
Question: Sun operates an upscale sandwich shop in New Jersey, in a storefront that
she leases from Ricky for $18,000 per month. The lease, which expires soon, allows
Sun to renew for five years at $22,000 per month. Ricky knows, but Sun does not, that
in a year, Prada will open a store on the same block. The dramatic increase in
pedestrian traffic will render Sun’s space more valuable. Ricky says nothing about
Prada, Sun declines to renew, and Ricky leases the space for $40,000 a month. Sun
sues Ricky, claiming he breached his duty of good faith and fair dealing. Based on the
Brunswick Hills case, how would the New Jersey Supreme Court rule?
Strategy: In the Brunswick Hills case, the court, on the one hand, criticized the
defendant for cynically evading the plaintiff’s efforts to renew. However, the court
also said, “We do not expect a landlord or even an attorney to act as his brother’s
keeper in a commercial transaction.” Using those opposing themes as guidelines,
examine the court’s decision and predict the ruling in Sun’s suit.
In March, Rosen replied that it had forwarded Spec-
tor’s letter to its attorney, who would be in touch. In April,
Spector again wrote, asking for a reply from Rosen or its
lawyer.
Over the next six months, Spector continually asked
for a copy of the lease, or information, but neither Route
18’s lawyer nor anyone else provided any data. In January
2001, Spector renewed his requests for a copy of the lease.
Route 18’s lawyer never replied. Sadly, in May 2001, after
a long illness, Spector died. In August 2001, Spector’s law
partner, Arnold Levin, wrote to Rosen, again stating
Brunswick’s intention to buy the 99-year lease and
requesting a copy of all relevant information. He received
no reply, and the September deadline passed.
In February 2002, Route 18’s lawyer dropped the
hammer, notifying Levin that Brunswick could not exer-
cise its option to lease because it had failed to pay the
$150,000 by September 30, 2001.
Brunswick sued, claiming that Route 18 had breached
its duty of good faith and fair dealing. The trial court
found that Route 18 had no duty to notify Brunswick of
impending deadlines and gave summary judgment for
Route 18. The appellate court affirmed, and Brunswick
appealed to the state supreme court.
Issue: Did Route 18 breach its duty of good faith and fair
dealing?
Decision: Yes, Route 18 breached its duty of good faith
and fair dealing.
Reasoning: Courts generally should not tinker with pre-
cisely drafted agreements entered into by experienced
businesspeople. Nonetheless, every party to a contract is
bound by a duty of good faith and fair dealing in its
performance. Good faith is conduct that conforms to com-
munity standards of decency and reasonableness. Neither
party may do anything that will prevent the other from
receiving the contract benefits.
Route 18 and its agents acted in bad faith. Nineteen
months before the deadline, Brunswick Hills notified the
landlord that it intended to exercise its option to purchase
a 99-year lease. Brunswick Hills mistakenly believed that
its payment was not due until closing. During that year
and a half, Route 18 engaged in a pattern of evasion,
sidestepping every request by Brunswick Hills to move
forward on closing the lease. After Spector’s death, Route
18’s lawyer continued to play possum despite the obvious
risk to Brunswick Hills. Route 18 acknowledged that it
did not want the lease payment because the long-term
lease was not in its financial interest.
Neither a landlord nor its attorney is required to act as
his brother’s keeper. However, there are ethical norms
that apply even in the harsh world of commercial transac-
tions. All parties must behave in good faith and deal fairly
with the other side. Brunswick Hills’ repeated letters and
calls to close the lease placed an obligation on Route 18 to
respond in a timely, honest manner. The company failed
to do that, and Brunswick Hills is entitled to exercise the
99-year lease.
366 U N I T 2 Contracts
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Result: Brunswick Hills begins: “Courts generally should not tinker with a finely drawn
and precise contract entered into by experienced business people.” Sun’s lease imposes
no responsibility on Ricky to report on neighborhood changes or forecast profitability.
Further, Sun made no requests to Ricky about the area’s future. Sun is asking Ricky to
be “her brother’s keeper,” and neither this court nor any other will do that. She loses.
16-2d Time of the Essence Clauses
Go, sir, gallop, and don’t forget that the world was made in six days. You can ask me for anything
you like, except time.
Napoleon, to an aide, 1803
Generals are not the only ones who place a premium on time. Ask Gene LaSalle. The
Seabreeze Restaurant agreed to sell him all of its assets. The parties signed a contract stating
the price and closing date. Seabreeze insisted on a clause saying, “Seabreeze considers that
time is of the essence in consummating the proposed transaction.” Such clauses are
common in real estate transactions and in any other agreement where a delay would cause
serious damage to one party. LaSalle was unable to close on the date specified and asked for
an extension. Seabreeze refused and sold its assets elsewhere. A Florida court affirmed that
Seabreeze acted legally.
A time of the essence clause will generally make contract deadlines strictly enforceable.
Seabreeze regarded a timely sale as important, and LaSalle agreed to the provision. There
was nothing unreasonable about the clause, and LaSalle suffered the consequences of his
delay.6
Suppose the contract had named a closing date but included no time of the essence
clause. If LaSalle offered to close three days late, could Seabreeze sell elsewhere? No.
Merely including a date for performance does not make time of the essence. Courts dislike
time of the essence arguments because even a short delay may mean that one party forfeits
everything it expected to gain from the bargain. If the parties do not clearly state that prompt
performance is essential, then both are entitled to reasonable delays.
16-3 BREACH
When one party breaches a contract, the other party is discharged. The discharged party has
no obligation to perform and may sue for damages. Edwin promises that on July 1, he will
deliver 20 tuxedos, tailored to fit male chimpanzees, to Bubba’s circus for $300 per suit.
After weeks of delay, Edwin concedes he hasn’t a cummerbund to his name. Bubba is
discharged and owes nothing. In addition, he may sue Edwin for damages.
16-3a Material Breach
As we know, parties frequently perform their contract duties imperfectly, which is why
courts accept substantial performance rather than strict performance, particularly in contracts
involving services. In a more general sense, courts will discharge a contract only if a party
6Seabreeze Restaurant, Inc. v. Paumgardhen, 639 So. 2d 69, 1994 Fla. App. LEXIS 4546 (Fla. Dist. Ct.
App. 1994).
Time of the essence
clauses
Generally make contract dates
strictly enforceable.
CHAPTER 16 Performance and Discharge 367
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committed a material breach. A material breach is one that substantially harms the innocent
party and for which it would be hard to compensate without discharging the contract.
Suppose Edwin fails to show up with the tuxedos on June 1 but calls to say they will arrive
under the big top the next day. He has breached the agreement. Is his breach material? No.
This is a trivial breach, and Bubba is not discharged. When the tuxedos arrive, he must pay.
The following case raises the issue in the context of a major college sports program.
16-3b Anticipatory Breach
Sally will receive her bachelor’s degree in May and already has a job lined up for September.
She has signed a two-year contract to work as window display designer for Surebet Depart-
ment Store. The morning of graduation, she reads in the paper that Surebet is going out of
business that very day. Surebet has told Sally nothing about her status. Sally need not wait
until September to learn her fate. Surebet has committed an anticipatory breach by making it
O’BRIEN V. OHIO STATE UNIVERSITY
2007 WL 2729077
Ohio Court of Appeals, 2007
C A S E S U M M A R Y
Facts: The Ohio State University (OSU), experiencing a
drought in its men’s basketball program, brought in Coach
Jim O’Brien to turn things around. He did. In only his
second year, he guided the OSU Buckeyes to its best
record ever. The team played in the most prestigious
postseason tournament, run by the National Collegiate
Athletic Association (NCAA), and won a berth in the “final
four.” O’Brien was named national coach of the year.
OSU’s athletic director promptly offered O’Brien a multi-
year contract worth about $800,000 per year.
Section 5.1 of the contract included termination pro-
visions. OSU could fire O’Brien for cause if (a) there was a
material breach of the contract by the coach, or (b)
O’Brien’s conduct subjected the school to NCAA sanc-
tions. OSU could also terminate O’Brien without cause, but
in that case it had to pay him the full salary owed.
O’Brien began recruiting a talented 21-year-old Ser-
bian player named Alex Radojevic. While getting to know
the young man, O’Brien discovered two things. First, it
appeared that Radojevic had been paid to play briefly for
a Yugoslavian team, meaning that he was ineligible to play
in the NCAA. Second, it was clear that Radojevic’s family
had suffered terribly during the strife in the Balkans.
O’Brien concluded that Radojevic would never play
for OSU or any major college. He also decided to loan
Radojevic’s mother some money. Any such loan would
violate an NCAA rule if done to recruit a player, but
O’Brien believed the loan was legal since Radojevic could
not play in the NCAA anyway. Several years later, OSU
learned of the loan and realized that O’Brien had never
reported it. Hoping to avoid trouble with the NCAA, OSU
imposed sanctions on itself. The university also fired the
coach, claiming he had lied, destroyed the possibility of
postseason play, and harmed the school’s reputation.
O’Brien sued, claiming he had not materially brea-
ched the contract. The trial court awarded the coach $2.5
million, and OSU appealed.
Issue: Did O’Brien materially breach the contract?
Decision: No, he did not materially breach his contract.
Affirmed.
Reasoning: OSU suffered no substantial damage. The
Buckeyes played poorly in the weeks leading up to the
announcement of the ban on postseason play, and they
were unlikely to receive an NCAA bid.
The university’s reputation was not significantly harmed
because Radojevic never played for the school. Also, OSU
promptly recruited a top coach to replace O’Brien. Moreover,
OSU presented no evidence that O’Brien lied about the
payment, tried to conceal it, or even knew that it was wrong.
Violations of NCAA rules are common. A minor viola-
tion is not necessarily a material breach. Coach O’Brien
remained entitled to his $2.5 million award.
368 U N I T 2 Contracts
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unmistakably clear that it will not honor the contract. Sometimes a promisor will actually
inform the promisee that it will not perform its duties. At other times, as here, the promisor
takes some step that makes the breach evident. Sally is discharged and may immediately seek
other work. She is also entitled to file suit for breach of contract. The court will treat Surebet’s
anticipatory breach just as though the store had actually refused to perform on September 1.
16-3c Statute of Limitations
A party injured by a breach of contract should act promptly. A statute of limitations begins
to run at the time of injury and will limit the time within which the injured party may file
suit. These laws set time limits for filing lawsuits. Statutes of limitation vary from state to
state and from issue to issue within a state. Failure to file suit within the time limits
discharges the party who breached the contract. Always consult a lawyer promptly in the
case of a legal injury.
16-4 IMPOSSIBILITY
“Your honor, my client wanted to honor the contract. He just couldn’t. Honest.” This plea
often echoes around courtrooms as one party seeks discharge without fulfilling his contract
obligations. Does the argument work? It depends. If performing a contract was truly
impossible, a court will discharge the agreement. But if honoring the deal merely imposed
a financial burden, the law will generally enforce the contract.
16-4a True Impossibility
These cases are easy—and rare. True impossibility means that something has happened
making it literally impossible to do what the promisor said he would do. Francoise owns a
vineyard that produces Beaujolais Nouveau wine. She agrees to ship 1,000 cases of her wine
to Tyrone, a New York importer, as soon as this year’s vintage is ready. Tyrone will pay $50
per case. But a fungus wipes out her entire vineyard. Francoise is discharged. It is theoretically
impossible for Francoise to deliver wine from her vineyard, and she owes Tyrone nothing.
Meanwhile, though, Tyrone has a contract with Jackson, a retailer, to sell 1,000 cases of
Beaujolais Nouveau wine at $70 per case. Tyrone has no wine from Francoise, and the only
other Beaujolais Nouveau available will cost him $85 per case. Instead of earning $20 per
case, Tyrone will lose $15. Does this discharge Tyrone’s contract with Jackson? No. It is
possible for him to perform—it’s just more expensive. He must fulfill his agreement.
True impossibility is generally limited to these three causes:
• Destruction of the Subject Matter, as happened with Francoise’s vineyard.
• Death of the promisor in a personal services contract. When the promisor agrees
personally to render a service that cannot be transferred to someone else, her death
discharges the contract. Producer hires Josephine to write the lyrics for a new
Broadway musical, but Josephine dies after writing only two words: “Act One.” The
contract was personal to Josephine and is now discharged. Neither Josephine’s estate
nor Producer has any obligation to the other. But notice that most contracts are not for
personal services. Suppose that Tyrone, the wine importer, dies. His contract to sell
wine to Jackson is not discharged because anyone can deliver the required wine.
Tyrone’s estate remains liable on the deal with Jackson.
• Illegality. Chet, a Silicon Valley entrepreneur, wants to capitalize on his computer
expertise. He contracts with Construction Co. to build a factory in Iran that will
manufacture computers for sale in that country. Construction Co. fails to build the factory
Statute of limitations
A statutory time limit within
which an injured party must
file suit.
CHAPTER 16 Performance and Discharge 369
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on time, and Chet sues. Construction Co. defends by pointing out that the President of
the United States has issued an executive order barring trade between the United States
and Iran. Construction Co. wins; the executive order discharged the contract.
16-4b Commercial Impracticability and Frustration
of Purpose
It is rare for contract performance to be truly impossible but very common for it to become a
financial burden to one party. Suppose Bradshaw Steel in Pittsburgh agrees to deliver 1,000
tons of steel beams to Rice Construction in Saudi Arabia at a given price, but a week later,
the cost of raw ore increases 30 percent. A contract once lucrative to the manufacturer is
suddenly a major liability. Does that change discharge Bradshaw? Absolutely not. Rice
signed the deal precisely to protect itself against price increases. As we have seen, the primary
purpose of contracts is to enable the parties to control their future.
Yet there may be times when a change in circumstances is so extreme that it would be
unfair to enforce a deal. What if a strike made it impossible for Bradshaw to ship the steel to
Saudi Arabia, and the only way to deliver would be by air, at five times the sea cost? Must
Bradshaw fulfill its deal? What if a new war meant that any ships or planes delivering the
goods might be fired upon? Other changes could make the contract undesirable for Rice.
Suppose the builder wanted steel for a major public building in Riyadh, but the Saudi
government decided not to go forward with the construction. The steel would then be
worthless to Rice. Must the company still accept it?
None of these hypotheticals involves true impossibility. It is physically possible for
Bradshaw to deliver the goods and for Rice to receive. But in some cases, it may be so
dangerous, costly, or pointless to enforce a bargain that a court will discharge it instead.
Courts use the related doctrines of commercial impracticability and frustration of purpose to
decide when a change in circumstances should permit one side to escape its duties.
Commercial impracticability means some event has occurred that neither party antici-
pated and fulfilling the contract would now be extraordinarily difficult and unfair to one party. If
a shipping strike forces Bradshaw to ship by air, the company will argue that neither side
expected the strike and that Bradshaw should not suffer a fivefold increase in shipping
costs. Bradshaw will probably win the argument.
Frustration of purpose means some event has occurred that neither party anticipated
and the contract now has no value for one party. If Rice’s building project is canceled, Rice will
argue that the steel now is useless to the company. Frustration cases are hard to predict.
Some states would agree with Rice, but others would hold that it was Rice’s obligation to
protect itself with a government guarantee that the project would be completed. Courts
consider the following factors in deciding impracticability and frustration claims:
• Mere financial difficulties will never suffice to discharge a contract. Barbara and
Michael Luber divorced, and Michael agreed to pay alimony. He stopped making
payments and claimed that it was impracticable for him to do so because he had hit
hard times and simply did not have the money. The court dismissed his argument,
noting that commercial impracticability requires some objective event that neither
party anticipated, not merely the financial deterioration of one party.7
• The event must have been truly unexpected. Wayne Carpenter bought land from the
state of Alaska, intending to farm it and agreeing to make monthly payments. The sales
contract stated that Alaska did not guarantee the land for agriculture or any other purpose.
Carpenter struggled to farm the land but failed; as soon as the ground thawed, the water
7Luber v. Luber, 418 Pa. Super. 542, 614 A.2d 771, 1992 Pa. Super. LEXIS 3338 (Pa. Super. Ct. 1992).
370 U N I T 2 Contracts
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table rose too high for crops. Carpenter abandoned the land and stoppedmakingpayments.
Alaska sued and won. The high court rejected Carpenter’s claim of impracticability since
the “event”—bad soil—was not unexpected. Alaska hadwarned that the landmight prove
unworkable, and Carpenter had no claim for commercial impracticability.8
• If the promisor must use a different means to accomplish her task, at a greatly increased
cost, she probably does have a valid claim of impracticability. If a shipping strike forces
Bradshaw to use a different means of delivery—say, air—and this multiplies its costs
several times, the company is probably discharged. But a mere increase in the cost of
raw materials, such as a 30 percent rise in the price of ore, will almost never discharge
the promisor.
• A force majeure clause is significant but not necessarily dispositive. To protect
themselves from unexpected events, companies sometimes include a force majeure
clause, allowing cancellation of the agreement in case of extraordinary and
unexpected events. A typical clause might permit the seller of goods to delay or
cancel delivery in the event of “acts of God, fire, labor disputes, accidents, or
transportation difficulties.” A court will always consider a force majeure clause, but it
may not enforce it if one party is trying to escape from routine financial problems.
Chapter Conclusion
Negotiate carefully. A casually written letter may imply a condition precedent that the
author never intended. The term personal satisfaction should be defined so that both parties
know whether one party may fire the other on a whim. Never assume that mere incon-
venience or financial loss will discharge contractual duties.
EXAM REVIEW
1. CONDITION A condition is an event that must occur before a party becomes
obligated. It may be stated expressly or implied, and no formal language is necessary
to create one. (pp. 358–362)
Question: Stephen Krogness, a real estate broker, agreed to act as an agent for
Best Buy Co., which wanted to sell several of its stores. The contract provided that
Best Buy would pay Krogness a commission of 2 percent for “a sale to any
prospect submitted directly to Best Buy by Krogness.” Krogness introduced
Corporate Realty Capital (CRC) to Best Buy, and the parties negotiated but could
not reach agreement. CRC then introduced Best Buy to BB Properties (BB). Best
Buy sold several properties to BB for $46 million. CRC acted as the broker.
Krogness sought a commission of $528,000. Is he entitled to it?
Strategy: This contract contains a conditional clause. What is it? What must occur
beforeBestBuy is obligated to payKrogness?Did that event happen? (See the“Result”
at the end of this section.)
E
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8State v. Carpenter, 869 P.2d 1181, 1994 Alaska LEXIS 23 (Alaska 1994).
CHAPTER 16 Performance and Discharge 371
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2. SUBSTANTIAL PERFORMANCE Strict performance, which requires one
party to fulfill its duties perfectly, is unusual. In construction and service contracts,
substantial performance is generally sufficient to entitle the promisor to the contract
price, minus the cost of defects in the work. (pp. 363–364)
3. PERSONAL SATISFACTION Personal satisfaction contracts are interpreted under
an objective standard, requiring reasonable ground for dissatisfaction, unless the work
involves personal judgment and the parties intended a subjective standard. (pp. 364–365)
4. GOOD FAITH Good faith performance is required in all contracts. (pp. 365–366)
5. TIME OF THE ESSENCE Time of the essence clauses result in strict
enforcement of contract deadlines. (p. 367)
Question: Colony Park Associates signed a contract to buy 44 acres of residential
land from John Gall. The contract stated that closing would take place exactly one
year later. The delay was to enable Colony Park to obtain building permits to
develop condominiums. Colony Park worked diligently to obtain all permits, but
delays in sewer permits forced Colony Park to notify Gall it could not close on the
agreed date. Colony Park suggested a date exactly one month later. Gall refused
the new date and declined to sell. Colony Park sued. Gall argued that since the
parties specified a date, time was of the essence and Colony Park’s failure to buy
on time discharged Gall. Please rule.
Strategy: A time of the essence clause generally makes a contract date strictly
enforceable. Was there one in this agreement? (See the “Result” at the end of this
section.)
6. MATERIAL BREACH A material breach is the only kind that will discharge a
contract; a trivial breach will not. (pp. 367–368)
7. IMPOSSIBILITY True impossibility means that some event has made it
impossible to perform an agreement. It is typically caused by destruction of the subject
matter, the death of an essential promisor, or intervening illegality. (pp. 369–371)
Question: Omega Concrete had a gravel pit and factory. Access was difficult, so
Omega contracted with Union Pacific Railroad (UP) for the right to use a private
road that crossed UP property and tracks. The contract stated that use of the road
was solely for Omega employees and that Omega would be responsible for closing
a gate that UP planned to build where the private road joined a public highway. In
fact, UP never constructed the gate; Omega had no authority to construct the gate.
Mathew Rogers, an Omega employee, was killed by a train while using the private
road. Rogers’s family sued Omega, claiming that Omega failed to keep the gate
closed as the contract required. Is Omega liable?
Strategy: True impossibility means that the promisor cannot do what he
promised to do. Is this such a case? (See the “Result” at the end of this section.)
E
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372 U N I T 2 Contracts
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8. COMMERCIAL IMPRACTICABILITY Commercial impracticability means that
some unexpected event has made it extraordinarily difficult and unfair for one party
to perform its obligations. (pp. 370–371)
9. FRUSTRATION OF PURPOSE Frustration of purpose may occur
when an unexpected event render/s a contract completely useless to one
party. (pp. 370–371)
1. Result: The conditional clause requires Best Buy to pay a commission for “a sale
to any prospect submitted directly to Best Buy by Krogness.” Krogness did not in
fact introduce BB Properties to Best Buy. The condition has not occurred, and Best
Buy is under no obligation to pay.
5. Result: Merely including a date for performance does not make time of the
essence. A party that considers a date critical must make that clear. This contract
did not indicate that the closing date was vital to either party, so a short delay was
reasonable. Gall was ordered to convey the land to Colony Park.
7. Result: There was no gate, and Omega had no right to build one. This is a case
of true impossibility. Omega was not liable.
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Nagel and Fields entered into a contract in which Nagel was
obligated to deliver certain goods by September 10. On September 3, Nagel told
Fields that he had no intention of delivering the goods. Prior to September 10,
Fields may successfully sue Nagel under the doctrine of:
(a) promissory estoppel
(b) accord and satisfaction
(c) anticipatory breach
(d) substantial performance
2. Most contracts are discharged by .
(a) agreement of the parties
(b) full performance
(c) failure of conditions
(d) commercial impracticability
(e) a material breach
3. If a contract contains a condition precedent, the has the burden of
proving that the condition actually happened. If a condition subsequent exists,
the has the burden of showing that the condition occurred.
(a) plaintiff; plaintiff
(b) plaintiff; defendant
(c) defendant; plaintiff
(d) defendant; defendant
CHAPTER 16 Performance and Discharge 373
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4. Big Co., a construction company, builds a grocery store. The contract calls for a final
price of $5 million. Big Co. incurred $4.5 million in costs and stands to make a profit of
$500,000. On a final inspection, the grocery store owner is upset. His blueprints called
for 24 skylights, but the finished building has only 12. Installing the additional
skylights would cost $100,000. Big Co. made no other errors. How much must the
grocery store owner pay Big Co.?
(a) $5,000,000
(b) $4,900,000
(c) $4,500,000
(d) $0
5. Lenny makes K2, a synthetic form of marijuana, in his basement. He signs an
agreement with the Super Smoke Shop to deliver 1,000 cans of K2 for $10,000.
After the contract is signed, but before the delivery, Super Smoke Shop’s state
legislature makes the sale of K2 illegal. Lenny’s contract will be discharged
because of .
(a) true impossibility
(b) commercial impracticability
(c) frustration of purpose
(d) None of the above
ESSAY QUESTIONS
1. ETHICS Commercial Union Insurance Co. (CU) insured Redux, Ltd. The contract
made CU liable for fire damage but stated that the insurer would not pay for harm
caused by criminal acts of any Redux employees. Fire destroyed Redux’s property.
CU claimed that the “criminal acts” clause was a condition precedent, but Redux
asserted it was a condition subsequent. What difference does it make, and who is
legally right? Does the insurance company’s position raise any ethical issues? Who
drafted the contract? How clear were its terms?
2. Stephen Muka owned U.S. Robotics. He hired his brother Chris to work in the
company. His letter promised Chris $1 million worth of Robotics stock at the end of
one year, “provided you work reasonably hard & smart at things in the next year.”
(We should all have such brothers.) Chris arrived at Robotics and worked the full year,
but toward the end of the year, Stephen died. His estate refused to give Chris the
stock, claiming their agreement was a personal satisfaction contract and only Stephen
could decide whether Chris had earned the reward. Comment.
3. Ken Ward was an Illinois farmer who worked land owned by his father-in-law, Frank
Ruda. To finance his operation, he frequently borrowed money from Watseka First
National Bank, paying back the loans with farming profits. But Ward fell deeper and
deeper into debt, and Watseka became concerned. When Ward sought additional
loans, Watseka insisted that Ruda become a guarantor on all of the outstanding debt,
and the father-in-law agreed. The new loans had an acceleration clause, permitting
the bank to demand payment of the entire debt if it believed itself “insecure”; that is,
at risk of a default. Unfortunately, just as Ward’s debts reached more than $120,000,
Illinois suffered a severe drought, and Ward’s crops failed. Watseka asked Ruda to sell
374 U N I T 2 Contracts
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some of the land he owned to pay back part of the indebtedness. Ruda reluctantly
agreed but never did so. Meanwhile, Ward decreased his payments to the bank
because of the terrible crop. Watseka then “accelerated” the loan, demanding that
Ruda pay off the entire debt. Ruda defended by claiming that Watseka’s acceleration
at such a difficult time was bad faith. Who should win?
4. Loehmann’s clothing stores, a nationwide chain with headquarters in New York, was
the anchor tenant in the Lincoln View Plaza Shopping Center in Phoenix, Arizona,
with a 20-year lease from the landlord, Foundation Development, beginning in 1978.
Loehmann’s was obligated to pay rent the first of every month and to pay common-
area charges four times a year. The lease stated that if Loehmann’s failed to pay on
time, Foundation could send a notice of default, and that if the store failed to pay all
money due within 10 days, Foundation could evict. On February 23, 1987,
Foundation sent to Loehmann’s the common-area charges for the quarter ending
January 31, 1987. The balance due was $3,500. Loehmann’s believed the bill was in
error and sent an inquiry on March 18, 1987. On April 10, 1987, Foundation insisted
on payment of the full amount within 10 days. Foundation sent the letter to the
Loehmann’s store in Phoenix. On April 13, 1987, the Loehmann’s store received the
bill and, since it was not responsible for payments, forwarded it to the New York
office. Because the company had moved offices in New York, a Loehmann’s officer
did not see the bill until April 20. Loehmann’s issued a check for the full amount on
April 24 and mailed it the following day. On April 28, Foundation sued to evict; on
April 29, the company received Loehmann’s check. Please rule.
5. YOU BE THE JUDGE WRITING PROBLEM Kuhn Farm Machinery, a
European company, signed an agreement with Scottsdale Plaza Resort, of Arizona, to
use the resort for its North American dealers’ convention during March 1991. Kuhn
agreed to rent 190 guest rooms and spend several thousand dollars on food and
beverages. Kuhn invited its top 200 independent dealers from the United States and
Canada and about 25 of its own employees from the United States, Europe, and
Australia, although it never mentioned those plans to Scottsdale.
On August 2, 1990, Iraq invaded Kuwait, and on January 16, 1991, the United States
and allied forces were at war with Iraq. Saddam Hussein and other Iraqi leaders
threatened terrorist acts against the United States and its allies. Kuhn became
concerned about the safety of those traveling to Arizona, especially its European
employees. By mid-February, 11 of the top 50 dealers with expense-paid trips had
either canceled their plans to attend or failed to sign up. Kuhn postponed the
convention. The resort sued. The trial court discharged the contract under the
doctrines of commercial impracticability and frustration of purpose. The resort
appealed. Did commercial impracticability or frustration of purpose discharge the
contract? Argument for Scottsdale Plaza Resort: The resort had no way of knowing
that Kuhn anticipated bringing executives from Europe, and even less reason to
expect that if anything interfered with their travel, the entire convention would
become pointless. Most of the dealers could have attended the convention, and the
resort stood ready to serve them. Argument for Kuhn: The parties never anticipated
the threat of terrorism. Kuhn wanted this convention so that its European executives,
among others, could meet top North American dealers. That is now impossible. No
company would risk employee lives for a meeting. As a result, the contract has no
value at all to Kuhn, and its obligations should be discharged by law.
CHAPTER 16 Performance and Discharge 375
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DISCUSSION QUESTIONS
1. Evans built a house for Sandra Dyer, but the house
had some problems. The garage ceiling was too
low. Load-bearing beams in the “great room”
cracked and appeared to be steadily weakening.
The patio did not drain properly. Pipes froze.
Evans wanted the money promised for the job, but
Dyer refused to pay. Comment.
2. Krug International, an Ohio corporation, had a
contract with Iraqi Airways to build aeromedical
equipment for training pilots. Krug then contracted
for Power Engineering, an Iowa corporation, to build
the specialized gearbox to be used in the training
equipment for $150,000. Power did not know that
Krug planned to resell the gearbox to Iraqi Airways.
When Power had almost completed the gearbox, the
GulfWar broke out and the UnitedNations declared
an embargo on all shipments to Iraq. Krug notified
Power that it no longer wanted the gearbox. Power
sued. Please rule.
3. The death of a promisor in a personal services
contract discharges an agreement. But if a promisor
dies, other kinds of contracts live on. Is this
sensible? Would it be better to discharge all kinds
of agreements if one of the parties passes away?
4. Is commercial impracticability (such as the
shipping strike described earlier in the chapter) a
good reason for discharge? What about frustration
of purpose (such as the cancellation of the
construction project in Saudi Arabia)? Is one more
justified than the other? Are parties who back out
of contracts on these grounds acting reasonably?
5. Franklin J. Moneypenny hires Angela to paint his
portrait. She is to be paid $50,000 if the painting is
acceptable “in Franklin’s sole judgment.” At the
big unveiling, 99 of 100 attendees think that Angela
has done a masterful job. Franklin disagrees. He
thinks the painting makes him look like a toad. (He
does in fact look like a toad, but he does not like to
contemplate this fact.) Franklin refuses to pay, and,
because he signed a personal satisfaction contract,
Angela gets nothing. Is this fair? Should the law
allow personal satisfaction contracts?
376 U N I T 2 Contracts
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CHAPTER17
REMEDIES
Ben is the general manager of an NFL football
team. Driving home in his truck, he is in a sour
humor. Spencer, the team’s best running back,
under contract to play for one more year at
$2.5 million, has announced he is leaving the
team to act in a new sitcom. Ben wonders
whether he can stop Spencer from leaving the
team. Even if it is possible, would it be worth-
while to make a disgruntled, out-of-condition
athlete carry (and fumble) the ball? If Spencer
leaves, it will cost at least $5 million to hire a
runner with equal speed and power.
Ben’s phone rings. Louise, a dealer in rare autos, has
bad news.
“I hate to tell you, Ben, but the deal just fell
through.”
“What are you talking about? We both signed!
That’s a binding contract!” A seller in Florida had
agreed in writing to sell Ben a 1955 Ferrari for $900,000.
“I know it’s true, and you know it,” Louise murmurs
soothingly. “But the seller has decided he just can’t part
with it.”
Ben slams his cell phone down, turns into his drive-
way—and notices that the back door is open. Did he
leave it that way? No. The burglar did. Ben has lost
about $100,000 worth of jewelry, clothing, and sports
memorabilia. Why didn’t the alarm sound? When he demands an explanation from
Alarmist, his home security provider, the quality assurance representative assures Ben that
he will receive the full compensation due under his contract—$600. Later that night, Ben
will have a long talk with his lawyer about breached contracts and remedies.
Ben slams his cell phone
down, turns into his
driveway—and notices
that the back door is
open. Did he leave it that
way? No. The burglar
did.
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17-1 BREACHING A CONTRACT
Someone breaches a contract when he fails to perform a duty without a valid excuse. Spencer
is legally committed to play for the team for one more year and is clearly breaching his
contract when he informs the team that in the future, he will be playing for laughs. But what
can the team do about the runner’s breach? In other words, what is the team’s remedy? A
remedy is the method a court uses to compensate an injured party.
Should a court stop Spencer from performing in his new sitcom? Force him to carry the
ball instead? An order forcing someone to refrain from doing something is an injunction.
Courts frequently grant injunctions to an employer, blocking an employee from leaving to
work elsewhere. However, courts almost never use an order to force an employee to complete
a contract with his employer because that would force two antagonistic parties to work
together. In other words, Ben can probably stop Spencer from working in television, but no
court will order the running back to suit up and play.
Courts also award expectation damages, meaning the money required to put one party in
the position he would have been in had the other side performed the contract. If Spencer’s
team is forced to hire another running back for double the money they expected to pay
Spencer, the team will probably recover the difference between the two players’ salaries.
The Ferrari seller has breached his deal with Ben. What is Ben’s remedy? He does not
want money damages; he wants that lovely red car. In cases of property that is rare or
difficult to replace, courts often award specific performance, forcing both parties to complete
the deal. Ben should get his car.
Finally, the alarm company is trying to insist upon a remedy—a very limited one, which will
leave Ben largely uncompensated for the burglary. Alarmist is relying on a liquidated damages
clause, meaning a provision in the contract that declares in advance what one party will receive
if the other side breaches. Courts sometimes enforce these clauses. But as we will see later,
Alarmist’s liquidated damages clause may be too harsh, and thus unenforceable.
How to best help an injured party, without unfairly harming the other person, is the focus of
remedies. The questions and issues created by Ben’s Bad Day are typical remedy problems.
Courts have struggled with remedies for centuries, but we will master the subject in one chapter.
Ethics Though a court may have several alternative remedies available, it is
important to note that most have one thing in common: The focus is on
compensating the injured party rather than punishing the party in breach. A court must
decide whether to prevent Spencer from leaving the gridiron for the television studio, but it
will not consider fining or jailing him.
Some critics argue that someone who willfully breaches a contract should pay a penalty.
The Ferrari seller knows he is obligated to part with his car but tries to keep it anyway.
Spencer blithely ignores his obligations to the team. Should a remedy reflect morality? In this
chapter, we will see very few instances in which a court punishes unethical conduct. Is this
right? Should contract law exact a price for bad behavior?
17-1a Identifying the “Interest” to Be Protected
The first step that a court takes in choosing a remedy is to decide what interest it is trying to
protect. An interest is a legal right in something. Someone can have an interest in property,
for example, by owning it, or renting it to a tenant, or lending money so someone else may
Injunction
A court order that requires
someone to do something or
refrain from doing something.
Expectation damages
The money required to put one
party in the position he would
have been in had the other side
performed the contract.
Specific performance
Forces both parties to complete
the deal.
Liquidated damages
clause
A provision in a contract that
declares in advance what one
party will receive if the other
party breaches.
Interest
A legal right in something.
378 U N I T 2 Contracts
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buy it. He can have an interest in a contract if the agreement gives him some benefit. There
are four principal contract interests that a court may seek to protect:
• Expectation interest. This refers to what the injured party reasonably thought she
would get from the contract. The goal is to put her in the position she would have
been in if both parties had fully performed their obligations.
• Reliance interest. The injuredpartymaybeunable todemonstrate expectationdamages,
perhaps because it is unclear he would have profited. But he may still prove that he spent
money in reliance on the agreement and that in fairness, he should receive compensation.
• Restitution interest. The injured party may be unable to show an expectation interest
or reliance. But perhaps she has conferred a benefit on the other party. Here, the
objective is to restore to the injured party the benefit she has provided.
• Equitable interest. In some cases, money damages will not suffice to help the injured
party. Something more is needed, such as an order to transfer property to the injured party
(specific performance) or an order forcing oneparty to stopdoing something (an injunction).
In this chapter, we look at all four interests.
17-2 EXPECTATION INTEREST
This is the most common remedy that the law provides for a party injured by a breach of
contract. The expectation interest is designed to put the injured party in the position she
would have been in had both sides fully performed their obligations. A court tries to give the
injured party the money she would have made from the contract. If accurately calculated,
this should take into account all the gains she reasonably expected and all the expenses and
losses she would have incurred. The injured party should not end up better off than she
would have been under the agreement, nor should she suffer a loss.
If you ever go to law school, you will almost certainly encounter the following case
during your first weeks of classes. It has been used to introduce the concept of damages in
contract lawsuits for generations. Enjoy the famous “case of the hairy hand.”
Landmark Case
Facts: Hawkins suffered a
severe electrical burn on the
palm of his right hand. After
years of living with disfigur-
ing scars, he went to visit
Dr. McGee, who was well
known for his early attempts
at skin-grafting surgery.The
doctor told Hawkins “I will
guarantee to make the hand
a hundred percent perfect hand.” Hawkins hired him to per-
form the operation.
McGee cut a patch of healthy skin from Hawkins’s
chest and grafted it over the scar tissue on Hawkins’
palm. Unfortunately, the
chest hair on the skin
graft was very thick,
and it continued to grow
after the surgery. The
operation resulted in a
hairy palm for Hawkins.
Feeling embarrassed,
Hawkins suedDr.McGee.
The trial court judge
instructed the jury to consider two factors in calculating
damages: (1) pain and suffering from the operation, and
(2) the difference in Hawkins’s condition before (with
the burned palm) and after the surgery (with the hairy
HAWKINS V. MCGEE
84 N.H. 114, 146 A. 641
Supreme Court of New Hampshire, 1929
C A S E S U M M A R Y
CHAPTER 17 Remedies 379
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Now let’s consider a more modern example.
William Colby was a former director of the CIA. He wanted to write a book about his
15 years in Vietnam. He paid James McCarger $5,000 for help in writing an early draft and
promised McCarger another $5,000 if the book was published. Then he hired Alexander
Burnham to cowrite the book. Colby’s agent secured a contract with Contemporary Books,
which included a $100,000 advance. But Burnham was hopelessly late with the manuscript
and Colby missed his publication date. Colby fired Burnham and finished the book without
him. Contemporary published Lost Victory several years late, and the book flopped, earning
no significant revenue. Because the book was so late, Contemporary paid Colby a total of
only $17,000. Colby sued Burnham for his lost expectation interest. The court awarded him
$23,000, calculated as follows:
$100,000 advance, the only money Colby was promised
– 10,000 agent’s fee
= 90,000 Fee for the two authors, combined
divided by 2 = 45,000 Colby’s fee (the other half went to the coauthor)
– 5,000 owed to McCarger under the earlier agreement
= 40,000 Colby’s expectation interest
– 17,000 Fee Colby eventually received from Contemporary
= 23,000 Colby’s expectation damages; that is, the additional amount
he would have received had Burnham finished on time
The Colby case1 presented a relatively easy calculation of damages. Other contracts are
complex. Courts typically divide the expectation damages into three parts: (1) direct (or
“compensatory”) damages, which represent harm that flowed directly from the contract’s
breach; (2) consequential (or “special”) damages, which represent harm caused by the
injured party’s unique situation; and (3) incidental damages, which are minor costs such
as storing or returning defective goods, advertising for alternative goods, and so forth. The
first two, direct and consequential, are the important ones.
Note that punitive damages are absent from our list. The golden rule in contracts cases
is to give successful plaintiffs “the benefit of the bargain” and not to punish defendants.
hand). The jury awarded Hawkins $3,000, but the court
reduced the award to $500. Harried, Hawkins appealed.
Issue: Did the jury calculate Hawkins’ damages correctly?
Decision: No. The court’s instructions were wrong on both
counts.
Reasoning: The jury found that the doctor’s promise of
“a hundred percent perfect hand” created an enforceable
contract. Contract damages are intended to put the plain-
tiff in the position he would have been in had the defen-
dant kept his part of the bargain. What would Hawkins’s
hand have looked like if Dr. McGee’s had kept his
promise? It certainly would not have had chest hair on it.
As such, the court concluded that the correct calculation of
contract damages was the difference in value between the
promised perfect hand and the resulting hairy paw. The
pain and suffering Hawkins experienced in the operation
had nothing to do with this calculation because it was part
of the price he was willing to pay for the promise of a good
hand.
The case was remanded for a new trial.
1Colby v. Burnham, 31 Conn. App. 707, 627 A.2d 457, 1993 Conn. App LEXIS 299 (Conn. App.
Ct. 1993).
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380 U N I T 2 Contracts
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Punitive damages are occasionally awarded in lawsuits that involve both a contract and
either an intentional tort (such as fraud) or a breach of fiduciary duty, but they are not
available in “simple” cases involving only a breach of contract.
17-2a Direct Damages
Direct damages are those that flow directly from the contract. They are the most common
monetary award for the expectation interest. These are the damages that inevitably result
from the breach. Suppose Ace Productions hires Reina to star in its new movie, Inside
Straight. Ace promises Reina $3 million, providing she shows up June 1 and works until the
film is finished. But in late May, Joker Entertainment offers Reina $6 million to star in its
new feature, and on June 1, Reina informs Ace that she will not appear. Reina has breached
her contract, and Ace should recover direct damages.
What are the damages that flow directly from the contract? Ace has to replace Reina. If
Ace hires Kayla as its star and pays her a fee of $4 million, Ace is entitled to the difference
between what it expected to pay ($3 million) and what the breach forced it to pay
($4 million), or $1 million in direct damages.
17-2b Consequential Damages
In addition to direct damages, the injured party may seek consequential damages or, as they are
also known, “special damages.” Consequential damages reimburse for harm that results from
the particular circumstances of the plaintiff. These damages are only available if they are a
foreseeable consequence of the breach. Suppose, for example, Raould breaches two contracts—he is
late picking both Sharon and Paul up for a taxi ride. His breach is the same for both parties, but
the consequences are very different. Sharon misses her flight to San Francisco and incurs a
substantial fee to rebook the flight. Paul is simply late for the barber, who manages to fit him in
anyway. Thus, Raould’s damages would be different for these two contracts. The rule con-
cerning this remedy comes from a famous 1854 case, Hadley v. Baxendale. This is another case
that all American law students read. Now it is your turn.
HADLEY V. BAXENDALE
9 EX. 341, 156 Eng. Rep. 145
Court of Exchequer, 1854
C A S E S U M M A R Y
Facts: The Hadleys operated a flour mill in Gloucester.
The crankshaft broke, causing the mill to grind to a
halt. The Hadleys employed Baxendale to cart the
damaged part to a foundry in Greenwich, where a new
one could be manufactured. Baxendale promised to
make the delivery in one day, but he was late transport-
ing the shaft, and as a result, the Hadleys’ mill was shut
for five extra days. They sued, and the jury awarded
damages based in part on their lost profits. Baxendale
appealed.
Issue: Was the defendant liable for profits lost because of his
delay in delivering the shaft?
Decision: No. The defendant was not liable for lost profits.
Reasoning: When one side breaches a contract, the
other party’s damages should be those that arise inevitably
from the breach or those that both parties reasonably
anticipated when they made the agreement. If the con-
tract involves special circumstances and the plaintiff tells
the defendant about them when they make the deal, then
Consequential damages
Are those resulting from the
unique circumstances of a
particular injured party.
Direct damages
Are those that flow directly
from the contract.
CHAPTER 17 Remedies 381
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The rule from Hadley v. Baxendale has been unchanged ever since: The injured party
may recover consequential damages only if the breaching party should have foreseen them
when the two sides formed the contract.
Let us return briefly to Inside Straight. Suppose that, long before shooting began, Ace
had sold the film’s soundtrack rights to Spinem Sound for $2 million. Spinem believed it
would make a profit only if Reina appeared in the film, so it demanded the right to
discharge the agreement if Reina dropped out. When Reina quit, Spinem terminated the
contract. Now, when Ace sues Reina, it will also seek $2 million in consequential damages
for the lost music revenue.
The $2 million is not a direct damage. The contract between Reina and Act has nothing
directly to do with selling soundtrack rights. But the loss is nonetheless a consequence of
Reina bailing out on the project. And so, if Reina knew about Ace’s contract with Spinem
when she signed to do the film, the loss would be foreseeable to her, and she would be
liable for $2 million. If she never realized she was an essential part of the music contract, and
if a jury determines that she had no reason to expect the $2 million loss, she owes nothing
for the lost soundtrack profits.
Injured plaintiffs often try to recover lost profits. Courts will generally award
these damages if (1) the lost profits were foreseeable and (2) plaintiff provides enough
information so that the factfinder can reasonably estimate a fair amount. The calculation
need not be done with mathematical precision. In the following case, the plaintiffs lost not
only profits—but their entire business. Can they recover for harm that is so extensive? You
decide.
the defendant is liable for all injuries. On the other hand,
if the plaintiff never informed the defendant about the
unique situation, then the defendant should be liable only
for harm that might occur in the normal course of events.
The Hadleys told Baxendale only that the article to
be carried was a broken shaft from their mill. How could
Baxendale have realized that a delay in delivery would
prevent the mill from operating? He might have
assumed, very reasonably, that the Hadleys owned a
second shaft and were sending this one for repairs while
the mill ground on. It would be unfair to presume that
Baxendale realized that delay would halt the mill. The
case should be retried, and the jury may not consider the
Hadleys’ lost profits.
You Be the Judge
Facts: Bi-Economy Mar-
ket was a family-owned
meat market in Rochester,
New York. The company
was insured by Harleysville
Insurance. The “Deluxe
Business Owner’s” policy
provided replacement cost
for damage to buildings and inventory. Coverage also
included “business interruption insurance” for one year,
meaning the loss of pretax profit plus normal operating
expenses, including payroll.
The company suffered
a disastrous fire, which
destroyed its building and
all inventory. Bi-Economy
immediately filed a claim
with Harleysville, but the
insurer responded slowly.
Harleysville eventually
offered a settlement of $163,000. A year later, an arbitrator
awarded the Market $407,000. During that year, Harleysville
paid for seven months of lost income but declined to pay
more. The company never recovered or reopened.
BI-ECONOMY MARKET, INC.
V. HARLEYSVILLE INS.
CO. OF NEW YORK
2008 WL 423451
New York Court of Appeals, 2008
382 U N I T 2 Contracts
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17-2c Incidental Damages
Incidental damages are the relatively minor costs that the injured party suffers when
responding to the breach. When Reina, the actress, breaches the film contract, the producers
may have to leave the set and fly back to Los Angeles to hire a new actress. The travel cost
is an incidental damage. In another setting, suppose Maud, a manufacturer, has produced
5,000 pairs of running shoes for Foot The Bill, a retail chain, but Foot The Bill breaches the
agreement and refuses to accept the goods. Maud will have to store the shoes and advertise
for alternate buyers. The storage and advertising costs are incidental expenses, and Maud
will recover them.
17-2d The UCC and Damages
Under the Uniform Commercial Code (UCC), remedies for breach of contract in the sale of
goods are similar to the general rules discussed throughout this chapter. UCC §§2-703
through 2-715 govern the remedies available to buyers and sellers.2
Bi-Economy sued, claiming that Harleysville’s slow,
inadequate payments destroyed the company. The com-
pany also sought consequential damages for the perma-
nent destruction of its business. Harleysville claimed that
it was only responsible for damages specified in the con-
tract: the building, inventory, and lost income. The trial
court granted summary judgment for Harleysville. The
appellate court affirmed, claiming that when they entered
into the contract, the parties did not contemplate damages
for termination of the business. Bi-Economy appealed to
the state’s highest court.
You Be the Judge: Is Bi-Economy entitled to consequential
damages for the destruction of its business?
Argument for Bi-Economy: Bi-Economy is a small,
family business. We paid for business interruption insur-
ance for an obvious reason: In the event of a disaster, we
lacked the resources to keep going while buildings were
constructed and inventory purchased. We knew that in
such a calamity, we would need prompt reimbursement—
compensation covering the immediate damage and our
ongoing lost income. Why else would we pay the pre-
miums?
At the time we entered into the contract, Harleysville
could easily foresee that if it responded slowly, with insuffi-
cient payments, we could not survive. They knew that is
what we wanted to avoid—and it is just what happened.
The insurer’s bad faith offer of a low figure, and its payment
of only seven months’ lost income, ruined a fine family
business. When the insurance company agreed to business
interruption coverage, it was declaring that it would act fast
and fairly to sustain a small firm in crisis. The insurer should
now pay for the full harm it has wrought.
Argument for Harleysville: We contracted to
insure the Market for three losses: its building, inventory,
and lost income. After the fire, we performed a reason-
able, careful evaluation and made an offer we considered
fair. An arbitrator later awarded Bi-Market additional
money, which we paid. However it is absurd to suggest
that in addition to that, we are liable for an open-ended
commitment for permanent destruction of the business.
Consequential damages are appropriate in cases
where a plaintiff suffers a loss that was not covered in
the contract. In this case, though, the parties bargained
over exactly what Harleysville would pay in the event of a
major fire. If the insurer has underpaid for lost income, let
the court award a fair sum. However, the parties never
contemplated an additional, enormous payment for cessa-
tion of the business. There is almost no limit as to what
that obligation could be. If Bi-Market was concerned that
a fire might put the company permanently out of busi-
ness, it should have said so at the time of negotiating for
insurance. The premium would have been dramatically
higher.
Neither Bi-Market nor Harleysville ever imagined
such an open-ended insurance obligation, and the insurer
should not pay an extra cent.
2We discuss these remedies in greater detail in Unit 3, on commercial transactions.
Incidental damages
Relatively minor costs that the
injured party suffers when
responding to the breach.
CHAPTER 17 Remedies 383
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SELLER’S REMEDIES
If a buyer breaches a sale of goods contract, the seller generally has at least two remedies.
She may resell the goods elsewhere. If she acts in good faith, she will be awarded the
difference between the original contract price and the price she was able to obtain in the
open market. Assume that Maud, the manufacturer, had a contract to sell her shoes to Foot
The Bill for $55 per pair and Foot The Bill’s breach forces her to sell them on the open
market, where she gets only $48 per pair. Maud will win $7 per pair times 5,000 pairs, or
$35,000, from Foot The Bill.
Alternatively, the buyer may choose not to resell and settle for the difference between
the contract price and the market value of the goods. Maud, in other words, may choose to
keep the shoes. If she can prove that their market value is $48 per pair, for example, by
showing what other retailers would have paid her for them, she will still get her $7 each,
representing the difference between what the contract promised her and what the market
would support. In either case, the money represents direct damages. Maud is also entitled
to incidental damages, such as the storage and advertising expenses described above. But
there is one significant difference under the UCC: Most courts hold that the seller of
goods is not entitled to consequential damages. Suppose Maud hired two extra workers to
inspect, pack, and ship the shoes for Foot The Bill. Those are consequential damages, but
Maud will not recover them because she is the seller and the contract is for the sale of
goods.
BUYER’S REMEDIES
The buyer’s remedies in sale of goods contracts (which are, as always, governed by the
Uniform Commercial Code) are similar to those we have already considered. She typically
has two options. First, the buyer can “cover” by purchasing substitute goods. To cover
means to make a good faith purchase of goods similar to those in the contract. The buyer
may then obtain the difference between the original contract price and her cover price.
Alternatively, if the buyer chooses not to cover, she is entitled to the difference between the
original contract price and the market value of the goods.
Suppose Mary has contracted to buy 1,000 six-foot Christmas trees at $25 per tree
from Elmo. The market suddenly rises, and not feeling the spirit of the season, Elmo
breaches his deal and sells the trees elsewhere. If Mary makes a good faith effort to
cover but is forced to pay $40 per tree, she may recover the difference from Elmo,
meaning $15 per tree times 1,000 trees, or $15,000. Similarly, if she chooses not to
cover but can prove that $40 is now the market value of the trees, she is entitled to her
$15 per tree.
Under the UCC, the buyer is entitled to consequential damages, provided that the seller
could reasonably have foreseen them. If Mary tells Elmo, when they sign their deal, that she
has a dozen contracts to resell the trees for an average price of $50 per tree, she may recover
$25 per tree, representing the difference between her contract price with Elmo and the
value of the tree to her, based on her other contracts.3 If she failed to inform Elmo of the
other contracts, she would not receive any money based on them. The buyer is also entitled
to whatever incidental damages may have accrued.
Cover
To make a good faith purchase
of goods similar to those in the
contract.
3As we discuss in the section on mitigation later in the chapter, Mary will get only her consequential
damages if she attempts to cover.
384 U N I T 2 Contracts
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EXAM Strategy
Question: Chloe is a fashion designer. Her recent collection of silk-velvet evening
gowns was gobbled up by high-end retailers, who now clamor for more. Chloe needs
300 yards of the same fabric by August 15. Mill House, which has supplied fabric to
Chloe for many years, agrees to sell her 300 yards at $100 per yard, delivered on
August 15. The market value of the fabric is $125, but Mill House gives Chloe a break
because she is a major customer.
Chloe contracts with Barneys and Neiman Marcus to sell a total of 50 dresses, at an
additional profit to Chloe of $800 per dress. On August 15, Mill House delivers
defective fabric. Chloe cannot make her dresses in time, and the retailers cancel their
orders. Chloe sues Mill House and wins—but what are her damages?
Strategy: To determine damages, first ask whether the contract is governed by the
common law or the UCC. This agreement concerns goods, so the Code applies. The
UCC permits a buyer to recover damages for the difference between the contract
price and the market value of the goods. The Code also allows consequential damages
if the seller could have foreseen them. Apply those standards.
Result: Because Chloe’s contract enabled her to save $25 per yard for 300 yards, she
is entitled to $7,500. Chloe has also lost profits of $40,000. Mill House could easily
have foreseen those losses because the supplier knew that Chloe was a designer who
fabricated and sold dresses. Chloe is entitled to $47,500.
We turn now to instances where the injured party cannot prove expectation damages.
17-3 RELIANCE INTEREST
To win expectation damages, the injured party must prove the breach of contract caused
damages that can be quantified with reasonable certainty. This rule sometimes presents
plaintiffs with a problem.
George plans to manufacture and sell silk scarves during the holiday season. In the
summer, he contracts with Cecily, the owner of a shopping mall, to rent a high-visibility stall
for $100 per day. George then buys hundreds of yards of costly silk and gets to work cutting
and sewing. But in September, Cecily refuses to honor the contract. George sues and proves
Cecily breached a valid contract. But what is his remedy?
George cannot establish an expectation interest in his scarf business. He hoped to sell
each scarf for a $40 gross profit. He planned on making $2,000 per day. But how much would
he actually have earned? Enough to retire on? Enough to buy a salami sandwich for lunch?
He has no way of proving his profits, and a court cannot give him his expectation interest.
Instead, George will ask for reliance damages.The reliance interest is designed to put an injured
party in the position he would have been in had the parties never entered into a contract. This
remedy focuseson the timeandmoney the injuredparty spentperforminghispart of the agreement.
George should be able to recover reliance damages from Cecily. Assuming he is unable
to sell the scarves to a retail store, which is probable since retailers will have made purchases
long ago, George should be able to recover the cost of the silk fabric he bought and perhaps
something for the hours of labor he spent cutting and sewing. But reliance damages can be
difficult to win because they are harder to quantify. Courts prefer to compute damages using
Reliance interest
Puts the injured party in the
position he would have been in
had the parties never entered
into a contract.
CHAPTER 17 Remedies 385
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the numbers provided in a contract. If a contract states a price of $25 per Christmas tree and
one party breaches, the arithmetic is easy. Judges can become uncomfortable when asked to
base damages on vague calculations. How much was George’s time worth in making the
scarves? How good was his work? How likely were the scarves to sell? If George has a track
record in the industry, he will be able to show a market price for his services. Without such a
record, his reliance claim becomes a tough battle.
17-3a Promissory Estoppel
We have seen in earlier chapters that a plaintiff may sometimes recover damages based on
promissory estoppel even when there is no valid contract. The plaintiff must show that the
defendant made a promise knowing that the plaintiff would likely rely on it, that the
plaintiff did rely, and that the only way to avoid injustice is to enforce the promise. In
promissory estoppel cases, a court will generally award reliance damages. It would be unfair to
give expectation damages for the full benefit of the bargain when, legally speaking, there
has been no bargain.
In the following case, the victorious plaintiff demonstrates how unreliable reliance
damages are and how winning can be hard to distinguish from losing.
TOSCANO V. GREENE MUSIC
124 Ca. App. 4th 685, 21 Ca.Rptr.3d 732
Court of Appeal of California, 2004
C A S E S U M M A R Y
Facts: Joseph Toscano was the general manager of Fields
Pianos (Fields) inSantaAna,California.Hewasunhappywith
his job and decided to seek other employment. Toscano
contactedMichael Greene, who owned similar stores. In July,
Greene offered Toscano a sales management job, starting
September 1. Relying on that offer, Toscano resigned from
Fields on August 1. However, in mid-August, Greene with-
drewhis employment offer.Toscano later found lower-paying
jobs in other cities.
Toscano sued Greene for breach of contract and pro-
missory estoppel. Greene argued that Toscano was not
entitled to any expectation damages because his employ-
ment with Greene would have been at will, meaning he
could lose the job at any time. Greene also urged that
because Toscano was an at-will employee at Fields, he
could recover at most one month’s lost wage.
The trial court ruled that Toscano was entitled to
reliance damages for all lost wages at Fields, starting from
the day he resigned, going forward until his anticipated
retirement in 2017. Toscano’s expert accountant calcu-
lated his past losses (until the time of trial) at $119,061,
and his future lost earnings at $417,772. The trial court
awarded Toscano $536,833, and Greene appealed.
Issue: Was Toscano entitled to reliance damages?
Decision: Yes, Toscano was entitled to reliance damages,
but only as recalculated after a new trial.
Reasoning: Toscano gave up his job with Fields, relying
on Greene’s promise of employment, but was then denied
his new position. Toscano made a claim of promissory estop-
pel. Because this is an equitable doctrine, a court applying it
must make a particular effort to do what is right and just.
A plaintiff such asToscano, lured away by a job promise
that goes unfulfilled, should be allowed to recover the
wages he lost at his former employment. That is basic fair-
ness. Further, Toscano should not be denied compensation
merely because he was an at-will employee at his former
job. Any other holding would contradict the basic equitable
principles mentioned. However, when the lower court
awarded Toscano lost future earnings from the time of trial
to his retirement, it went too far.
Toscano’s expert on damages was Roberta Spoon. In
calculating Toscano’s lost future wages, she assumed that
without the job offer from Greene, he would have remained
with Fields until he retired. She made this assumption based
on the fact that, in the past, Toscano had never changed jobs
386 U N I T 2 Contracts
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Notice that the court never even mentions that Toscano acted in good faith, relying on
Greene’s promise, while the latter offered no excuse for suddenly withdrawing his offer. Is it
fair to permit Greene to escape all liability? This court, like most, simply will not award
significant damages where there is no contract permitting a clear calculation of losses.
The judges, though, have not entirely closed the door on Toscano. What is the purpose
of the remand? What might Toscano demonstrate on remand? What practical difficulties will
he encounter?
17-4 RESTITUTION INTEREST
Lillian and Harold Toews signed a contract to sell 1,500 acres of Idaho farmland to Elmer
Funk. (No, not that one—the Bugs Bunny character you are thinking of is Elmer Fudd.) He
was to take possession immediately, but he would not receive the deed until he finished
paying for the property, in 10 years. This arrangement enabled him to enroll in a govern-
ment program that would pay him “set-asides” for not farm-
ing. Funk kept most aspects of his agreement. He did
move onto the land and did receive $76,000 from the
government for a year’s worth of inactivity. (Nice work if
you can get it.) The only part of the bargain Funk did not
keep was his promise to pay. Lillian and Harold sued. Funk
had clearly breached the deal. But what remedy?
The couple still owned the land, so they did not need
it reconveyed. Funk had no money to pay for the farm, so
they would never get their expectation interest. And they
had expended almost no money based on the deal, so they
had no reliance interest. What they had done, though, was
to confer a benefit on Funk. They had enabled him to obtain
$76,000 in government money. Harold and Lillian wanted a
return of the benefit they had conferred on Funk, a remedy
called restitution. The restitution interest is designed to return to the injured party a benefit
that he has conferred on the other party, which it would be unjust to leave with that person.
The couple argued that they had bestowed a $76,000 benefit on Funk and that it made
absolutely no sense for him to keep it. The Idaho Court of Appeals agreed. It ruled that the
couple had a restitutionary interest in the government set-aside money and ordered Funk to
pay them the money.4
for any reason except an increase in pay. Her assumption,
however, missed the basic point of at-will employment.
WhetherToscano intended to remainwith Fields until retire-
ment was irrelevant. What counts was whether the Fields
company itself wanted Toscano to remain. Because he was
an at-will employee, Fields could have terminated him any
time it wanted, for virtually any reason.
For an expert witness to assume that Toscano would
remain at the same job for nearly a decade and a half
was sheer speculation. Toscano should have presented
testimony from Jerry Goldman, Toscano’s boss at Fields,
or some other evidence indicating that he would have
been permitted to remain at the company until he retired.
The lower court award of past losses, until the time of
trial, was affirmed. The award of lost future earnings
was vacated, and the case was remanded for a new trial
on those damages only. The judgment was otherwise
affirmed.
4Toews v. Funk, 129 Idaho 316, 924 P.2d 217, 1994 Idaho App. LEXIS 75 (Idaho Ct. App. 1994).
Restitution interest
Is designed to return to the
injured party a benefit he has
conferred on the other party.
He did move onto the
land and did receive
$76,000 from the
government for a year’s
worth of inactivity. (Nice
work if you can get it.)
CHAPTER 17 Remedies 387
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Restitution is awarded in two types of cases. First, the law allows restitution when
the parties have reached a contract and one of them breaches, as Funk did. In such
cases, a court may choose restitution because no other remedy is available or because no
other remedy would be as fair. Second, courts may award restitution in cases of quasi-
contract, which we examined in Chapter 9. In quasi-contract cases, the parties never
made a contract, but one side did benefit the other. We consider each kind of restitu-
tion interest in turn.
17-4a Restitution in Cases of a Voidable Contract
Restitution is a common remedy in contracts involving fraud, misrepresentation,
mistake, and duress. In these cases, restitution often goes hand in hand with rescission,
which means to “undo” a contract and put the parties where they were before they made
the agreement. Courtney sells her favorite sculpture to Adam for $95,000, both parties
believing the work to be a valuable original by Barbara Hepworth. Two months later, Adam
learns that the sculpture is a mere copy, worth very little. A court will permit Adam to
rescind the contract on the ground of mutual mistake. At the same time, Adam is entitled to
restitution of the purchase price. Courtney gets the worthless carving, and Adam receives
his money back.
The following case involved fraud in the sale of a valuable property.
PUTNAM CONSTRUCTION & REALTY CO. V. BYRD
632 So.2d 961, 1992 Ala. LEXIS 1289
Supreme Court of Alabama, 1992
C A S E S U M M A R Y
Facts: Putnam Construction & Realty Co. owned the Uni-
versity Square Business Center (USBC), an office complex
with several major tenants, including McDonnell-Douglas,
TRW, and the Army Corps of Engineers. William Byrd and
some partners (the “buyers”) entered into a contract to buy
USBC for slightly over $17 million. They financed the pur-
chase with a $16.2 million loan from Northwestern Mutual
Life. Northwestern’s loan was secured with a mortgage on
the USBC, meaning that if the borrowers failed to repay the
loan, Northwestern would own the property. Shortly after the
sale closed, Byrd learned that several of the major tenants
were leaving. The buyers sued Putnam, seeking rescission of
the contract and restitution of their money. The trial court
found that Putnam (the “sellers”) had committed fraud. It
rescinded the sales contract, returning the property to the
sellers. It ordered the sellers to assume full liability for the
mortgage. The trial court did not, however, order restitution
of the buyers’ expenses, such as the closing costs. The sellers
appealed—which proved to be a big mistake.
Issue: Were the buyers entitled to rescission and/or restitution?
Decision: Yes. The buyers were entitled to both rescis-
sion and restitution.
Reasoning: The sellers knew that the Corps of Engi-
neers planned to build its own facility and vacate the
USBC, yet they told the buyers that the Corps would be
staying. They also knew that McDonnell-Douglas was
leaving but failed to inform the buyers. The sellers clearly
committed fraud.
Money damages would be speculative and would
leave the buyers saddled with a property that operates at
a steadily increasing loss. The fairest way to compensate
them was by rescinding the contract, and the trial court’s
ruling on that issue was affirmed. However, the buyers
also incurred substantial out-of-pocket expenses because
of the sellers’ fraud. To compensate them for these losses,
they were entitled to receive restitution damages of
$483,006.75 in closing costs, $121,000 in mortgage interest
payments, and $500,000 in nonrefundable fees paid to
Northwestern to obtain the loan. The case was remanded
for the trial court to impose all of these remedies.
Rescission
To “undo” a contract and put
the parties where they were
before they made the
agreement.
388 U N I T 2 Contracts
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Ethics Imagine that you are the officer from Putnam in charge of negotiating the
sale of USBC to the buyers. You learn that several major tenants are
soon to depart and realize that if the buyers learn this, they will lower their offer or reject the
deal altogether. Your boss insists you tell the buyers that all tenants will be staying. What
will you do? What Life Principles will you apply?
17-4b Restitution in Cases of a Quasi-Contract
George Anderson owned a valuable 1936 Plymouth. He took it to Ronald Schwegel’s repair
shop, and the two orally agreed that Schwegel would restore the car for $6,000. Unfortunately,
they never agreed on the meaning of the word restore. Anderson thought the term meant
complete restoration, including body work and engine repairs, whereas Schwegel intended
body work but no engine repairs. After doing some of the work, Schwegel told Anderson that
the car needed substantial engine work, and he asked for Anderson’s permission to allow an
engine shop to do it. Anderson agreed, believing the cost was included in the original estimate.
When the car was finished and running smoothly, Schwegel demanded $9,800. Anderson
refused to pay more than the $6,000 agreed price, and Schwegel sued.
The court held that there was no valid contract between the parties. A contract requires
a meeting of the minds. Here, said the court, there was no meeting of the minds on what
restore included, and hence Schwegel could not recover either his expectation or his reliance
interest since both require an enforceable agreement. Schwegel then argued that a quasi-
contract existed. In other words, he claimed that even if there had been no valid agreement,
he had performed a service for Anderson and that it would be unjust for Anderson to keep it
without paying. A court may award restitution, even in the absence of a contract, where one
party has conferred a benefit on another and it would be unjust for the other party to retain
the benefit. The court ruled that Schwegel was entitled to the full $3,800 above and beyond
the agreed price because that was the fair market value of the additional work. Anderson
had asked for the repairs and now had an auto that was substantially improved. It would be
unjust, ruled the court, to permit him to keep that benefit for free.5
17-5 OTHER REMEDIES
In contract lawsuits, plaintiffs are occasionally awarded the remedies of specific perfor-
mance, injunction, and reformation.
17-5a Specific Performance
Leona Claussen owned Iowa farmland. She sold some of it to her sister-in-law, Evelyn
Claussen, and, along with the land, granted Evelyn an option to buy additional property at
$800 per acre. Evelyn could exercise her option anytime during Leona’s lifetime or within
six months of Leona’s death. When Leona died, Evelyn informed the estate’s executor that
she was exercising her option. But other relatives wanted the property, and the executor
refused to sell. Evelyn sued and asked for specific performance. She did not want an award of
damages; she wanted the land itself. The remedy of specific performance forces the two
parties to perform their contract.
5Anderson v. Schwegel, 118 Idaho 362, 796 P.2d 1035, 1990 Idaho App. LEXIS 150 (Idaho Ct. App.
1990).
CHAPTER 17 Remedies 389
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A court will award specific performance, ordering the parties to perform the contract,
only in cases involving the sale of land or some other asset that is considered “unique.”
Courts use this remedy when money damages would be inadequate to compensate an
injured party. If the subject is unique and irreplaceable, money damages will not put the
injured party in the same position she would have been in had the agreement been kept. So
a court will order the seller to convey the rare object and the buyer to pay for it.
Historically, every parcel of land has been regarded as unique, and therefore specific perfor-
mance is always available in real estate contracts. Family heirlooms and works of art are also often
considered unique. Evelyn Claussen won specific performance. The Iowa Supreme Court
ordered Leona’s estate to convey the land to Evelyn for $800 per acre.6 Generally speaking,
either the seller or the buyer may be granted specific performance. One limitation in land sales is
that a buyer may obtain specific performance only if she was ready, willing, and able to purchase
the property on time. If Evelyn had lacked the money to buy Leona’s property for $800 per acre
within the six-month time limit, the court would have declined to order the sale.
EXAM Strategy
Question: TheMonroes, a retired couple who live in Illinois, want to move to Arizona to
escape thenorthernwinter. InMay, theMonroes contract inwriting to sell their house to the
Temples for $450,000. Closing is to take place June 30. The Temples pay a deposit of
$90,000. However, in early June, the Monroes travel through Arizona and discover it is too
hot for them. They promptly notify the Temples they are no longer willing to sell, and
return the $90,000, with interest. The Temples sue, seeking the house. In response, the
Monroes offer evidence that the value of the house has dropped from about $450,000 to
about $400,000. They claim that the Temples have suffered no loss. Who will win?
Strategy: Most contract lawsuits are for money damages, but not this one. The Temples
want the house. Because they want the house itself, and not money damages, the drop in
value is irrelevant. What legal remedy are the Temples seeking? They are suing for
specific performance. When will a court grant specific performance? Should it do so here?
Result: In cases involving the sale of land or some other unique asset, a court will
grant specific performance, ordering the parties to perform the agreement. All houses
are regarded as unique. The court will force the Monroes to sell their house, provided
the Temples have sufficient money to pay for it.
Other unique items, for which a court will order specific performance, include such
things as secret formulas, patents, and shares in a closely held corporation. Money damages
would be inadequate for all these things since the injured party, even if she got the cash,
could not go out and buy a substitute item. By contrast, a contract for a new Cadillac
Escalade is not enforceable by specific performance. If the seller breaches, the buyer is
entitled to the difference between the contract price and the market value of the car. The
buyer can take his money elsewhere and purchase a virtually identical SUV.
17-5b Injunction
In the opening scenario, the NFL team’s general manager considered whether to seek an
injunction against his running back who wanted to leave the team and act in a TV show. An
injunction is a court order that requires someone to refrain from doing something.
6In re Estate of Claussen, 482 N.W.2d 381, 1992 Iowa Sup. LEXIS 52 (Iowa 1992).
390 U N I T 2 Contracts
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In the increasingly litigious world of professional sports, injunctions are commonplace.
In the following basketball case, the trial court issued a preliminary injunction; that is, an
order issued early in a lawsuit prohibiting a party from doing something during the course of the
lawsuit. The court attempts to protect the interests of the plaintiff immediately. If, after trial,
it appears that the plaintiff has been injured and is entitled to an injunction, the trial court
will make its order a permanent injunction. If it appears that the preliminary injunction
should never have been issued, the court will terminate the order.
MILICIC V. BASKETBALL MARKETING COMPANY, INC.
2004 Pa.SUPER. 333, 857 A.2d 689
Superior Court of Pennsylvania, 2004
C A S E S U M M A R Y
Facts: The Basketball Marketing Company (BMC) mar-
keted, distributed, and sold basketball apparel and related
products. BMC signed a long-term endorsement contract with
a 16-year-old Serbian player, Darko Milicic, who was virtually
unknown in theUnitedStates.Twoyears later,Milicic became
the second pick in the National Basketball Association’s draft,
making him an immensely marketable young man.
Four days after his 18th birthday, Milicic made a buy-
out offer to BMC, seeking release from his contract so that
he could arrange a more lucrative one elsewhere. BMC
refused to release him. A week later, Milicic notified
BMC in writing that he was disaffirming the contract,
and he returned all money and goods he had received
from the company. BMC again refused to release Milicic.
Believing that Milicic was negotiating an endorse-
ment deal with either Reebok or Adidas, BMC sent both
companies letters informing them it had an enforceable
endorsement deal with Milicic that was valid for several
more years. Because of BMC’s letter, Adidas ceased nego-
tiating with Milicic just short of signing a contract. Milicic
sued BMC, seeking a preliminary injunction that would
prohibit BMC from sending such letters to competitors.
The trial court granted the preliminary injunction and
BMC appealed.
Issue: Was Milicic entitled to a preliminary injunction?
Decision: Yes, Milicic was entitled to a preliminary injunc-
tion. Affirmed.
Reasoning: Like any plaintiff seeking a preliminary
injunction, Milicic had to prove four elements.
First, Milicic had to prove his case had a strong like-
lihood of success on the merits. Under Pennsylvania law, a
minor may void a contract by disaffirming it within a
reasonable time of turning 18 years old. Milicic sent
BMC a letter only 11 days after his 18th birthday, unequi-
vocally stating that he disavowed the agreement made
when he was a minor. In all likelihood, Milicic will suc-
ceed in nullifying the contract with BMC.
Second, he had to prove injunctive relief was neces-
sary to prevent immediate and irreparable harm for which
money damages would not adequately compensate
Milicic. Top NBA picks negotiate and secure endorse-
ments quickly, to take advantage of the excitement and
publicity generated by the draft. BMC blocked Milicic’s
efforts to conclude an agreement with Adidas. Continued
obstruction would have caused Milicic irreparable harm.
Third, denying the injunction would cause greater
injury than granting it. BMC violated important public pol-
icy by refusing to acknowledge a minor’s power to disaffirm.
The law presumes that a minor lacks the maturity to negoti-
ate such an important agreement.When a company wants to
conclude a contract with a minor, it is well-established
practice to ask that a court appoint a guardian for the minor.
It is astonishing that BMC, a company whose business was
based entirely on contract law, failed to protect Milicic’s
interest—and its own—by requesting a guardian.
Finally, Milicic had to prove that a preliminary
injunction would restore the parties to the status quo that
existed when he turned 18, by preventing BMC from
further interfering with Milicic’s negotiations. The lower
court properly granted injunctive relief.
CHAPTER 17 Remedies 391
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17-5c Reformation
The final remedy, and perhaps the least common, is reformation, a process in which a court
will partially rewrite a contract. Courts seldom do this because the whole point of a contract
is to enable the parties to control their own futures. But a court may reform a contract if it
believes a written agreement includes a simple mistake. Suppose that Roger orally agrees to
sell 35 acres to Hannah for $600,000. The parties then draw up a written agreement,
accidentally describing the land as including 50 additional acres that neither party consid-
ered part of the deal. Roger refuses to sell. Hannah sues for specific performance but asks
the court to reform the written contract to reflect the true agreement. Most but not all courts
would reform the agreement and enforce it.
A court may also reform a contract to save it. If Natasha sells her advertising business to
Joseph and agrees not to open a competing agency in the same city anytime in the next
10 years, a court may decide that it is unfair to force her to wait a decade. It could reform the
agreement and permit Natasha to compete, say, 3 years after the sale. But some courts are
reluctant to reform contracts and would throw out the entire noncompetition agreement
rather than reform it. Parties should never settle for a contract that is sloppy or overbroad,
assuming that a court will later reform errors. They may find themselves stuck with a
bargain they dislike, or with no contract at all.
17-6 SPECIAL ISSUES
Finally, we consider some special issues of damages, beginning with a party’s obligation to
minimize its losses.
17-6a Mitigation of Damages
A party injured by a breach of contract may not recover for damages that he could have avoided
with reasonable efforts. In other words, when one party perceives that the other has breached
or will breach the contract, the injured party must try to prevent unnecessary loss. A party is
expected to mitigate his damages; that is, to keep damages as low as he reasonably can.
Malcolm agrees to rent space in his mall to Zena, for a major department store. As part of
the lease, Malcolm agrees to redesign the interior to meet her specifications. After Malcolm
has spent $20,000 in architect and design fees, Zena informs Malcolm that she is renting other
space and will not occupy his mall. Malcolm nonetheless continues the renovation work,
spending an additional $50,000 on materials and labor. Malcolm will recover the lost rental
payments and the $20,000 expended in reliance on the deal. He will not recover the extra
$50,000. He should have stopped work when he learned of Zena’s breach.
17-6b Nominal Damages
Nominal damages are a token sum, such as one dollar, given to a plaintiff who demonstrates
that the defendant breached the contract but cannot prove serious injury. A school board
unfairly fires Gemma, a teacher. If she obtains a teaching job at a better school for identical
pay the very next day, she probably can show no damages at all. Nonetheless, the school
wrongfully terminated her, and a court may award nominal damages. Nominal damages
provide plaintiff with a “moral victory.”
17-6c Liquidated Damages
It can be difficult or even impossible to prove how much damage the injured party has
suffered. So lawyers and executives negotiating a deal may include in the contract a liqui-
dated damages clause, a provision stating in advance how much a party must pay if it
Reformation
A process in which a court will
partially rewrite a contract.
Mitigate
To keep damages as low as
reasonable.
Nominal damages
A token sum, such as one
dollar, given to a plaintiff who
demonstrates a breach but no
serious injury.
Liquidated damages
A clause stating in advance how
much a party must pay if it
breaches.
392 U N I T 2 Contracts
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breaches. Assume that Laurie has hired Bruce to build a five-unit apartment building for
$800,000. Bruce promises to complete construction by May 15. Laurie insists on a liquidated
damages clause providing that if Bruce finishes late, Laurie’s final price is reduced by $3,000 for
each week of delay. Bruce finishes the apartment building June 30, and Laurie reduces her
payment by $18,000. Is that fair? The answer depends on two factors: A court will generally
enforce a liquidated damages clause if (1) at the time of creating the contract, it was very
difficult to estimate actual damages, and (2) the liquidated amount is reasonable. In any other
case, the liquidated damage will be considered a mere penalty and will prove unenforceable.
We will apply the two factors to Laurie’s case. When the parties made their agreement,
would it have been difficult to estimate actual damages caused by delay? Yes. Laurie could
not prove that all five units would have been occupied or how much rent the tenants would
have agreed to pay. Was the $3,000 per week reasonable? Probably. To finance an $800,000
building, Laurie will have to pay at least $6,000 interest per month. She must also pay taxes
on the land and may have other expenses. Laurie does not have to prove that every penny
of the liquidated damages clause is justified, but only that the figure is reasonable. A court
will probably enforce her liquidated damages clause.
On the other hand, suppose Laurie’s clause demanded $3,000 per day. There is no basis for
such a figure, and a court will declare it a penalty clause and refuse to enforce it. Laurie will be back
to square one, forced to prove in court any damages she claims to have suffered fromBruce’s delay.
In the chapter’s opening scenario, the alarm company tries to invoke a liquidated
damages clause that would leave Ben largely uncompensated. Depending on what the
parties knew when they made the agreement, a court may well find the clause too harsh
and permit Ben to sue for his actual losses.
EXAM Strategy
Question: In March, James was accepted into the September ninth-grade class at
the Brookstone Academy, a highly competitive private school. To reserve his spot,
James’s father, Rex, sent in a deposit of $2,000 and agreed in writing to pay the
balance due, $19,000. If James withdrew in writing from the school by August 1, Rex
owed nothing more to Brookstone. However, once that date passed, Rex was obliged
to pay the full $19,000, whether or not James attended. On August 5, Rex hand-
delivered to Brookstone a letter stating that James would not attend. Brookstone
demanded the full tuition and, when Rex refused to pay, sued for $19,000. Analyze
the case.
Strategy: When one party seeks contract damages that are specified in the
agreement, it is relying on a liquidated damages clause. A court will generally enforce
a liquidated damages clause provided the plaintiff can prove two things. What are
those two things? Can this plaintiff meet that standard?
Result: Brookstone must prove that at the time of creating the contract it was
difficult to estimate actual damages and that the liquidated amount is reasonable. Rex
will probably argue that the liquidated amount is unreasonable, contending that a
competitive school can quickly fill a vacancy with another eager applicant. Brookstone
will counter that budgeting, which begins in January, is difficult and imprecise.
Tuition money goes toward staff salaries, maintenance, utilities, and many other
expenses. If the school cannot not rely in January on a certain income, the calculation
becomes impossible. Rex had four months to make up his mind, and by August 1, the
school was firmly committed to its class size and budget. In a similar case, the court
awarded the full tuition to the school, concluding that the sum was a reasonable
estimate of the damages.
CHAPTER 17 Remedies 393
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Chapter Conclusion
The powers of a court are broad and flexible and may suffice to give an injured party what it
deserves. But problems of proof and the uncertainty of remedies demonstrate that the best
solution is a carefully drafted contract and socially responsible behavior.
EXAM REVIEW
1. BREACH Someone breaches a contract when he fails to perform a duty without a
valid excuse. (pp. 378–379)
2. REMEDY A remedy is the method a court uses to compensate an injured party. (p. 378)
3. INTERESTS An interest is a legal right in something, such as a contract. The first step
that a court takes in choosing a remedy is todecidewhat interest it is protecting. (pp. 378–379)
4. EXPECTATION The expectation interest puts the injured party in the position
she would have been in had both sides fully performed. It has three components:
(a) Direct damages, which flow directly from the contract.
(b) Consequential damages, which result from the unique circumstances of the particular
injured party. The injured party may recover consequential damages only if the
breaching party should have foreseen them.
(c) Incidental damages, which are the minor costs an injured party incurs responding to a
breach. (pp. 379–385)
Question: Mr. and Ms. Beard contracted for Builder to construct a house on
property he owned and sell it to the Beards for $785,000. The house was to be
completed by a certain date, and Builder knew that the Beards were selling their
own home in reliance on the completion date. Builder was late with construction,
forcing the Beards to spend $32,000 in rent. Ultimately, Builder never finished the
house, and the Beards moved elsewhere. They sued. At trial, expert testimony
indicated the market value of the house as promised would have been $885,000.
How much money are the Beards entitled to, and why?
Strategy: Normally, in cases of property, an injured plaintiff may use specific
performance to obtain the land or house. However, there is no house, so there will
be no specific performance. The Beards will seek their expectation interest.
Under the contract, what did they reasonably expect? They anticipated a finished
house, on a particular date, worth $885,000. They did not expect to pay rent while
waiting. Calculate their losses. (See the“Result” at the end of this section.)
5. RELIANCE The reliance interest puts the injured party in the position he would
have been in had the parties never entered into a contract. It focuses on the time and
money that the injured party spent performing his part of the agreement. If there was
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394 U N I T 2 Contracts
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no valid contract, a court might still award reliance damages under a theory of
promissory estoppel. (pp. 385–387)
Question: Bingo is emerging as a rock star. His last five concerts have all sold
out. Lucia signs a deal with Bingo to perform two concerts in one evening in Big
City for a fee of $50,000 for both shows. Lucia then rents the Auditorium for that
evening, guaranteeing to pay $50,000. Bingo promptly breaks the deal before any
tickets are sold. Lucia sues, pointing out that the Auditorium seats 3,000 and she
anticipated selling all tickets for an average of $40 each, for a total gross of
$120,000. How much will Lucia recover, if anything?
Strategy: The parties created a valid contract, and Lucia relied on it. She claims
two losses: the payment to rent the hall and her lost profits. A court may award
reliance damages if the plaintiff can quantify them, provided the damages are not
speculative. Can Lucia quantify either of those losses? Both of them? Were they
speculative? (See the“Result” at the end of this section.)
6. RESTITUTION The restitution interest returns to the injured party a benefit that
she has conferred on the other party which would be unjust to leave with that
person. Restitution can be awarded in the case of a contract created, for example, by
fraud, or in a case of quasi-contract, where the parties never created a binding
agreement. (pp. 387–389)
7. SPECIFIC PERFORMANCE Specific performance, ordered only in cases of
land or a unique asset, requires both parties to perform the contract. (pp. 389–390)
8. INJUNCTION An injunction is a court order that requires someone to do
something or refrain from doing something. (pp. 390–391)
9. REFORMATION Reformation is the process by which a court will—occasionally—
rewrite a contract to ensure that it accurately reflects the parties’ agreement and/or to
maintain the contract’s viability. (p. 392)
10. MITIGATION The duty to mitigate means that a party injured by a breach of
contract may not recover for damages that he could have avoided with reasonable
efforts. (p. 392)
Question: Ambrose hires Bierce for $25,000 to supervise the production of
Ambrose’s crop, but then breaks the contract by firing Bierce at the beginning of
the season. A nearby grower offers Bierce $23,000 for the same growing season,
but Bierce refuses to take such a pay cut. He stays home and sues Ambrose. How
much money, if any, will Bierce recover from Ambrose, and why?
Strategy: Ambrose has certainly breached the contract. The injured party normally
receives the difference between his expectation interest and what he actually
received. Bierce expected $25,000 and received nothing. However, Bierce made no
effort to minimize his losses. How much would Bierce have lost had he mitigated?
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CHAPTER 17 Remedies 395
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11. NOMINAL DAMAGES Nominal damages are a token sum, such as one dollar,
given to an injured plaintiff who cannot prove damages. (p. 392)
12. LIQUIDATED DAMAGES A liquidated damages clause will be enforced if and
only if, at the time of creating the contract, it was very difficult to estimate actual
damages and the liquidated amount is reasonable. (pp. 392–393)
4. Result: The Beards’ direct damages represent the difference between the
market value of the house and the contract price. They expected a house worth
$100,000 more than their contract price, and they are entitled to that sum. They
also suffered consequential damages. The Builder knew they needed the house as
of the contract date, and he could foresee that his breach would force them to pay
rent. He is liable for a total of $132,000.
5. Result: Lucia can easily demonstrate that Bingo’s breach cost her $50,000—the
cost of the hall. However, it is uncertain how many tickets she would have sold.
Unless Lucia has a strong track record selling tickets to concerts featuring Bingo, a
court is likely to conclude that her anticipated profits were speculative. She will
probably receive nothing for that claim.
10. Result: Even if he had mitigated, Bierce would have lost $2,000. He is entitled
to that sum. However, he cannot recover the remaining $23,000. After Ambrose
breached, Bierce had identical work available to him, but he failed to take it. His
failure to mitigate is fatal.
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Master Mfg., Inc., contracted with Accur Computer Repair Corp.
to maintain Master’s computer system. Master’s manufacturing process depends on its
computer system operating properly at all times. A liquidated damages clause in the
contract provided that Accur would pay $1,000 to Master for each day that Accur was
late responding to a service request. On January 12, Accur was notified that Master’s
computer system had failed. Accur did not respond to Master’s service request until
January 15. If Master sues Accur under the liquidated damage provision of the
contract, Master will:
(a) Win, unless the liquidated damages provision is determined to be a penalty
(b) Win, because under all circumstances liquidated damage provisions are
enforceable
(c) Lose, because Accur’s breach was not material
(d) Lose, because liquidated damage provisions violate public policy
2. CPA QUESTION Kaye contracted to sell Hodges a building for $310,000. The
contract required Hodges to pay the entire amount at closing. Kaye refused to close
the sale of the building. Hodges sued Kaye. To what relief is Hodges entitled?
(a) Punitive damages and direct damages
(b) Specific performance and direct damages
(c) Consequential damages or punitive damages
(d) Direct damages or specific performance
396 U N I T 2 Contracts
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3. A manufacturer delivers a new tractor to Farmer Ted on the first day of the
harvest season. But, the tractor will not start. It takes two weeks for the right parts
to be delivered and installed. The repair bill comes to $1,000. During the two
weeks, some acres of Farmer Ted’s crops die. He argues in court that his lost
profit on those acres is $60,000. If a jury awards $1,000 for tractor repairs, it will
be in the form of damages. If it awards $60,000 for the lost crops, it
will be in the form of damages.
(a) direct; direct
(b) direct; consequential
(c) consequential; direct
(d) consequential; consequential
(e) direct; incidental
4. Julie signs a contract to buy Nick’s 2002 Mustang GT for $5,000. Later, Nick changes
his mind and refuses to sell his car. Julie soon buys a similar 2002 Mustang GT for
$5,500. She then sues Nick and wins $500. The $500 represents her .
(a) expectation interest
(b) reliance interest
(c) restitution interest
(d) None of the above
5. Under the Uniform Commercial Code, a seller generally entitled to
recover consequential damages, and a buyer generally entitled to recover
consequential damages.
(a) is; is
(b) is; is not
(c) is not; is
(d) is not; is not
ESSAY QUESTIONS
1. Lewis signed a contract for the rights to all timber located on Nine-Mile Mine.
He agreed to pay $70 per thousand board feet ($70/mbf). As he began work,
Nine-Mile became convinced that Lewis lacked sufficient equipment to do the
job well and forbade him to enter the land. Lewis sued. Nine-Mile moved for
summary judgment. The mine offered proof that the market value of the timber
was exactly $70/mbf, and Lewis had no evidence to contradict Nine-Mile. The
evidence about market value proved decisive. Why? Please rule on the summary
judgment motion.
2. Twin Creeks Entertainment signed a deal with U.S. JVC Corp. in which JVC
would buy 60,000 feature-film videocassettes from Twin Creeks over a three-year
period. JVC intended to distribute the cassettes nationwide. Relying on its deal
with JVC, Twin Creeks signed an agreement with Paramount Pictures, agreeing to
purchase a minimum of $600,000 worth of Paramount cassettes over a two-year
period. JVC breached its deal with Twin Creeks and refused to accept the
CHAPTER 17 Remedies 397
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cassettes it had agreed upon. Twin Creeks sued and claimed, among other
damages, the money it owed to Paramount. JVC moved to dismiss the claim based
on the Paramount contract, on the ground that Twin Creeks, the seller of goods,
was not entitled to such damages. What kind of damages is Twin Creeks seeking?
Please rule on the motion to dismiss.
3. Racicky was in the process of buying 320 acres of ranchland. While that sale was being
negotiated, Racicky signed a contract to sell the land to Simon. Simon paid $144,000,
the full price of the land. But Racicky went bankrupt before he could complete the
purchase of the land, let alone its sale. Which of these remedies should Simon seek:
expectation, restitution, specific performance, or reformation?
4. Parkinson was injured in an auto accident by a driver who had no insurance. Parkinson
filed a claim with her insurer, Liberty Mutual, for $2,000 under her “uninsured
motorist” coverage. Liberty Mutual told her that if she sought that money, her
premiums would go “sky high,” so Parkinson dropped the claim. Later, after she had
spoken with an attorney, Parkinson sued. What additional claim was her attorney
likely to make?
5. YOU BE THE JUDGE WRITING PROBLEM John and Susan Verba sold a
Vermont lakeshore lot to Shane and Deborah Rancourt for $115,000. The Rancourts
intended to build a house on the property, but after preparing the land for construction,
they learned that a wetland protection law prevented building near the lake. They
sued, seeking rescission of the contract. The trial court concluded that the parties had
reached their agreement under a “mutual, but innocent, misunderstanding.” The trial
judge gave the Verbas a choice: They could rescind the contract and refund the
purchase price, or they could give the Rancourts $55,000, the difference between the
sales price and the actual market value of the land. The Rancourts appealed. Were the
Rancourts entitled to rescission of the contract? Argument for the Rancourts: When the
parties have made a mutual mistake about an important factual issue, either party is
entitled to rescind the contract. The land is of no use to us and we want our money
back. Argument for the Verbas: Both sides were acting in good faith and both sides
made an honest mistake. We are willing to acknowledge that the land is worth
somewhat less than we all thought, and we are willing to refund $55,000. The buyers
should not complain—they are getting the property at about half the original price, and
the error was as much their fault as ours.
398 U N I T 2 Contracts
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DISCUSSION QUESTIONS
1. ETHICS The National Football League owns the
copyright to the broadcasts of its games. It licenses
local television stations to telecast certain games and
maintains a “blackout rule,” which prohibits stations
from broadcasting home games that are not sold out
72 hours before the game starts. Certain home games
of the Cleveland Browns teamwere not sold out, and
the NFL blocked local broadcast. But several bars in
the Cleveland area were able to pick up the game’s
signal by using special antennas. The NFL wanted
the bars to stop showing the games. What did it do?
Was it unethical of the bars to broadcast the games
that they were able to pick up? Apart from the
NFL’s legal rights, do you think it had the moral
right to stop the bars from broadcasting the games?
2. Consequential damages can be many times higher
than direct damages. Consider the “Farmer Ted”
scenario raised in multiple-choice question 3, which
is based on a real case.7 Is it fair for consequential
damages to be 60 times higher than direct damages?
The Supreme Court is skeptical that punitive
damages should be more than 9 times compensatory
damages in a tort case. Should a similar “soft limit”
apply to consequential damages in contract cases?
3. Is reformation ever a reasonable remedy? Should
courts be in the business of rewriting contracts, or
should they stick to determining whether
agreements are enforceable?
4. If someone breaks a contract, the other party can
generally sue and win some form of damages. But
for centuries, the law has considered land to be
unique. And so, a lawsuit that involves a broken
agreement for a sale of land will usually result in an
order of specific performance. Is this ancient rule
still reasonable? If someone backs out of an
agreement to sell an acre of land, should he be
ordered to turn over the land itself? Why not just
require him to pay an appropriate number of
dollars in damages?
5. Is it reasonable to require the mitigation of
damages? If a person is wronged because the
other side breached a contract, should she have
any obligations at all? For example, suppose
that a tenant breaches a lease by leaving
early. Should the landlord have an obligation
to try to find another tenant before the end
of the lease?
7Prutch v. Ford, 574 P.2d 102 (Colo. 1977).
CHAPTER 17 Remedies 399
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CHAPTER18
PRACTICAL
CONTRACTS
Two true stories:
One
Holly (on the phone to her client, Judd): Harry’s
lawyer just emailed me a letter that Harry says
he got from you last year. I’m reading from the
letter now: “Each year that you meet your
revenue goals, you’ll get a 1 percent equity
interest.” Is it possible you sent that letter?
Judd: I don’t remember the exact wording, but
probably something like that.
Holly: You told me, absolutely, positively, you
had never promised Harry any stock. That he was
making the whole thing up.
Judd: He was threatening to leave unless I gave him
some equity, so I said what he wanted to hear. But that
letter didn’t mean anything. This is a family business,
and no one but my children will ever get stock.
Two
Grace (on the phone with her lawyer): Providential has raised its price to $12 a pound. I can’t
afford to pay that! We had a deal that the price would never go higher than 10 bucks. I’ve
talked to Buddy over there, but he is refusing to back down. We need to do something!
Lawyer: Let me look at the contract.
Grace (her voice rising): I don’t know what the contract says—that’s just the legal stuff.
Our business deal was no more than $10 a pound!
I don’t know what the
contract says—that’s just
the legal stuff.
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You have been studying the theory of contract law. This chapter is different—its
purpose is to demonstrate how that theory operates in practice. We will look at the
structure and content of a standard agreement and answer questions such as: Do you
need a written agreement? What do all these legal terms mean? Are any important
provisions missing? By the end of the chapter, you will have a road map for under-
standing a written contract.1 (Note that we do not repeat here what you have learned in
prior chapters about the substantive law of contracts.) This chapter has another goal, too:
We will look at the relationship between lawyers and their clients and their different
roles in creating a contract.
Businesspeople, not surprisingly, tend to focus more on business than on the techni-
calities of contract law. However, ignoring the role of a written agreement can lead to serious
trouble. Both of the clients in the opening scenario ended up being bound by a contract
they did not want.
To illustrate our discussion of specific contract provisions, we will use a real contract
between an actor and a producer to make a movie. For reasons of confidentiality, however,
we have changed the names.
Before we begin our discussion of written contracts, let’s ask: Do you need a written
agreement at all? Some years ago, this author was with a group of lawyers, all of
whom had done a major home renovation and none of whom had signed a contract with
the builder. All of the projects had turned out well. The lawyers had not prepared a
written contract because they trusted their builders, who all had good recommendations
from prior clients. Also, a building project by its very nature requires regular negotia-
tions because it is impossible to predict all the potential changes: How much would it
cost to move that door? How much do we save if we use Caesarstone instead of granite?
These cases worked out well without a written contract, but there are times when you
should definitely sign an agreement:
1. The Statute of Frauds requires it.
2. The deal is crucial to your life or the life of your business.
3. The terms are complex.
4. You do not have an ongoing relationship of trust with the other party.
Once you decide you need a written contract, then what?
18-1 THE LAWYER
The American Bar Association commissioned a study to find out what people think of
lawyers. Survey participants responded with these words: greedy, corrupt, manipulative,
snakes, and sharks.2 Businesspeople refer to their lawyers with terms like business
prevention department. They are reluctant to ask an attorney to draft a contract for fear
of the time and expense that lawyers can inject into the process. And they worry that
the lawyers will interfere in the business deal itself, at best causing unnecessary
hindrance, at worst killing the deal. Part of the problem is that lawyers and clients
have different views of the future.
1For further reading on practical contracts, see Scott Burnham, Drafting and Analyzing Contracts (Lexis/
Nexis, 2003); Charles M. Fox, Working with Contracts (Practical Law Institute, 2008); George W.
Kuney, The Elements of Contract Drafting (Thomson/West, 2006).
2Robert Clifford, Opening Statement: Now More than Ever, 28 Litigation 1, Spring 2002.
CHAPTER 18 Practical Contracts 401
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18-1a Lawyers and Clients
Businesspeople are optimists—they believe that they have negotiated a great deal and
everything is going to go well—sales will boom, the company will prosper. Lawyers have a
different perspective—their primary goal is to protect their clients by avoiding litigation,
now and in the future. For this reason, lawyers are trained to be pessimists—they try to
foresee and protect against everything that can possibly go wrong. Businesspeople sometimes view
this lawyering as a waste of time and a potential deal-killer. What if the two parties cannot agree
about what to do in the event of a very unlikely circumstance? The deal might just collapse.
To take one example of this lawyerly perspective, a couple happily married nigh on
40 years went to see a lawyer about changes in their will. The husband wanted to transfer
some assets to his wife. The lawyer advised against it—after all, the couple might divorce.
They became angry and indignant because they would never get divorced. And they may very
well be right. However, just that week, the lawyer had seen another couple who did divorce
after 41 years of marriage. He thought it better to be on the safe side and consider the
possibility that such events might happen.
Lawyers also prefer to negotiate touchy subjects at the beginning of a relationship, when
everyone is on friendly terms and eager to make a deal, rather than waiting until
trouble strikes. In the long run, nothing harms a relationship more than unpleasant surprises.
For example, the Artist in the movie contract we will refer to throughout this chapter did not
know in advance what conditions on the set would be, how grueling the shooting schedule,
or how many friends and family would visit him. So his lawyer negotiated a deal in
which the Producer agreed to provide a driver, a “first-class star trailer (which shall be a
double pop-out),” a luxury hotel suite, and an adjacent room for visitors. In the end, because
the role called for the Artist to live in the wilderness, he ultimately slept in a tent on the set
to experience his part more fully, so he did not need the double pop-out trailer or the luxury
suite. He also dispensed with the driver. But, under different circumstances, he might have
wanted those luxuries, and his lawyer’s goal was to protect his interests. It is a lot easier to
forgo an expense than to add one to a movie budget.
Another advantage of using lawyers to conduct these negotiations is that they can serve as
the bad guys. Instead of the client raising tough issues, the lawyers do. Many a client has said,
“but my lawyer insists … ” If the lawyer takes the blame, the client is able to maintain a
better relationship with the other party. And hiring a lawyer communicates to the other parties
that you are taking the deal seriously, and they will not be able to take advantage of you.
Of course, this lawyerly protection comes at a cost—legal fees, time spent bargaining, the
hours used to read complexprovisions, and thepotential for goodwill to erodeduringnegotiations.
Do you need a lawyer? The answer largely depends on the complexity of the deal. Most
people do not hire a lawyer to review an apartment lease—the language is standard, and the
prospective tenant has little power to change the terms of the deal. On the other hand,
you should not undertake a significant acquisition or purchase agreement on your own.
18-1b Hiring a Lawyer
If you do hire a lawyer, be aware of certain warning signs. Although the lawyer’s goal is to
protect you, a good attorney should be a dealmaker, not a deal-breaker. She should help you
do what you want and, therefore, should never (or, at least, hardly ever) say, “You cannot do
this.” Instead, she should say, “Here are the risks to this approach” or “Here is another way
to achieve your goal.”
Moreover, your lawyer’s goal should not be to annihilate the other side. In the end, the
contract will be more beneficial to everyone if the parties’ relationship is harmonious.
Trying to exact every last ounce of flesh, using whatever power you have to an abusive
extreme, is not a sound long-term strategy. In the end, the best deals are those in which all
the parties’ incentives are aligned. Success for one means success for all—or at least, success
402 U N I T 2 Contracts
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for one party does not prohibit a positive outcome for the other side. If either side in the
movie contract behaved unreasonably, word would quickly spread in the insular Hollywood
world, damaging the troublemaker’s ability to make other deals.
Now either you have a lawyer or you do not. The next step is to think about developing
the contract.
18-2 THE CONTRACT
In this section, we discuss how a contract is prepared and what provisions it should include.
18-2a Who Drafts It?
Once businesspeople have agreed to the terms of the deal, it is time to prepare a draft of the
contract. Generally, both sides would prefer to control the pen (i.e., to prepare the first draft of
the contract) because the drafter has the right to choose a structure and wording that best
represents his interests. Typically, the party with the most bargaining power prepares the
drafts. In the movie contract, Producer’s lawyer prepared the first draft. The contract then
went to Artist’s lawyer, who added the provisions that mattered to his client.
18-2b How to Read a Contract
Reading a contract is not like cracking open a novel. Instead, it should be a focused, multi-
step process:
• Pre-reading. Before you begin reading the first draft of a contract, spend some time
thinking about the provisions that are important to you. If you skip this step, you may
find that as you read, your attention is so focused on the specific language of the
contract that you lose sight of the larger picture.
• The first read. Read through once, just to get the basic idea of the contract—its
structure and major provisions.
• What-ifs. This is the time to think about various outcomes, good andbad.Under the terms
of the contract, what happens if all goes according to your plan? Also consider worst-case
scenarios. In both situations, does the contract produce the result that you want? What
happens if sales are higher than you expect, or if the product causes unexpected harm?
• The second read. Now read the contract to make sure that it handles the what-ifs in a
manner that is satisfactory to you. Think about the relationship between various
provisions—does it make sense?
Following this approach will help you avoid mistakes.
18-2c Mistakes
This author once workedwith a lawyer whomade amistake in a contract. “No problem,” he said.
“I canwin that one in court.”Not a helpful attitude, given that one purpose of a contract is to avoid
litigation. In this section, we look at the most common types of mistakes and how to avoid them.
VAGUENESS
Businesspeople sometimes deliberately choose vagueness. They do not want the terms of the
contract to be clear. It may be that they are not sure what they can get from the other side,
or in some cases, even what they really want. So they try to create a contract that leaves their
options open. However, as the following case illustrates: Vagueness is your enemy.
CHAPTER 18 Practical Contracts 403
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What a disaster for both parties that they have to litigate the meaning of this letter of
intent! The problem is that they agreed to something so vague. Sometimes parties adopt
vagueness as a strategy. One party may be trying to get a commitment from the other side
without obligating itself. A party may feel almost ready to commit and yet still have
reservations. It wants the other party to make a commitment so that planning can go forward.
This is understandable but dangerous.
If you were negotiating for Jones Brothers and wanted to clarify negotiations without
committing your company, how could you do it? State in the letter that it is not a contract,
and that neither side is bound by it. State that it is a memorandum summarizing negotiations
thus far, but that neither party will be bound until a full written contract is signed.
But what if Quake cannot get a commitment from its subcontractors until they are
certain that it has the job? Quake should take the initiative and present Jones Brothers with
its own letter of intent, stating that the parties do have a binding agreement for $1 million
worth of work. Insist that Jones Brothers sign it. Jones Brothers would then be forced to
You Be the Judge
Facts: Jones Brothers
Construction was the gen-
eral contractor on a job to
expand American Airlines’
facilities at O’Hare Inter-
national Airport. After
Quake bid on the project,
Jones Brothers orally informed Quake that it had won the
project and would receive a contract soon. Jones Brothers
wanted the license numbers of the subcontractors that Quake
would be using, but Quake could not furnish those numbers
until it had assured its subcontractors that they had the job.
Quake did not want to give that assurance until it was certain
of its own work. So Jones Brothers sent a letter of intent that
stated, among other things:
We have elected to award the contract for the subject
project to your firm as we discussed on April 15. A con-
tract agreement outlining the detailed terms and condi-
tions is being prepared and will be available for your
signature shortly.
Your scope of work includes the complete installation of
expanded lunchroom, restaurant, and locker facilities for
AmericanAirlines employees, aswell as an expansion ofAmerican
Airlines’ existing Automotive Maintenance Shop. A sixty
(60) calendar day period shall be allowed for the con-
struction of the locker room, lunchroom, and restaurant
area beginning the week of April 22. The entire project
shall be completed by August 15.
This notice of award authorizes the work set forth in
the attached documents at a lump sum price of
$1,060,568.00.
Jones Brothers Con-
struction Corporation
reserves the right to can-
cel this letter of intent if
the parties cannot agree
on a fully executed sub-
contract agreement.
The parties never signed a more detailed written con-
tract, and ultimately Jones Brothers hired another company.
Quake sued, seeking to recover the money it spent in pre-
paration and its loss of anticipated profit.
You Be the Judge: Was the letter of intent a valid contract?
Argument for Quake: This letter was a valid contract. It
explicitly stated that Jones awarded the contract to Quake.
It also said, “This notice of award authorizes the work.”The
letter included significant detail about the scope of the
contract, including the specific facilities Quake would be
working on. Furthermore, the work was to commence
approximately 4 to 11 days after the letter was written. This
short period of time indicates that the parties intended to be
bound by the letter so that work could begin quickly. And,
the letter contained a cancellation clause. If it was not a
contract, why would anyone need to cancel it?
Argument for Jones: This letter was not a contract. It
referred several times to the execution of a formal contract
by the parties, thus indicating that they did not intend to
be bound by the letter. Look at the cancellation clause
carefully: It could also be interpreted to mean that the
parties did not intend to be bound by any agreement until
they entered into a formal contract.
QUAKE CONSTRUCTION, INC.
V. AMERICAN AIRLINES, INC.
141 Ill. 2d 281, 565 N.E.2d 990, 1990 Ill. LEXIS 151
Supreme Court of Illinois, 1990
404 U N I T 2 Contracts
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decide whether it is willing to make a binding commitment. If Jones Brothers is not willing
to commit, let it openly say so. At least both parties will know where they stand.
The movie contract provides another example of deliberate vagueness. In these con-
tracts, nudity is always a contentious issue. Producers believe that nudity sells movie tickets;
actors are afraid that it may tarnish their reputation. In the first draft of our contract, Artist’s
lawyer specified:
Artist may not be photographed and shall not be required to render any services nude below the
waist or in simulated sex scenes without Artist’s prior written consent.
(This clause also applied to any double depicting Artist.) However, the script called for a
scene in which Artist was swimming nude and the director wanted the option of showing
him below the waist from the back. Ultimately, the nudity clause read as follows:
Producer has informed Artist that Artist’s role in the Picture might require Artist to appear and be
photographed (a) nude, which nudity may include only above-the-waist nudity and rear below-
the-waist nudity, but shall exclude frontal below-the-waist nudity; and (b) in simulated sex
scenes. Artist acknowledges and agrees that Artist has accepted such employment in the Picture
with full knowledge of Artist’s required participation in nude scenes and/or in simulated sex
scenes and Artist’s execution of the Agreement constitutes written consent by Artist to appear in
the nude scenes and simulated sex scenes and to perform therein as reasonably required by
Producer. A copy of the scenes from the screenplay requiring Artist’s nudity and/or simulated sex
are attached hereto. Artist shall have a right of meaningful prior consultation with the director of
the Picture regarding the manner of photography of any scenes in which Artist appears nude or
engaged in simulated sex acts.
Artist may wear pants or other covering that does not interfere with the shooting of the nude
scenes or simulated sex scenes. Artist’s buttocks and/or genitalia shall not be shown, depicted, or
otherwise visible without Artist’s prior written consent. Artist shall have the absolute right to
change his mind and not perform in any nude scene or simulated sex scene, notwithstanding that
Artist had prior thereto agreed to perform in such scene.
What does this provision mean? Has Artist agreed to perform in nude scenes or not? He has
acknowledged that the script calls for nude scenes and he has agreed, in principle, that he
will appear in them. However, he did not want to agree categorically, before shooting had
even started and he had experience working with this director. Actor has a number of
options—he can refuse to shoot nude scenes altogether, or he can shoot them and then,
after viewing them, decide not to allow them in the movie. With a clause such as this one,
the director shot different versions of the scene—some with nudity and some without—so
that if Artist rejected the nude scene, the director still had options.
The true test of whether a vague clause belongs in a contract is this: Would you sign the
contract if you knew that the other side’s interpretation would prevail in litigation? In this
example, each side was staking out its position, and deferring a final negotiation until there
was an actual disagreement about a nude scene. If you would be happy enough with the other
side’s position in the end, the vague clause simply defers a fight that you can afford to lose.
But if the point is really important to you, it may be wiser to resolve the issue before you sign
the contract by writing the clause in a way that clearly reflects your desired outcome.
EXAM Strategy
Question: The nudity provision in the movie contract is vague. Rewrite it so that it
accurately expresses the agreement between the parties.
Strategy: This is easy! Just say what the parties intended the deal to be.
CHAPTER 18 Practical Contracts 405
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Result: “The script for the Picture includes scenes showing Artist (a) with frontal
nudity from the waist up and with rear below-the-waist nudity (but no frontal below-
the-waist nudity); and (b) in simulated sex scenes. However, no scenes shall be shot
in which Artist’s buttocks and/or genitalia are shown, depicted, or otherwise visible
without Artist’s prior written consent. Artist shall have the absolute right not to
perform in any nude scene or simulated sex scene. If shot, no nude or sex scenes may
appear in the Picture without Artist’s prior written consent.”
AMBIGUITY
Vagueness occurs when the parties do not want the contract to be clear. Ambiguity is
different—it means that the provision is accidentally unclear. It occurs in contracts when
the parties think only about what they want a provision to mean, without considering the
literal meaning or the other side’s perspective. When reading a contract, try to imagine all
the different ways a clause can be interpreted. Because you think it means one thing does
not mean that the other side will share your view. For example, suppose that an employ-
ment contract says, “Employee agrees not to work for a competitor for a period of three
years from employment.” Does that mean three years from the date of hiring or the date of
termination? Unclear, so who knows?
To take another example, the dictionary defines vandalism as deliberately mischievous or
malicious destruction or damage of property. Arson is the malicious burning of a house or property.
Seems clear enough—but does arson count as vandalism? In the following case, no one
thought about this question until a house burned down.
CIPRIANO V. PATRONS MUTUAL INSURANCE COMPANY
OF CONNECTICUT
2005 Conn. Super. LEXIS 3577
Superior Court of Connecticut, 2005
C A S E S U M M A R Y
Facts: Juacikino Cipriano purchased an insurance policy
on his house from Patrons Mutual Insurance Company.
The policy stated that the company would not pay for any
damage to the residence caused by vandalism or burglary if
the residence was vacant for more than 30 days in a row
just before the loss. Furthermore, the company would not
pay for damage to personal property caused by fire, light-
ning, or vandalism.
After Cipriano’s house had been vacant for more than
30 days, an arsonist burned it down. Patrons denied his claim
on the grounds that arson is vandalism, which his policy did
not cover. Cipriano filed suit against Patrons. The insurance
company filed a motion for summary judgment.
Issues: Does arson count as vandalism? Must Patrons pay
Cipriano’s claim?
Decision: Arson does not count as vandalism. Patrons’
motion for summary judgment is denied. It will have to
pay Cipriano.
Reasoning: Patrons would not have to pay Cipriano if his
house was damaged by vandalism. Does vandalism include
arson? The policy never defined this important term. But the
406 U N I T 2 Contracts
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This case illustrates an important rule of contract drafting: Any ambiguity is interpreted
against the drafter of the contract. (The Cipriano policy is a good example of how incompre-
hensible insurance policies can be. This complexity tends to erode judicial sympathy for the
perpetrator.) Although both sides need to be careful in reading a contract—litigation benefits
no one—the side that prepares the documents bears a special burden. This rule is meant to:
1. Protect laypeople from the dangers of form contracts that they have little power to
change. Even if the insured in this case had read the contract carefully, it is unlikely
that an insurance company would change its form contract for him.
2. Protect people who are unlikely to be represented by a lawyer. Most people do not
hire a lawyer to read insurance contracts (or any form contract). And without an
experienced lawyer, it is highly unlikely that an insured would ask, “So is arson
included in the vandalism clause?”
3. Encourage those who prepare contracts to do so carefully.
TYPOS
The bane of a lawyer’s existence! This author worked on a securities offering in which
the sales document almost went out with part of the company’s name spelled Pertoleum
instead of Petroleum. (And legend has it that a United Airlines securities offering once
featured “Untied Airlines.”) Although clients tend not to have a sense of humor about
such errors, at least there would be no adverse legal result. That is not always the case with typos.
A group of condominium buyers ended up in litigation over a tiny typo in their purchase
agreements: an “8” instead of a “9.”What difference could that possibly make? A lot, it turns out.
Extell Development Corporation built the Rushmore, a luxury condominium complex in Man-
hattan. When Extell began selling the units, it agreed to refund any buyer’s down payment if the
first closing did not occur by September 1, 2009. (The goal was to protect buyers who might not
have any place to live if the buildingwas not finished on time.) In the end, the first closing occurred
in February 2009. No problem, right? No problem except that, by accident, the purchase contract
said September 1, 2008 rather than 2009. In the meantime, the Manhattan real estate market
tumbled, and many purchasers of Rushmore condominiums wanted to back out. After litigation all
the way to the Federal Court of Appeals, Extell was required to refund the deposits.
What is the law of typos? First of all, the law has a fancier word than typo—it is scrivener’s error.
A scrivener is a clerk who copies documents. In the case of a scrivener’s error, a court will reform a
contract if there is clear and convincing evidence that the mistake does not reflect the true intent of
the parties. In the Rushmore case, an arbitrator refused to reform the contract, ruling that there was
no clear and convincing evidence that the parties intended something other than the contract term
as written.
In the following case, even more money was at stake. What would you do if you were
the judge?
policy did list fire and vandalism as two different dangers. Is
arson fire or vandalism? Or both?
In the case of ambiguity, two rules apply:
• Language in an insurance policy is interpreted as an
ordinary person would understand it.
• A term is interpreted in favor of the party that did
not draft the contract.
The term “arson” can reasonably mean “fire,” “vand-
alism,” or both. There is no way to know which definition
the parties meant. Because the insurance company
drafted the policy, this term must be interpreted in favor
of Cipriano. Therefore, we rule that the term “vandalism”
does not include “arson.”
Patrons’ motion for summary judgment is denied.
Scrivener’s error
A typo.
CHAPTER 18 Practical Contracts 407
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Ethics When Heritage found a different mistake in the contract, Phibro agreed to
correct it, even though the correction was unfavorable to Phibro. But when
a mistake occurred in Heritage’s favor, it refused to honor the intended terms of the
agreement. Is Heritage behaving ethically? Does Heritage have an obligation to treat Phibro
as well as Phibro behaved towards Heritage? Is it right to take advantage of other people’s
mistakes? What Life Principle would you apply in this situation?
You Be the Judge
Facts: Heritage wanted
to buy a substance called
tribasic copper chloride
(TBCC) from Phibro but,
because of uncertainty in
the industry, the two com-
panies could not agree on a
price for future years. It
turned out, though, that the price of TBCC tended to rise
and fall with that of copper sulfate, soHeritage proposed that
the amount it paid for TBCC would increase an additional
$15 per ton for each $0.01 increase in the cost of copper
sulfate over $0.38 per pound.
Two top officers of Heritage and Phibro met in the
Delta Crown Room at LaGuardia Airport to negotiate the
purchase contract. At the end of their meeting, the Phibro
officer hand wrote a document stating the terms of their
deal and agreeing to the Heritage pricing proposal.
Negotiations between the two companies continued,
leading to some changes and additions to their Crown Room
agreement. In a draft prepared by Phibro, the $.01 number
was changed to $0.1—that is, from 1 cent to 10 cents. In
other words, in the original draft, Heritage agreed to a first
increase if copper sulfate went above 39 cents per pound, an
additional price rise at 40 cents, and so on. But in the Phibro
draft, Heritage’s first increase would not occur until the price
of copper sulfate went to 48 cents a pound, with a second rise
at 58 cents. In short, the Phibro draft was much more favor-
able to Heritage than the Heritage proposal had been.
At some point during the negotiations, the lawyer for
Heritage asked his client if the $0.1 figure was accurate.
The Heritage officer said that the increase in this amount
was meant to be payment for other provisions that favored
Phibro. There is no evidence that this statement was true.
The contract went through eight drafts and numerous
changes, but after the Crown Room meeting, the two
sides never again discussed the $0.1 figure.
After the execution of the agreement, Heritage discov-
ered a different mistake. When Heritage brought the error
to Phibro’s attention, Phibro agreed to make the change
even though it was to Phibro’s disadvantage to do so.
All was peaceful until
the price of copper sulfate
went to $0.478 per pound.
Phibrobelievedthatbecause
the price was above $0.38
per pound, it was entitled
to an increased payment.
Heritage responded that the
increasewouldnotoccuruntil thepricewentabove$0.48.Phibro
then looked at the agreement and noticed the $0.1 term for the
first time.PhibrocontactedHeritage to say that the$0.1 termwas
a typo and not what the two parties had originally agreed in the
Delta Crown Room. Heritage refused to amend the agreement
and Phibro filed suit.
You Be the Judge: Should the court enforce the contract as
written, or as the parties agreed in their Crown Room meet-
ing? Which number is correct—$0.10 or $0.01
Argument for Phibro: In theDeltaCrownRoom, the two
negotiators agreed to a $15 per ton increase in the price of
TBCC for each 1-cent increase in copper sulfate price. Then
by mistake, the contract said 10 cents. The two parties never
negotiated the10-cent provision, and there is no evidence that
they had agreed to it. The court should revise this contract to
be consistent with the parties’ agreement, which was 1 cent.
Also, the 10-cent figure makes no economic sense. The
point of the provision was that the price of TBCC would go
up at the same rate as copper sulfate, and 1 cent for each ton
is a much more accurate reflection of the relationship
between these two commodities than 10 cents per ton.
Argument for Heritage: The Delta Crown Room agree-
ment was nothing more than a draft. The contract went
through eight rounds of changes. The change in price was
in return for other provisions that benefited Phibro.
The parties conducted negotiations by sending drafts
backand forth rather thanby talkingon thephone.Bothparties
were represented by a team of lawyers, the agreement went
through eight drafts, and this pricing term was never altered
despite several other changes and additions. There is no clear
and convincing evidence that both parties were mistaken
about what the document actually said. Ultimately, the parties
agreed to 10 cents, and that is what the court should enforce.
HERITAGE TECHNOLOGIES V.
PHIBRO-TECH
2008 U.S. Dist. LEXIS 329
United States District Court for the Southern District
of Indiana, 2008
408 U N I T 2 Contracts
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PREVENTING MISTAKES
Here are ways to prevent mistakes in a contract.
Let your lawyer draft the contract As a general
rule, your lawyer is less likely to make mistakes than you
are. Of all the players in the Heritage case, only one person
noticed the error—Heritage’s lawyer.
Resist overlawyering Yes, your lawyer should draft
the contract, but that does not mean she should have free
rein, no matter what. This author once worked with a
real estate attorney who had developed his own standard
mortgage contract, of which he was immensely proud.
Whenever he saw a provision in another contract that was missing from his own, he
immediately added it. His standard form contract soon topped 100 pages. That contract
was painful to read and did no service to his clients.
Read the important terms carefully Before signing a contract, check carefully and
thoughtfully the names of the parties, the dates, dollar amounts, and interest rates. If all
these elements are correct, you are unlikely to go too far wrong. And, of course, having read
this chapter, you will never mistake $0.10 for $0.01.
Finally, when your lawyer presents you with a written contract, you should follow
these rules:
1. Complain if your lawyer gives you a contract with provisions that are irrelevant to your
situation.
2. If you do not know what a provision means, ask. If you still do not know (or if your
lawyer does not know), ask her to take it out. Lawyers rarely draft from scratch; they
tend to use other contracts as templates. Just because a provision was in another
agreement does not mean that it is appropriate for you.
3. Remember that a contract is also a reference document. During the course of your
relationship with the other party, you may need to refer to the contract regularly. That
will be difficult if you do not understand portions of it, or if the contract is so
disorganized you cannot find a provision when you need it.
Which brings us to our next topic—the structure of a contract. Once you understand the
standard outline of a contract, it will be much easier for you to find your way through the
thicket of provisions.
18-2d The Structure of a Contract
Traditional contracts tended to use archaic words—whereas and heretofore were common.
Modern contracts are more straightforward, without as many linguistic flourishes. Our movie
contract takes the modern approach.
TITLE
Contracts have a title, which generally is in capital letters, underlined, and centered at the
top of the page. The title should be as descriptive as possible—a generic title such as
AGREEMENT does not distinguish one contract from another. Much better to entitle it
EMPLOYMENT AGREEMENT or CONFIDENTIALITY AGREEMENT. The title of our movie contract
is MEMORANDUM OF AGREEMENT (not a particularly useful name), but in the upper right-hand
corner, there is space for the date of the contract and the subject. Let’s say the subject is
“Dawn Rising/Clay Parker.” It would have been even better if the title of the movie had
been: Agreement between Clay Parker and Winterfield Productions for Dawn Rising.
As a general rule, your
lawyer is less likely
to make mistakes than
you are.
CHAPTER 18 Practical Contracts 409
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INTRODUCTORY PARAGRAPH
The introductory paragraph includes the date, the names of the parties, and the nature of the
contract. The names of the parties and the movie are defined terms, for example, Clay Parker
(“Artist”). By defining the names, the actual names do not have to be repeated throughout the
agreement. In this way, a standard form contract can be used in different deals without
worrying about whether the names of the parties are correct throughout the document.
The introductory paragraph should also include specific language indicating that the
parties entered into an agreement. In our contract, the opening paragraph states:
This shall confirm the agreement (“Agreement”) between WINTERFIELD PRODUCTIONS
(“Producer”) and CLAY PARKER (“Artist”) regarding the acting services of Artist in
connection with the theatrical motion picture tentatively entitled “DAWN RISING” (the “Pic-
ture”),3 as follows:
This introductory paragraph is not numbered.
It is here that traditional contracts included their “Whereas” provisions. Thus, for
example, a traditional movie contract might say the following:
WHEREAS, Producer desires to retain the services of Artist for the purpose of making a theatrical
motion picture; and
WHEREAS, Artist desires to work for Producer on the terms and subject to the conditions set
forth herein;
NOW, THEREFORE, in consideration of the mutual covenants contained herein, and for
other good and valuable consideration, the receipt and adequacy of which are hereby acknowl-
edged, the parties agree as follows:
None of these flourishes are necessary, but some people prefer them.
DEFINITIONS
Most contracts have some definitions. As we have seen in the movie contract, Artist,
Producer, and Movie were defined in the introductory paragraph. Sometimes, definitions
are included in a separate section. Alternatively, they can appear throughout the
contract. The movie contract does not have a definitions section, but many terms, such as
fixed compensation and teaser, are defined within it.
COVENANTS
Now we get to the heart of the contract: What are the parties agreeing to do? Failure to
perform these obligations constitutes a breach of the contract and damages will result.
Covenant is a legal term that means a promise in a contract.
At this stage, the relationship between lawyer and client is particularly important.
They will obtain the best result if they work well together. And to achieve a successful
outcome, both need to contribute. Clients should figure out what they need for the
agreement to be successful. It is at this point that they have the most control over the deal,
and they should exercise it. It is a mistake to assume that everything will work itself out. Instead,
clients need to protect themselves now as best they can. Lawyers can help in this process
because they have worked on other similar deals and they know what can go wrong. Listen
to them—they are on your side.
Imagine you are an actor about to sign a contract to make a movie. What provisions would
you want? Begin by asking what your goals are for the project. Certainly, to make a movie that
gets good reviews and good box office. So you will ask for as much control over the process and
product as you can get—selection of the director and costars, for instance. Maybe influence on
3These are not the parties’ real names but are offered to illustrate the concepts.
Covenant
A promise in a contract.
410 U N I T 2 Contracts
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the editing process. But you also want to make sure that the movie does not hurt your career.
What provisions would you need to achieve that goal? And shooting a movie can be grueling
work, so you want to ensure that your physical and emotional needs are met, particularly when
you are on location away from home. Try to think of all the different events that could happen
and how they would affect you. The contract should make provisions for these occurrences.
Now take the other side and imagine what you would want if you were the producer.
The producer’s goal is to make money—which means creating a quality movie while
spending as little as possible and maintaining control over the process and final product.
As you can see, some of the goals conflict—both Artist and Producer want control over the
final product. Who will win that battle?
Here are the terms of the movie contract.
The Artist negotiated:
1. A fixed fee of $1,800,000, to be paid in equal installments at the end of each week of
filming
2. Extra payment if the filming takes longer than 10 weeks
3. 7.5 percent of the gross receipts of the movie
4. A royalty on any product merchandising, the rate to be negotiated in good faith
5. Approval over (but approval shall not be unreasonably withheld):
a. the director, costars, hairdresser, makeup person, costume designer, stand-ins, and
the look of his role (although he lists one director and costar whom he has
preapproved)
b. any changes in the script that materially affect his role
c. all product placements, but he preapproves the placement of Snickers candy bars
d. locations where the filming takes place
e. all videos, photos, and interviews of him
f. the translation of the script for French subtitles (he is fluent in French)
6. Approval (at his sole discretion) over the release of any blooper videos
7. His name to be listed first in the movie credits, on a separate card (i.e., alone on
the screen)
8. That the producer not give any photographs from the set to a tabloid (such as, the
National Enquirer or the Star)
9. At least 12 hours off duty from the end of each day of filming to the start of the next day
10. That he fly first class to any locations outside of Los Angeles
11. That the producer pay for 10 first-class airline tickets for his friends to visit him
on location
12. A luxury hotel suite for himself and a room for his friends
13. A driver and four-wheel-drive SUV to transport him to the set
14. The right to keep some wardrobe items
The Producer negotiated:
1. All intellectual property rights to the movie
2. The right not to make the movie, although he would still have to pay Artist the fixed fee
3. Control over the final cut of the movie
CHAPTER 18 Practical Contracts 411
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4. That the Artist will show up on a certain date and work in good faith for
a. 2 weeks in pre-production (wardrobe and rehearsals)
b. 10 weeks shooting the movie
c. 2 free weeks after the shooting ends, in case the director wants to reshoot some
scenes. The Artist must in good faith make himself available whenever the director
needs him
5. The right to fire Artist if his appearance or voice materially changes before or during
the filming of the movie
6. That the Artist help promote the movie on dates subject to Artist’s approval, which
shall not be unreasonably withheld
BREACH
So now we have the covenants in the movie contract. What happens if one of the parties
breaches a covenant? Throughout the life of a contract, there could be many small breaches.
Say, Artist shows up one day late for filming or he gains five pounds. Maybe Producer
deposits Artist’s paycheck a few days late. Perhaps a pop-out trailer is not available.
Although these events may technically be violations, a court would not impose sanctions
over such minor issues. To constitute a violation of the contract, the breach must be
material. A material breach is important enough to defeat an essential purpose of the
contract. Although a court would probably not consider one missed day to be a material
breach, if Artist repeatedly failed to show up, that would be material.
Given that the goal of a contract is to avoid litigation, it is can be useful to define what a
breach is. The movie contract uses this definition:
Artist fails or refuses to perform in accordance with Producer’s instructions or is otherwise in
material breach or material default hereof,” and “Artist’s use of drugs [other than prescribed by a
medical doctor].”
The contract goes on, however, to give Artist one free pass:
It being agreed that with regard to one instance of default only, Artist shall have 24 hours after
receipt of notice during principal photography, or 48 hours at all other times, to cure any alleged
breach or default hereof.
Sometimes, you will recall, contracts state the consequences of a breach, such as the
amount of damages. A damages clause can specify a certain amount, a limitation on the
total, or other variations. In other words, the contract could say, “If Artist breaches,
Producer is entitled to $1 million in damages.” (You remember from prior chapters that
these are called liquidated damages.) Alternatively, a damage clause could say, “Damages
will not exceed $1 million.” But the vast majority of contracts have neither liquidated
damages nor damage caps.
Good Faith Note that many of the covenants in the movie contract provide that the right
must be exercised reasonably or that a decision must be made in good faith (except for the
right to approve blooper videos, over which Artist has sole discretion). A party with sole
discretion has the absolute right to make any decision on that issue. Sole discretion clauses
are not entered into lightly. Reasonable means ordinary or usual under the circumstances.
Good faith means an honest effort to meet both the spirit and letter of the
contract. These are the technical definitions. What do material, reasonably, and in good
faith mean in practice?
In the following case, a famous athlete felt that the other party had committed
a material breach of their contract, behaved unreasonably, and acted in bad faith. Do you
agree?
Material breach
A violation of a contract that
defeats an essential purpose of
the agreement.
Sole discretion
A party to a contract has the
absolute right to make a
decision on that issue.
Reasonable
Ordinary or usual under the
circumstances.
Good faith
An honest effort to meet both
the spirit and letter of a
contract.
412 U N I T 2 Contracts
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In drafting covenants, there are two issues to keep in mind.
Reciprocal Promises and Conditions Suppose that a contract provides that:
1. Actor shall take part in the principal photography of Movie for 10 weeks, commencing
on March 1.
2. Producer shall pay Artist $180,000 per week.
LEMOND CYCLING, INC. V. PTI HOLDING, INC.
2005 U.S. Dist. LEXIS 742
United States District Court for the District of Minnesota, 2005
Facts: American Greg LeMond was a three-time winner
of the Tour de France, cycling’s most prestigious race. In
1994, Sports Illustrated named him one of the 40 most
influential people in sports during the prior 40 years.
Protective Technologies International, Inc. (Protective)
sold cycling accessories under brand names like Barbie,
Playskool, and Tonka to retailers such as Target, Wal-
Mart, and Toys R Us.
LeMond and Protective signed a contract giving Pro-
tective the right to market LeMond cycling accessories. In
return, Protective promised to:
• pay LeMond $500,000 a year plus royalties on
annual sales exceeding $8.33 million
• use commercially reasonable efforts to produce and
market the LeMond products
• keep LeMond informed of Protective’s efforts
Protective tried to sell LeMond products to its regular
customers, but only Target was interested and then only
in a minor way. It agreed to allocate just 6 feet of shelf
space to LeMond items. Protective did not tell LeMond
about this deal.
Few of the LeMond accessories sold at Target, per-
haps because Protective did not promote or advertise the
products. Protective argued that it was Target’s job to do
the marketing. Because of poor sales, Target reduced the
LeMond shelf space to just 4 feet and, ultimately, discon-
tinued the products altogether. In neither instance did
Protective inform LeMond.
Protective began to sell Schwinn bicycle accessories
to the retailers that had rejected LeMond products, earn-
ing over $30 million in the process. Protective then aban-
doned all efforts to sell LeMond items.
LeMond filed suit against Protective for breach of
contract. Protective filed a motion for summary judgment.
Issue: Did Protective breach its contract with LeMond?
Decision: The court granted part of the summary judg-
ment motion, but not all. Protective may have breached
the contract.
Reasoning: LeMond argued that Protective violated the
contract by acting unreasonably and in bad faith.
To win, LeMond must first prove that Protective
breached a material term of the contract. “Material”means
a term so fundamental that its violation frustrates an
essential purpose of the contract. Protective’s failure to
keep LeMond informed of its efforts was not material.
The essential purpose of the contract was to sell bicycle
accessories, not to send reports. More reports would not
have meant more sales.
However, Protective’s promise to use commercially
reasonable efforts to sell products was material because
that was the primary purpose of the contract. Although the
contract does not define this term, it is well established
that in evaluating commercial reasonableness, courts con-
sider two factors:
1. standard practice in the licensing industry.
2. the financial resources, business expertise and
practices of Protective.
Whether Protective met this standard must be deter-
mined at trial.
In addition, LeMond argued that Protective violated
the contract’s implied covenant of good faith and fair
dealing by contracting with Schwinn. Bad faith means
that a party has acted dishonestly or out of some ulterior
motive. LeMond has produced some evidence that Pro-
tective effectively abandoned LeMond and focused solely
on Schwinn. That factual dispute is another matter that
must be determined at trial.
CHAPTER 18 Practical Contracts 413
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In this case, even if Artist does not show up for shooting, Producer is still required to
pay him. These provisions are reciprocal promises, which means that they are each enforce-
able independently. Producer must make payment and then sue Artist, hoping to recover
damages in court.
The better approach is for the covenants to be conditional—a party agrees to perform
them only if the other side has first done what it promised. For example, in the real movie
contract, Producer promises to pay Artist “On the condition that Artist fully performs all of
Artist’s services and obligations and agreements hereunder and is not in material breach or
otherwise in material default hereof.” And Artist has the right to attend any premieres of the
movie and invite three friends, “On the condition that Artist fully performs all services and
material obligations hereunder.”
In short, if you do not expect to perform under the contract until the other side has met
its obligations, be sure to say so.
Language of the Covenants To clarify who exactly is doing what, covenants in a
contract should use the active, not passive voice. In other words, a contract should say
“Producer shall pay Artist $1.8 million,” not “Artist shall be paid $1.8 million.”
For important issues where disputes are likely to arise, the language should be precise,
detailed, and complete. The movie contract uses 453 words to define the Artist’s services
just for shooting the movie, not including promotional efforts once the film is released.
These acting services include, “dubbing, retakes, reshoots, and added scenes.”
REPRESENTATIONS AND WARRANTIES
Covenants are the promises the parties make about what they will do in the future. Repre-
sentations and warranties are statements of fact about the past or present: They are true
when the contract is signed (or at some other specific, designated time).4 Representations
and warranties are important—without them, the other party might not have agreed to the
contract. For example, in the movie contract, Artist warrants that he is a member of the
Screen Actors Guild. This provision is important because, if it were not true, Producer
would either have to obtain a waiver or pay a substantial penalty.
In a contract between two companies, each side will generally represent and warrant
facts such as: They legally exist, they have the authority to enter into the contract, their
financial statements are accurate, they have revealed all material litigation, and they own all
relevant assets. In a contract for the sale of goods, the contract will include warranties about
the condition of the goods being sold.
EXAM Strategy
Question: Producer does not want Artist to pilot an airplane during the term of the
contract. Would that provision be a warranty and representation or a covenant? How
would you phrase it?
Strategy: Warranties and representations are about events in the past or present. A
covenant is a promise for the future. If, for example, Producer wanted to know that
Artist had never used drugs in the past, that provision would be a warranty and
representation.
4Although, technically, there is a slight difference between a representation and a warranty, many
lawyers confuse the two terms, and the distinction is not important. We will treat them as synonyms,
as many lawyers do.
Reciprocal promises
Promises that are each
enforceable independently.
Conditional promises
Promises that a party agrees to
perform only if the other side
has first done what it promised.
Representations and
warranties
Statements of fact about the
past or present.
414 U N I T 2 Contracts
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Result: A promise not to pilot an airplane is a covenant. The contract could say,
“Until Artist completes all services required hereunder, he shall not pilot an
airplane.”
BOILERPLATE
These standard previsions are typically placed in a section entitled Miscellaneous. Many
people think that boilerplate is a synonym for boring and irrelevant, but it is worth
remembering that the term comes from the iron or steel that protects the hull of a
ship—something that shipbuilders ignore to the passengers’ peril. A contract without
boilerplate is valid and enforceable—so it can be tempting to skip these provisions, but
they do play an important protective role. In essence, boilerplate creates a private law
that governs disputes between the parties. Courts can also play this role and, indeed, in
the absence of boilerplate they will. But remember that an important goal of a contract
is to avoid court involvement.
Here are some standard, and important, boilerplate provisions.
Choice of Law and Forum Choice of law provisions determine which state’s laws will
be used to interpret the contract. Choice of forum determines the state in which
any litigation would take place. (One state’s courts can apply another state’s laws.)
Lawyers often view these two provisions as the most important boilerplate. Individual
states might have dramatically different laws. Even the so-called uniform statutes, such as
the Uniform Commercial Code, can vary widely from state to state. Variations are even
more pronounced in other areas of the law, in particular in the common law, which is
created by state courts. As for forum, it is a lot more convenient and cheaper to litigate a
case in one’s home courts.
When resolving a dispute, the choice of law and forum can strongly influence the
outcome. For this reason, sometimes parties are reluctant to negotiate the provision and
instead decide not to designate a forum and just take their chances. Or they may choose a
neutral, equally inconvenient forum like Delaware. Without a choice of forum clause, the
parties may well end up litigating where to litigate, or they may find themselves even worse
off—with parallel cases filed by each in his preferred forum.
The movie contract states: “This Agreement shall be deemed to have been made in
the State of California and shall be construed and enforced in accordance with the law of the
State of California.” The contract did not, but might have, also specified the forum—that
any litigation would be tried in California.
Modification Contracts should contain a provision governing modification. The movie
contract states: “This Agreement may not be amended or modified except by an instrument
in writing signed by the party to be charged with such amendment or modification.”
“Charged with such amendment” means the party who is adversely affected by the
change. For example, if Producer agrees to pay Artist more, then Producer must sign the
amendment. Without this provision, a conversation over beers between Producer and Artist
about a change in pay might turn out to be an enforceable amendment.
The original version of the movie contract said that Artist would be photographed nude
only above the waist. He ultimately agreed to rear-below-the-waist photography. That
amendment (which the parties called a rider—another term for amendment or
addition) took the form of a letter from Artist agreeing to the change. Producer then signed
the letter, acknowledging receipt and acceptance. The amendment would have been valid
even without Producer’s signature because Artist was “charged with such Amendment.”
Choice of law provisions
Determine which state’s laws
will be used to interpret the
contract.
Rider
An amendment or addition to a
contract.
Choice of forum provisions
Determine the state in which
any litigation would take place.
CHAPTER 18 Practical Contracts 415
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If a contract has a provision requiring that amendments be in writing, there are three
ways to amend it:
1. Signing an amendment (or rider).
2. Crossing out by hand the wrong language and replacing it with the correct terms. It is
good practice for both parties to initial each change. This method is typically used
before the document is signed—say, at the closing if the parties notice a mistake.
3. Rewriting the entire contract to include the changed provisions. In this case, the
contract is typically renamed: The Amended and Restated Agreement. This method
is most appropriate if there are many complex alterations.
Note that amending a contract may raise issues of consideration, a topic discussed in
Chapter 11.
Assignment of Rights and Delegation of Duties An assignment of rights is a
transfer of your benefits under a contract to another person, while delegation of duties is a
transfer of your obligations. In the movie contract, Producer has the right to assign the
contract, but he must stay secondarily liable on it. In other words, someone else can take
over the contract for him, but if that person fails to live up to his obligations, Producer is
liable. Artist might be unhappy if another production company takes over the movie, but he
is still required under the contract to perform his acting services. At least he knows that
Producer is liable for his paycheck.
Delegation means that someone else performs the duties under the contract. It certainly
matters to Producer which actor shows up to do the shooting. Artist cannot say, “I’m too
busy—here’s my cousin Jack.” So the movie contract provides:
It is expressly understood and agreed that the services to be rendered by Artist hereunder are of
the essence of this Agreement and that such services shall not be delegated to any other person or
entity, nor shall Artist assign the right to receive compensation hereunder.
In essence, Producer not only cares who shows up for shooting, but he also wants to make
sure that no one else cashes the checks. He wants to deal only with Artist. And he worries
that if Artist assigns the right to receive payment, he will feel less motivated to do his
job well.
Arbitration Some contracts prohibit the parties from suing in court and require that
disputes be settled by an arbitrator. The parties to a contract do not have to arbitrate a
dispute unless the contract specifically requires it. Arbitration has its advantages—flexibility
and savings in time and money—but it also has disadvantages. For example, most contracts
between consumers and brokerage houses require arbitration. Consumer advocates argue
that the arbitrators in these disputes are biased in favor of the brokerage houses—who
engage in many arbitrations—over consumers who are likely to be one-time customers. And
many believe that employees receive a less favorable result when they arbitrate, rather than
litigate, disputes with their employer. Also, if a court makes a mistake in applying the law,
an appellate court can correct the error. But if an arbitrator makes a mistake, there is
generally no appeal. The movie contract does not include an arbitration provision.
Attorney’s Fees As a general rule, parties to a contract must pay their own legal fees,
no matter who is in the wrong. But contracts may override this general rule and provide that
the losing party in a dispute must pay the attorney’s fees for both sides. Such a provision
tends to discourage the poorer party from litigating with a rich opponent for fear of having to
pay two sets of attorney’s fees. The movie contract provides:
Artist hereby agrees to indemnify Producer from and against any and all losses, costs (including,
without limitation, reasonable attorneys’ fees), liabilities, damages, and claims of any nature
arising from or in connection with any breach by Artist of any agreement, representation, or
warranty made by Artist under this Agreement.
Assignment of rights
A transfer of benefits under a
contract to another person.
Delegation of duties
A transfer of obligations in a
contract.
416 U N I T 2 Contracts
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There is no equivalent provision for breaches by Producer. What does that omission tell you
about the relative bargaining power of the two parties?
Integration During contract negotiations, the parties may discuss many ideas that are
not ultimately included in the final version. The point of an integration clause is to prevent
either side from later claiming that the two parties had agreed to additional provisions. The
movie contract states:
This Agreement, along with the exhibits attached hereto, shall constitute a binding contract
between the parties hereto and shall supersede any and all prior negotiations and communica-
tions, whether written or oral, with respect hereto.
Without this clause, even a detailed written contract can be amended by an undocumented
conversation—a dangerous situation since the existence and terms of the amendment will
depend on what a court thinks was said and intended, which may or may not be what actually
happened.
EXAM Strategy
Question: Daniel and Annie signed a contract providing that Daniel would lend
$50,000 to Annie’s craft beer business at an interest rate of 8 percent. During
negotiations, Daniel and Annie agreed that the interest rate would go down to
5 percent once she had sold 25,000 cases. This provision never made it into the
contract. After the contract had been signed, Daniel agreed to reduce the interest rate
to 6 percent once volume exceeded 25,000 cases. The contract had an integration
provision but no modification clause. What interest rate must Annie pay once she has
sold 25,000 cases?
Strategy: If a contract has an integration provision, then side agreements made
during negotiations are unenforceable unless included in the written contract.
Without a modification provision, oral agreements made after the contract was signed
may be enforceable.
Result: A court would not enforce the side agreement that reduced the interest rate
to 5 percent. However, it is possible that a court would enforce the 6 percent
agreement.
Severability If, for whatever reason, some part of the contract turns out to be unenforce-
able, a severability provision asks the court simply to delete the offending clause and enforce
the rest of the contract. For example, courts will not enforce unreasonable noncompete
clauses. (California courts will not enforce any noncompetes, unless made in connection with
the sale of a business.) In one case, a consultant signed an employment contract that
prohibited him from engaging in his occupation “anyplace in the world.” The court struck
down this noncompete provision but ruled that the rest of the contract (which contained trade
secret clauses) was valid. The movie contract states:
In the event that there is any conflict between any provision of this Agreement and any statute, law,
or regulation, the latter shall prevail; provided, however, that in such event, the provision of this
Agreement so affected shall be curtailed and limited only to the minimum extent necessary to
permit compliance with the minimum requirement, and no other provision of this Agreement shall
be affected thereby and all other provisions of this Agreement shall continue in full force and effect.
CHAPTER 18 Practical Contracts 417
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Force Majeure A force majeure event is a disruptive, unexpected occurrence for
which neither party is to blame that prevents one or both parties from complying with
the contract. Force majeure events typically include war, terrorist attack, fire, flood, or
general acts of God. If, for example, a major terrorist event were to halt air travel, Artist
might not be able to appear on set as scheduled. The movie contract defines force
majeure events thus:
fire, war, governmental action or proceeding, third-party breach of contract, injunction, or
other material interference with the production or distribution of motion pictures by Producer,
or any other unexpected or disruptive event sufficient to excuse performance of this Agreement
as a matter of law or other similar causes beyond Producer’s control or by reason of the death,
illness, or incapacity of the producer, director, or a member of the principal cast or other
production personnel.
Notices After a contract is signed, there may be times when the parties want to send
each other official notices—of a breach, an objection, or an approval, for example.
In this section, the parties list the addresses where these notices may be sent. For
Producer, it is company headquarters. For Artist, there are three addresses: his agent,
his manager, and his lawyer. The notice provision also typically specifies when
the notice is effective: when sent, when it would normally be expected to arrive, or
when it actually does arrive.
Closing To indicate that the parties have agreed to the terms of the contract, they must
sign it. A simple signature is sufficient, but contracts often contain flourishes. The movie
contract, for example, states:
IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first
written above.
With clauses like this, it is important to make sure that there is an (accurate) date on the first
page. If not otherwise provided in the “Notices” section, it is a good idea to include the
parties’ addresses. The movie contract also listed Artist’s social security number.
When a party to the contract is a corporation, the signature lines should read like this:
Winterfield Productions, Inc.
By:
Name:
Title:
If an individual signs her own name without indicating that she is doing so in her role as an
employee of Winterfield Productions, Inc., she would be personally liable.
In the end, both parties signed the contract, and the movie was made. According to
Rotten Tomatoes, the online movie site, professional reviewers rated it 7.9 out of 10.
Chapter Conclusion
You will undoubtedly sign many contracts in your life. Their length and complexity can be
daunting. (In the movie contract, one of the paragraphs is 1,000 words.) The goal of this
chapter is to help you understand the structure and meaning of the most important provi-
sions so that you can read and analyze contracts more effectively.
Force majeure event
A disruptive, unexpected
occurrence for which neither
party is to blame that prevents
one or both parties from
complying with a contract.
418 U N I T 2 Contracts
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EXAM REVIEW
1. AMBIGUITY Any ambiguity in a contract is interpreted against the party who
drafted the agreement. (pp. 406–407)
2. SCRIVENER’S ERROR A scrivener’s error is a typographical mistake. In the
case of a scrivener’s error, a court will reform a contract if there is clear and convincing
evidence that the mistake does not reflect the true intent of the parties. (p. 407)
Question: Martha intended to transfer a piece of land to Paul. By mistake, she
signed a contract transferring two parcels of land. Each piece was accurately
described in the contract. Will the court reform this contract and transfer one piece
of land back to her?
Strategy: Begin by asking if this was a scrivener’s error. Then consider whether
the court will correct the mistake.
3. BEFORE SIGNING A CONTRACT Before signing a contract, check carefully
and thoughtfully the names of the parties, the dates, dollar amounts, and interest
rates. (p. 409)
4. MATERIAL BREACH A material breach is important enough to defeat an
essential purpose of the contract. (p. 412)
Question: Laurie’s contract to sell her tortilla chip business to Hudson contained
a provision that she must continue to work at the business for five years. One year
later, she quit. Hudson refused to pay her the amounts still owing under the
contract. Laurie alleged that he is liable for the full amount because her breach
was not material. Is Laurie correct?
Strategy: What was the essential purpose of the contract? Was Laurie’s breach
important enough to defeat it?
5. SOLE DISCRETION A party with sole discretion has the absolute right to make
any decision on that issue. (p. 412)
Question: A tenant rented space from a landlord for a seafood restaurant. Under
the terms of the lease, the tenant could assign the lease only if the landlord gave her
consent, which she had the right to withhold “for any reason whatsoever, at her sole
discretion.” The tenant grew too ill to run the restaurant and asked permission to
assign the lease. The landlord refused. In court, the tenant argued that the landlord
could not unreasonably withhold her consent. Is the tenant correct?
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CHAPTER 18 Practical Contracts 419
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Strategy: A sole discretion clause grants the absolute right to make a decision.
Are there any exceptions?
6. REASONABLE Reasonablemeans ordinary or usual under the circumstances. (p. 412)
7. GOOD FAITH Good faith means an honest effort to meet both the spirit and letter
of the contract. (p. 412)
8. STRUCTURE OF A CONTRACT The structure of a contract looks like this:
1. Title
2. Introductory Paragraph
3. Definitions
4. Covenants
5. Breach
6. Conditions
7. Representations and Warranties
i. Covenants are the promises the parties make about what they will do in the
future.
ii. Representations and warranties are statements of fact about the present or
past—they are true when the contract is signed (or at some other specific,
designated time).
8. Boilerplate
i. Choice of Law and Forum
ii. Modification
iii. Assignment of Rights and Delegation of Duties
iv. Arbitration
v. Attorney’s Fees
vi. Integration
vii. Severability
viii. Force Majeure
ix. Notices
x. Closing (pp. 409–412)
2. Result: The court ruled that it was not a scrivener’s error because it was not a
typo or clerical error. Therefore, the court did not reform the contract, and the land
was not transferred back to Martha.
4. Result: The purpose of the contract was for Hudson to build up the business
and make a profit. Laurie’s departure interfered with that goal. The court ruled that
the breach was material and Hudson did not have to pay the sums still owing under
the contract.
5. Result: The court ruled for the landlord. She had the absolute right to make any
decision so long as the decision was not illegal. The moral: Sole discretion clauses
are serious business. Do not enter into one lightly.
420 U N I T 2 Contracts
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MULTIPLE-CHOICE QUESTIONS
1. Which of the following statements is true?
(a) Vagueness occurs when the parties do not want the contract to be clear.
(b) Ambiguity occurs when the parties do not want the contract to be clear.
(c) Vagueness in a contract is often appropriate as a way to clinch a deal.
(d) Ambiguity is an appropriate tactic, particularly by the party drafting the contract.
2. In the Cipriano case, what happened?
(a) The jury decided in favor of Cipriano because arson is vandalism.
(b) The jury decided against Cipriano because arson is not vandalism.
(c) The judge dismissed the motion for summary judgment because the contract was
ambiguous.
(d) The judge granted the motion for summary judgment because the contract was
not ambiguous.
3. In the case of a scrivener’s error, what happens?
(a) A court will not reform the contract. The parties must live with the document
they signed.
(b) A court will reform the contract if there is clear and convincing evidence that the
clause in question does not reflect the true intent of the parties.
(c) A court will reform the contract if a preponderance of the evidence indicates that
that the clause in question does not reflect the true intent of the parties.
(d) A court will invalidate the contract in its entirety.
4. In the LeMond case, the court ruled:
(a) Protective’s failure to supply marketing and media plans was a material breach of
the contract because without those plans, LeMond could not monitor sales.
(b) Protective’s failure to supply marketing and media plans was a material breach of
the contract because Protective had agreed to supply the plans.
(c) The requirement that Protective use commercially reasonable means to promote
the product line was not enforceable because the term was ambiguous.
(d) Protective’s failure to supply marketing and media plans was not a material
breach of the contract.
5. A contract states (1) that Buzz Co. legally exists and (2) will provide 2,000 pounds of
wild salmon each week. Which of the following statements is true?
(a) Clause 1 is a covenant and Clause 2 is a representation.
(b) Clause 1 is a representation and Clause 2 is a covenant.
(c) Both clauses are representations.
(d) Both clauses are covenants.
ESSAY QUESTIONS
1. List three types of contracts that should definitely be in writing, and one that
probably does not need to be.
2. Make a list of provisions that you would expect in an employment contract.
CHAPTER 18 Practical Contracts 421
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3. List three provisions in a contract that would be material, and three that would not be.
4. Slimline and Distributor signed a contract providing that Distributor would use
reasonable efforts to promote and sell Slimline’s diet drink. Slimline was already
being sold in Warehouse Club. After the contract was signed, Distributor stopped
conducting in-store demos of Slimline. It did not repackage the product as Slimline
and Warehouse requested. Sales of Slimline continued to increase during the term of
the contract. Slimline sued Distributor, alleging a violation of the agreement. Who
should win?
5. YOU BE THE JUDGE WRITING PROBLEM Chip bought an insurance policy
on his house from Insurance Co. The policy covered damage from fire but explicitly
excluded coverage for harm caused “by or through an earthquake.” When an
earthquake struck, Chip’s house suffered no fire damage, but the earthquake caused a
building some blocks away to catch on fire. That fire ultimately spread to Chip’s
house, burning it down. Is Insurance Co. liable to Chip? Argument for Insurance Co.:
The policy could not have been clearer or more explicit. If there had been no
earthquake, Chip’s house would still be standing. The policy does not cover his loss.
Argument for Chip: His house was not damaged by an earthquake; it burned down.
The policy covered fire damage. If a contract is ambiguous, it must be interpreted
against the drafter of the contract.
DISCUSSION QUESTIONS
1. In the movie contract, which side was the more
successful negotiator? Can you think of any terms
that either party left out? Are any of the provisions
unreasonable?
2. What are the advantages and disadvantages of
hiring a lawyer to draft or review a contract?
3. What are the penalties if Artist breaches the movie
contract? Are these reasonable? Too heavy?
Too light?
4. ETHICS In the Heritage case, the two companies
had agreed to a price change of $0.01. When
Heritage’s lawyer pointed out to his client the
change to $0.10, the Heritage officer did not tell
Phibro. The change was subtle in appearance but
important in its financial impact. Was Heritage’s
behavior ethical? When the opposing side makes a
mistake in a contract, do you have an ethical
obligation to tell them? What Life Principles
would you apply in this situation?
5. Blair Co.’s top officers approached an investment
bank to find a buyer for the company. The bank
sent an engagement letter to Blair with the
following language:
If, within 24 months after the termination of this
agreement, Blair is bought by anyone with whom
Bank has had substantial discussions about such a
sale, Blair must pay Bank its full fee.
Is there any problem with the drafting of this
provision? What could be done to clarify the
language?
422 U N I T 2 Contracts
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UNIT3
Commercial
Transactions
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CH-
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INTRODUCTION
TO SALES
He Sued, She Sued. Harold and Maude made a
great couple because both were compulsive
entrepreneurs. One evening they sat on their
penthouse roof deck, overlooking the twinkling
Chicago skyline. Harold sipped a decaf coffee
while negotiating, over the phone, with a real
estate developer in San Antonio. Maude puffed
a cigar as she bargained on a different line with a
toy manufacturer in Cleveland. They hung up at
the same time. “I did it!” shrieked Maude, “I made an
incredible deal for the robots—five bucks each!” “No, I
did it!” trumpeted Harold, “I sold the 50 acres in Texas
for $300,000 more than it’s worth.” They dashed
indoors.
Maude quickly scrawled a handwritten memo, which
said, “Confirming our deal—100,000 Psychopath
Robots—you deliver Chicago—end of summer.” She
did not mention a price, or an exact delivery date, or when
payment would be made. She signed her memo and
faxed it to the toy manufacturer. Harold took more time.
He typed a thorough contract, describing precisely the
land he was selling, the $2.3 million price, how and when each payment would be made
and the deed conveyed. He signed the contract and faxed it, along with a plot plan showing
the surveyed land. Then the happy couple grabbed a bottle of champagne, returned to the
deck—and placed a side bet on whose contract would prove more profitable. The loser would
have to cook and serve dinner for six months.
Neither Harold nor Maude ever heard again from the other parties. The toy manufac-
turer sold the Psychopath Robots to another retailer at a higher price. Maude was forced to
buy comparable toys elsewhere for $9 each. She sued. And the Texas property buyer
changed his mind, deciding to develop a Club Med in Greenland and refusing to pay
Harold for his land. He sued. Only one of the two plaintiffs succeeded. Which one?
Confirming our deal—
100,000 Psychopath
Robots—you deliver
Chicago—end of summer.
CHAPTER
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424 U N I T 3 Commercial Transactions
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The adventures of Harold and Maude illustrate the Uniform Commercial
Code (UCC) in action. The Code is the single most important source of law for
people engaged in commerce and controls the vast majority of contracts made
every day in every state. The Code is ancient in origin, contemporary in usage,
admirable in purpose, and flawed in application. “Yeah, yeah, that’s fascinating,”
snaps Harold, “but who wins the bet?” Relax, Harold, we’ll tell you in a minute.
19-1 DEVELOPMENT OF COMMERCIAL LAW
In England in the 1500s, it was far more important to hold land than it was to have money.
Large landowners—barons, earls, and dukes—stood in excellent positions. They had access
to the king or queen, they were exempt from many kinds of arrest, and, if they did get into
trouble, they generally were tried before other members of the nobility in special courts. It
is not surprising that law was then centered squarely upon real property, which mainly
consists of land and permanent structures. But society changes, and so do businesses. When
this happens, the law may fall behind the times.
In the 1500s, merchants in England began to have problems using existing law to resolve
commercial disputes. There were many laws about land, but few for contracts. English judges
were only beginning to acknowledge that an exchange of mere promises, with no money or
property changing hands,might lead to an enforceable agreement. Butmerchants dealt in the sale
of goods, not real estate. Their livelihood depended upon promises, on the rapid movement of
their wares, and on their ability to enforce bargains. Dissatisfied with the few remedies that courts
offered, businessmen throughout England and theContinent began to treat their own customs as
law and to settle disputes in trade organizations rather than civil courts. The body of rules they
relied on became known as the lex mercatoria, or law merchant. The law merchant was thus a
“custom made” law, created by the merchants who used it. The new doctrine focused on
promises, the sale and exchange of goods, and payment.
In the middle of the 20th century, contract law again required a reinvention. Two
problems had become apparent in the United States:
1. Old contract law principles often did not reflect modern business practices.
2. Laws had become different from one state to another.
Onmany legal topics, contract law included, the national government has had little to say and
has allowed the states to act individually. Texas decides what kinds of agreements count as
contracts in Texas, and next door in Oklahoma, the rules may be very different. On many issues,
states reached essentially similar conclusions, so contract lawdeveloped in the samedirection. But
sometimes, the states disagreed, and contract law took on the aspect of a patchwork quilt.
The UCC was created as an attempt to solve these two problems. It was a proposal written
by legal scholars and not a law drafted bymembers of Congress or state legislatures. The scholars
at the American Law Institute and the National Conference of Commissioners on Uniform State
Laws had great ideas, but they had no legal authority to make anyone do anything.
Over time, lawmakers in all 50 states were persuaded to adopt many parts of the UCC.
They responded to these persuasive arguments:
1. Businesses will benefit if most commercial transactions are governed by the modern
and efficient contract law principles that are outlined in the UCC.
2. Businesses everywhere will be able to operate more efficiently, and transactions will
be more convenient, if the law surrounding most of their transactions is the same in all
50 states.
CHAPTER 19 Introduction to Sales 425
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This chapter will focus on Article 2 of the UCC, which applies to the sale of goods. A
good is a moveable physical object except for money and securities (like stock certificates).
A house is not a good, but the stuff in the house—the car in the garage, the televisions, the
furniture, and almost everything else—is. Article 2 applies to contracts that sell goods, as
well as to contracts that sell a mix of goods and services if the predominant purpose of the deal
is to sell goods.
It is worth noting that the UCC is not a total replacement for older principles in contract
law. Contract lawsuits not involving goods are still resolved using the older common law
rules. The table below outlines the UCC and the types of contracts that it does govern.
The entire Code is available online at http://www.law.cornell.edu/ucc/ucc.table.html.
Article 1:
General Provisions The purpose of the code, general guidance in applying
it, and definitions.
Article 2:
Sale of Goods The sale of goods, such as a new car, 20,000 pairs of
gloves, or 101 dalmatians. This is one of the two most
important articles in the UCC.
Article 2A:
Leases A temporary exchange of goods for money, such as
renting a car.
Article 3:
Negotiable Instruments The use of checks, promissory notes, and other
negotiable instruments.
Article 4:
Bank Deposits and
Collections
The rights and obligations of banks and their
customers.
Article 4A:
Funds Transfers An instruction, given by a bank customer, to credit a
sum of money to another’s account.
Article 5:
Letters of Credit The use of credit, extended by two or more banks, to
facilitate a contract between two parties who do not
know each other and require guarantees by banks
they trust.
Article 6:
Bulk Transfers The sale of a major part of a company’s inventory or
equipment. This article has been repealed in all but a
few states.
Article 7:
Warehouse Receipts,
Bills of Lading, and Other
Documents of Title
Documents proving ownership of goods that are being
transported or stored.
(continued)
426 U N I T 3 Commercial Transactions
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Article 8:
Investment Securities Rights and liabilities concerning shares of stock or
other ownership of an enterprise.
Article 9:
Secured Transactions A sale of goods in which the seller keeps a financial
stake in the goods he has sold, such as a car dealer
who may repossess the car if the buyer fails to make
payments. This is one of the two most important
articles in the Code.
19-1a Harold and Maude, Revisited
Harold and Maude each negotiated what they believed was an enforceable agreement, and
both filed suit: Harold for the sale of his land, Maude for the purchase of toy robots. Only
one prevailed. The difference in outcome demonstrates one of the changes that the UCC
has wrought in the law of commercial contracts and illustrates why everyone in business
needs a working knowledge of the Code. As we revisit the happy couple, Harold is clearing
the dinner dishes. Maude sits back in her chair, lights a cigar, and compliments her husband
on the apple tart. Harold, scowling and spilling coffee, wonders what went wrong.
Harold’s contract was for the sale of land and governed by the common law of
contracts. The common law Statute of Frauds requires any agreement for the sale of land
to be in writing and signed by the defendant, in this case the buyer in Texas. Harold signed it,
but the buyer never did, so Harold’s meticulously detailed document was worth less than a
five-cent cigar.
Maude’s quickly scribbled memorandum concerning psychotic robot toys was for the
sale of goods and was governed by Article 2 of the UCC. The Code requires less detail and
formality in a writing. Because Maude and the seller were both merchants, the document
she scribbled could be enforced even against the defendant, who had never signed anything.
The fact that Maude left out the price and other significant terms was not fatal to a contract
under the UCC, although under the common law such omissions would have made the
bargain unenforceable. We will look in greater detail at these UCC changes. For now it is
enough to see that the Code has carved major changes into the common law of contracts,
alterations that Harold is beginning to appreciate.
19-1b This Unit and This Chapter
This unit covers three principal subjects, all relating to commercial transactions that the
Code governs. The first chapters concern the sale of goods and focus primarily on Article 2.
In the present chapter we emphasize how Code provisions work together to change
the common law. In the following chapters we examine title to goods and warranties
(Chapter 20) and performance and remedies (Chapter 21).
A future chapter (Chapter 22) surveys the law of negotiable instruments. Checks are the
most common kind of negotiable instrument, but we will see that there are many other
varieties and that each creates different rights and obligations. We include in the unit a
chapter devoted to secured transactions (Chapter 23), that is, a sale of goods in which the
seller keeps a financial stake in the goods he has sold, and a later chapter that analyzes
bankruptcy law (Chapter 24).
The remainder of this chapter examines contract formation under Article 2 of the UCC.
When an agreement is struck, the first fundamental question of contract law is this: Has
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CHAPTER 19 Introduction to Sales 427
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an enforceable contract been formed? As you read the chapter, keep the following
ideas in mind:
1. The UCC is pro-business. The whole point of the UCC is to make business transactions
more reliable, convenient, and predictable.
2. Tie goes to the contract. In baseball, a tie goes to the runner. Under the UCC, the
preference is to declare an agreement to be a contract if no clear reason exists to
declare it invalid.
19-2 UCC BASICS
19-2a Code’s Purpose
The UCC proclaims its purposes clearly:
UCC §1-102(2): Underlying purposes and policies of this Act are
(a) to simplify, clarify and modernize the law governing commercial transactions;
(b) to permit the continued expansion of commercial practices through custom, usage and
agreement of the parties;
(c) to make uniform the law among the various jurisdictions.
This is not mere boilerplate. To “modernize,” in (a), requires a focus on the needs of
contemporary businesspeople, not on rules developed when judges rode horseback. Sup-
pose a court must decide whether a writing is detailed enough to satisfy the Code’s Statute
of Frauds. The judge may rely on §1-102 to decide that because modern commerce is so
fast, even the skimpiest of writings is good enough to demonstrate that the parties had
reached a bargain. In doing so, the judge would deliberately be turning away from legal
history to accommodate business practices in an electronic age.
Section 1-102 also states that “[t]his Act shall be liberally construed and applied to
promote its underlying purposes,” meaning that when in doubt, courts should focus on the
goals described. The Code emphasizes getting the right results rather than following rigid rules
of contract law.
19-2b Scope of Article 2
Because the UCC changes the common law, it is essential to know whether the Code
applies in a given case. Negotiations may lead to an enforceable agreement when
the UCC applies, even though the same bargaining would create no contract under the
common law.
UCC §2-102: Article 2 applies to the sale of goods.1Goods are things that are moveable,
other than money and investment securities. Hats are goods, and so are railroad cars, lumber,
books, and bottles of wine. Land is not a good, nor is a house. So an agreement for the
delivery of 10,000 board feet of white pine is a contract for the sale of goods, and Article 2
governs it. But the article does not apply to a contract for the sale of an office building. A
skyscraper is not moveable (although an entire city may be2).
1Officially, Article 2 tells us that it applies to transactions in goods, which is a slightly broader category
than sale of goods. But most sections of Article 2, and most court decisions, focus exclusively on sales,
and so shall we.
2
“If you are lucky enough to have lived in Paris as a young man, then wherever you go for the rest of
your life, it stays with you, for Paris is a moveable feast.” (Ernest Hemingway, 1950).
Good
Are things that are moveable,
other than money and
investment securities.
428 U N I T 3 Commercial Transactions
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Article 2 regulates sales, which means that one party transfers title to the other in
exchange for money. If you sell your motorcycle to a friend, that is a sale of goods. If you
lend the bike to your friend for the weekend, that is not a sale, and Article 2 does not apply.
Article 2 also does not apply to the leasing of goods, for example, when you rent a car. A sale
involves a permanent change in ownership whereas a lease concerns a temporary change in
possession.
19-2c Mixed Contracts
To determine whether the UCC governs, we need to know what kind of an agreement the
parties made. Was it one for the sale of goods (UCC) or one for services (common law)? In
fact the agreement combined both goods and services and was therefore a mixed contract. In
a mixed contract involving sales and services, the UCC will govern if the predominant purpose
is the sale of goods, but the common law will control if the predominant purpose is providing
services.
For example, assume that you take your car to a mechanic for repairs and that there are
problems with the work. If a lawsuit ensues, a court will have to determine whether the
predominant purpose of the contract was the parts (goods) which were replaced or the labor
(service) involved in the work.
19-2d Merchants
UCC §2-104: A merchant is someone who routinely deals in the particular goods involved,
or who appears to have special knowledge or skill in those goods, or who uses agents with
special knowledge or skill in those goods. A used car dealer is a “merchant” when it comes
to selling autos, because he routinely deals in them. A man selling his own car to someone
who responded to his classified ad is not acting as a merchant.
The UCC frequently holds a merchant to a higher standard of conduct than a non-
merchant. For example, a merchant may be held to an oral contract if she received written
confirmation of it, even though the merchant herself never signed the confirmation. That
same confirmation memo, arriving at the house of a non-merchant, would not create a
binding deal. We will see many instances of this dual level of responsibility, one for a
merchant and the other for a non-merchant.
19-2e Good Faith and Unconscionability
The UCC imposes a duty of good faith in the performance of all contracts. For non-merchants,
good faith means honesty in fact. For a merchant, good faith means honesty in fact plus the
exercise of reasonable commercial standards of fair dealing.3 Thus, when parties perform a
contract, or in certain cases when they negotiate, neither side may lie or mislead. Further, a
party who is a merchant must act as fairly as the business community routinely expects.
The UCC employs a second principle to encourage fair play and just results: the doctrine
of unconscionability. UCC §2-302: A contract may be unconscionable if it is shockingly
one-sided and fundamentally unfair. If a court concludes that some part of a contract is
unconscionable, it will refuse to enforce that provision. Courts seldom find a contract
unconscionable if the two parties are businesses, but they are quicker to apply the
doctrine when one party is a consumer.
The doctrine of good faith focuses on a party’s behavior as it performs an agreement:
Was it attempting to carry out its obligations in a reasonable manner and do what both sides
expected when they made the deal? Unconscionability looks primarily at the contract itself.
Are any terms so grossly unfair that a court should reform or ignore them?
3UCC §§1-201(19), 1-203, and 2-103.
Merchant
Generally, someone who
routinely deals in the particular
goods involved.
Unconscionable
A contract that is shockingly
one-sided and fundamentally
unfair.
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19-3 CONTRACT FORMATION
The common law expected the parties to form a contract in a fairly predictable and
traditional way: The offeror made a clear offer that included all important terms, and the
offeree agreed to all terms. Nothing was left open. The drafters of the UCC recognized that
businesspeople frequently do not think or work that way and that the law should
reflect business reality.
19-3a Formation Basics: §2-204
UCC §2-204 provides three important rules that enable parties to make a contract quickly
and informally:
1. Any Manner That Shows Agreement. The parties may make a contract in any manner
sufficient to show that they reached an agreement. They may show the agreement
with words, writings, or even their conduct. Lisa negotiates with Ed to buy
300 barbecue grills. The parties agree on a price, but other business prevents them
from finishing the deal. Then six months later, Lisa writes, “Remember our deal for
300 grills? I still want to do it if you do.” Ed does not respond, but a week later, a
truck shows up at Lisa’s store with the 300 grills and Lisa accepts them. The
combination of their original discussion, Lisa’s subsequent letter, Ed’s delivery, and
her acceptance all adds up to show that they reached an agreement. The court will
enforce their deal, and Lisa must pay the agreed-upon price.
2. Moment of Making Is Not Critical. The UCC will enforce a deal even though it is
difficult, in common law terms, to say exactly when it was formed. Was Lisa’s deal
formed when they orally agreed? When he delivered? She accepted? The Code’s
answer: It does not matter. The contract is enforceable.
3. One or More Terms May Be Left Open. The common law insisted that the parties
clearly agree on all important terms. If they did not, there was no meeting of minds
and no enforceable deal. The Code changes that. Under the UCC, a court may
enforce a bargain even though one or more terms were left open. Lisa’s letter never
said when she required delivery of the barbecues or when she would pay. Under
the UCC, the omission is not fatal. As long as there is some certain basis for
giving damages to the injured party, the court will do just that. Suppose Lisa
refused to pay, claiming that the agreement included no date for her payment. A
court would rule that the parties assumed she would pay within a commercially
reasonable time, such as 30 days.
In the following case, we can almost see the roller coasters, smell the cotton candy—and
hear the carnival owners arguing. Because the cases in this chapter involve more than one
Code section, we will outline the relevant provisions at the outset.
Code Provisions Discussed in This Case
Issue Relevant Code Section
1. What law governs? UCC §2-102: Article 2 applies to the sale of goods.
2. Did the parties form a contract? UCC §2-204: The parties may make a contract in
any manner sufficient to show agreement.
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Based on the UCC, the Jannuschs won a case they would have lost under the common law.
Next we look at changes the Code has made in the centuries-old requirement of a writing.
19-3b Statute of Frauds
UCC §2-201 requires a writing for any sale of goods worth $500 or more. However, under
the UCC, the writing need not summarize the agreement completely, and it need not even
be entirely accurate. Once again, the Code is modifying the common law rule, permitting
parties to enforce deals with less formality. In some cases, the court grants an exception and
enforces an agreement with no writing at all. Here are the rules.
CONTRACTS FOR GOODS WORTH $500 OR MORE
Section 2-201 demands a writing for any contract of goods over this limit, meaning that
virtually every significant sale of goods has some writing requirement. Remember that a
contract for goods costing less than $500 is still covered by the UCC, but it may be oral.
WRITING SUFFICIENT TO INDICATE A CONTRACT
The Code only requires a writing sufficient to indicate that the parties made a contract. In
other words, the writing need not be a contract. A simple memo is enough, or a letter or
informal note, mentioning that the two sides reached an agreement, is enough. In general,
the writing must be signed by the defendant, that is, whichever party is claiming there was
no deal. Dick signs and sends to Shirley a letter saying, “This is to acknowledge your
JANNUSCH V. NAFFZIGER
2008 WL 540877
Illinois Court of Appeals, 2008
C A S E S U M M A R Y
Facts: Festival Foods prepared and sold prepared food at
carnivals in the Midwest. Owners Gene and Martha Jan-
nusch made a verbal agreement to sell the business to the
Naffzigers for $150,000. They paid $10,000 and took
possession of the Festival Foods truck and trailer. They
paid taxes and employees, bought supplies, and sold food
at six events.
Because they had earned less at the carnivals than
they had expected, the Naffzigers returned the truck and
trailer and refused to pay the remaining $140,000. At trial,
they argued that no definite agreement had been reached.
The common law requires a meeting of the minds for
a contract to be created. Under the UCC, parties may
form a contract in “any manner sufficient to show agree-
ment.”
The Naffzigers argued that the UCC did not apply to
their agreement. The trial court agreed and ruled that a
contract did not exist because there had never been a
meeting of the minds. The Jannuschs appealed.
Issues: Did the common law or the UCC govern this agree-
ment? Did the parties form a contract?
Decision: The UCC applied to the contract. Under the
UCC, an enforceable agreement existed. Reversed and
remanded.
Reasoning: The defendants argued that the purchase of
a business was not a sale of goods. However, Article 2 of
the UCC applies to an agreement so long as the predomi-
nant purpose of the deal is a sale of goods. The truck and
trailer were valuable assets, and those goods were the core
of the contract. Thus, the UCC did apply.
Therefore, we must next ask whether the parties had
shown agreement. They set the price at $150,000. They
discussed which items were to be included. The defen-
dants took and used the items at six different carnivals.
Under the UCC, these exchanges were enough to create
an enforceable contract. The Naffzigers breached the
contract when they returned the truck and trailer.
CHAPTER 19 Introduction to Sales 431
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agreement to buy all 650 books in my rare book collection for $188,000.” Shirley signs
nothing. A day later, Louis offers Dick $250,000. Is Dick free to sell? No. He signed the
memo, it indicates a contract, and Shirley can enforce it against him.
Now reverse the problem. Suppose that after Shirley receives Dick’s letter, she decides
against rare books in favor of original scripts from the South Park television show. Dick sues.
Shirley wins because she signed nothing.
INCORRECT OR OMITTED TERMS
If the writing demonstrates the two sides reached an agreement, it satisfies §2-201 even if it omits
important terms or states them incorrectly. Suppose Dick writes “$1888,000,” indicating almost
$2 million, when he meant to write “$188,000.” The letter still shows that the parties made a
deal, and the court will enforce it, relying on oral testimony to determine the correct price.
ENFORCEABLE ONLY TO THE QUANTITY STATED
Since the writing only has to indicate that the parties agreed, it need not state every term of
their deal. But one term is essential: quantity.The Code will enforce the contract only up to the
quantity of goods stated in the writing. This is logical, since a court can surmise other terms,
such as price, based on market conditions. Buyer agrees to purchase pencils from Seller. The
market value of the pencils is easy to determine, but a court would have no way of knowing
whether Buyer meant to purchase 1,000 pencils or 100,000; the quantity must be stated.
EXCEPTIONS
In the following three sets of circumstances, the UCC Statute of Frauds is “turned off.”
Merchant Exception. This is a major change from the common law. When two merchants
make an oral contract, and one sends a confirming memo to the other within a reasonable
time, and the memo is sufficiently definite that it could be enforced against the sender
herself, then the memo is also valid against the merchant who receives it, unless he objects
within 10 days. Laura, a tire wholesaler, signs and sends a memo to Scott, a retailer, saying,
“Confm yr order today—500 tires cat #886—cat price.” Scott realizes he can get the tires
cheaper elsewhere and ignores the memo. Big mistake. Both parties are merchants, and
Laura’s memo is sufficient to bind her. So it also satisfies the Statute of Frauds against Scott,
unless he objects within 10 days.
Specialty Goods Exception. If a buyer orders goods that are to be specially manufactured
for the buyer and are not suitable for sale to others in the ordinary course of the seller’s
business, then a verbal agreement is enforceable even if it exceeds $500.
Judicial Admission Exception. If a defendant admits in his pleading, testimony, or otherwise in
court that a contract for salewasmade, then the contract he admitted to is enforceable against him.
The following case examines all three of these exceptions in the context of an agree-
ment to buy carpet and tile. When the Supreme Court of Virginia issued its ruling, one
company was floored.
Code Provisions Discussed in This Case
Issue Relevant Code Section
1. Is there a confirmatory memo? UCC 2-201(2)
2. Has the buyer ordered specialty goods? UCC 2-201(3)(a)
3. Did the buyer admit in its testimony that an
agreement existed?
UCC 2-201(3)(b)
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19-3c Added Terms: §2-207
Under the common law’s mirror image rule, when one party makes an offer, the offeree
must accept those exact terms. If the offeree adds or alters any terms, the acceptance is
ineffective and the offeree’s response becomes a counteroffer. In one of its most significant
modifications of contract law, the UCC changes that result. Under §2-207, an acceptance
that adds or alters terms will often create a contract. The Code has made this change in
DELTA STAR, INC. V. MICHAEL’S CARPET WORLD
276 Va. 524
Supreme Court of Virginia, 2008
Facts: Ivan Tepper, CEO of Delta Star, visited the
Michael’s Carpet World showroom to view flooring options
for a lobby entryway, his office, and his executive assis-
tant’s office. Tommy Martin, Michael’s sales manager,
helped Tepper select carpet and tile from the samples
displayed and gave him price quotes. For the entryway,
Tepper chose carpet; for the two offices, he selected a
tile that, although on showroom display, had never
before been sold by Michael’s. (After all, it was named
Michael’s Carpet World for a reason.) Tepper verbally
agreed to the materials and the prices and directed Mar-
tin to make further arrangements with his executive
assistant, Donna Nash.
Martin measured the three spaces and faxed Nash a
purchase order that read, “Carpet for entrance to lobby,
$832.22.”Michael’s installed the entryway carpet and Delta
Star paid the $832.22. Nash then authorized Martin to order
the tile for the two offices.When the materials arrived, Nash
told Martin to install the tile in her office, but sought to
cancel the tile for Tepper’s office. Michael’s sued.
At trial, Delta Star argued that it never had an enforce-
able contract with Michael’s for the office tiles because the
agreement was not in writing as required by the UCC’s
Statute of Frauds for the sale of goods over $500. Michael’s
contended that the tile contract did not require a writing to
be enforceable because: (1) The specialty goods exception
applied, since Michael’s ordered that particular tile for the
first time, and (2) the judicial admission exception applied,
since Nash had testified that she tried to cancel the order
and, as Michael’s argued, “you can’t cancel something
unless you’re admitting that you got a contract and you want
to cancel it.” The court agreed with Michael’s and awarded
$2,565 in damages. Delta Star appealed.
Issue: Did the specialty goods and judicial admission excep-
tions to the UCC’s Statute of Frauds rule apply?
Decision: No, neither exception applied. The verbal con-
tract was not enforceable. Reversed.
Reasoning: Tepper and Martin entered into a verbal
agreement for the sale and installation of flooring in three
different areas. One of the three—the entryway carpet—
was confirmed in writing by a purchase order, which only
served as confirmation for that specific portion of the trans-
action. When Delta Star attempted to cancel Tepper’s office
tile installation, the question became whether that tile
purchase was enforceable, even if not in writing.
The trial court concluded that the specialty goods
exception applied because the tiles were specially manu-
factured goods, which Michael’s could not resell. The court
misapplied the exception. Tepper chose the tiles from
among samples displayed in Michael’s showroom. The fact
that Michael’s had never sold these particular tiles before
did not mean they were specially made. In fact, the tiles
were not altered in any way for Delta Star, and were
suitable for sale to others in Michael’s ordinary course of
business, which was, after all, the sale of flooring. Michael’s
sold the tile to Delta Star and it could certainly sell it again
to someone else. Therefore, the specialty goods exception
did not apply.
The trial court also held that the judicial admission
exception applied because Nash’s testimony referenced
the purchase and installation of Tepper’s flooring and her
attempt to cancel it. A review of Nash’s trial testimony
reveals that she stated that Delta Star “didn’t want to act
on the estimate” and that Delta Star “hadn’t agreed to
order the flooring for Tepper’s office yet.” Therefore,
Nash did not admit the existence of a contract and the
judicial admission exception also did not apply.
Because the agreement for Tepper’s tiles had not
been confirmed in writing and neither exception applied,
the contract was not enforceable.
CHAPTER 19 Introduction to Sales 433
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response to battles of the form. Every day, corporations buy and sell millions of dollars of
goods using pre-printed forms. The vast majority of all contracts involve such documents.
Typically, the buyer places an order using a pre-printed form, and the seller acknowledges
with its own pre-printed acceptance form. Because each form contains language favorable to
the party sending it, the two documents rarely agree. The Code’s drafters concluded that
the law must cope with real practices.
We discuss §2-207 in detail in Chapter 10 and summarize it here only to emphasize how
it works with other UCC provisions. The section is confusing, and a diagram helps. For a
schematic look at UCC §2-207, see Exhibit 19.1.
No Contract Accepts Terms
as They Are
Accepts with
Additional Terms
Accepts with
Different Terms
Makes
Acceptance
Conditional on
Offeror’s
Assent to
Additional or
Different Terms
No Contract
(Unless Offeror
Accepts the New
Terms)
Contract
Generally a
Valid Contract
Generally a
Valid Contract
Offeree Does Not
Intend to Accept
Offeree Intends
to Accept
Offeror Makes
an Offer
Begin Here
Terms: The Offer Terms: Assuming bothparties are merchants,
the additional terms
become part of the
contract UNLESS
(1) the offer insisted on
its own terms
(2) the additional terms
materially alter the
old terms
(3) the offeror
promptly rejects the
additional terms.
Terms: In most states
the different
(contradictory) terms
cancel each other out
and are replaced by UCC
gap-filler provisions.
(In some states, though,
the offer terms govern,
and in a few states
the acceptance
terms govern.)
EXHIB IT 19.1 A Schematic Look at UCC §2-207
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INTENTION
The parties must still intend to create a contract. Section 2-207 is full of exceptions, but there
is no change in this basic requirement of contract law. If the differing forms indicate that the
parties never reached agreement, there is no contract.
ADDITIONAL OR DIFFERENT TERMS
An offeree may include a new term in his acceptance and still create a binding deal.
Suppose Breeder writes to Pet Shop, offering to sell 100 guinea pigs at $2 each. Pet Shop
faxes a memo saying, “We agree to buy 100 g.p. We get credit for any unhealthy pig.” Pet
Shop has added a new term, concerning unhealthy pigs, but the parties have created a
binding contract because the writings show they intended an agreement. Now the court
must decide what the terms of the contract are, since there is some discrepancy. The first
step is to decide whether the new language is an additional term or a different term.
Additional Terms Additional terms are those that raise issues not covered in the offer.
The “unhealthy pig” issue is an additional term because the offer said nothing about it.
When both parties are merchants, additional terms generally become part of the bargain.
Pet Shop’s insistence on credit for sick guinea pigs is binding on Breeder. In three
circumstances, however, additional terms do not bind the parties:
• If the original offer insisted on its own terms. If Breeder offered the pets for sale “on
these and no other terms,” Pet Shop’s additional language would not become part of
their deal.
• If the additional terms materially alter the offer. Pet Shop’s new language about credit
for unhealthy animals is fairly uncontroversial. But suppose Pet Shop wrote back,
“Breeder is liable for any illness of any animal in Pet Shop within 90 days of shipment
of guinea pigs.” Breeder would potentially have to pay for a $500 iguana with
pneumonia or a $6,000 parrot with gout. This is a material alteration of the bargain
and is not part of the contract.
• If the offeror promptly objects to the new terms. If Breeder received Pet Shop’s fax and
immediately called up to say “No credit for unhealthy pigs,” then Pet Shop’s
additional term is not part of their deal.
In all other circumstances, additional terms do become part of an agreement between
merchants.
Different Terms Different terms are terms that contradict those in the offer. Suppose
Brilliant Corp. orders 1,500 cellular phones from Makem Co., for use by Brilliant’s sales
force. Brilliant places the order using a pre-printed form stating that the product is fully
warranted for normal use and that seller is liable for compensatory and consequential
damages. This means, for example, that Makem could be liable for lost profits if a sales-
man’s phone fails during a lucrative sales pitch. Makem responds with its own memo stating
that in the event of defective phones, Makem is liable only to repair or replace, and is not
liable for consequential damages, lost profits, or any other damages.
Makem’s acceptance has included a different term because its language contradicts the
offer. Almost all courts would agree that the parties intended to reach an agreement and
therefore the contract is enforceable. The question is, what are its terms? Is the full warranty
of the offer included, or the very limited warranty of the acceptance? The majority of states
hold that different terms cancel each other out. Neither party’s language goes into the
contract. But what then are the terms of the deal?
If the evidence indicates that the parties had orally agreed on the issue disputed in the
forms, then the courts will ignore the contradictory writings and enforce the oral contract.
If there is no clear oral agreement, the Code supplies its own terms, called gap-fillers, which
Additional terms
Terms that introduce issues
not covered in the offer.
CHAPTER 19 Introduction to Sales 435
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cover prices, delivery dates and places, warranties, and other subjects. In the cellular phone
case, the contradicting warranty provisions cancel each other out. The parties had not orally
agreed on a warranty, so a court would enforce the Code’s gap-filler warranty, which does
permit recovery of compensatory and consequential damages. Therefore, Makem would be
liable for lost profits. We outline most of the gap-filler terms in Chapter 10. Warranty
provisions are analyzed in greater detail in Chapter 20.
In the following case, the Rhode Island Supreme Court seeks the fairest method of
sorting out conflicting terms.
Code Provisions Discussed in This Case
Issue Relevant Code Section
1. Which are the terms of this
agreement?
UCC §2-207: Additional terms generally but not
always become part of the bargain. Different
terms generally cancel each other out.
2. What is the Code’s provision
concerning delivery?
UCC §2-309: The time for shipment or delivery if
not agreed upon is a reasonable time.
3. What is a “reasonable”
delivery time?
UCC §1-204: A “reasonable” time depends on
the nature, purpose, and circumstances of the
action.
SUPERIOR BOILER WORKS, INC. V. R. J. SANDERS, INC.
711 A.2d 628
Supreme Court of Rhode Island, 1998
C A S E S U M M A R Y
Facts: R. J. Sanders, Inc., had a contract with the federal
government to install the heating system at a federal
prison camp. The company negotiated with Superior Boi-
ler Works to purchase three large commercial units. On
March 27, Superior sent a proposal to Sanders, offering to
sell three boilers for a total of $156,000 and estimating
time of delivery at four weeks. The parties exchanged
further documents and held various discussions. Finally,
on July 20, Sanders sent a “purchase order” for three
boilers, agreeing to pay $145,827 and stating “Date
required: 4 Weeks,” that is, August 20. On August 6,
Superior sent a “sales order,” agreeing to sell the three
boilers at that price, but providing a shipping date of
October 1. This later delivery date forced Sanders to rent
temporary boilers at a cost of $45,315. On October 1,
Superior shipped the boilers, which arrived on October 5.
Sanders sent a check in the amount of $100,000, claiming
that Superior had delivered the boilers late and deducting
the cost of its rental equipment. Superior sued for the
additional $45,000 and moved for summary judgment,
which the trial court granted. Sanders appealed, claiming
that the contract had required Superior to deliver the
boilers within four weeks.
Issue: Did Superior’s October delivery breach the contract?
Decision: No, Superior did not breach the contract.
Affirmed.
Reasoning: Sanders’s amended purchase order of July
20 and Superior’s August 6 response agree on the specifi-
cations and price of the boilers. Although the documents
disagree on time of delivery, they still create a contract
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EXAM Strategy
Question: Martin, a diamond wholesaler, writes Serge, a jewelry retailer, offering
to sell 75 specified diamonds for $2 million. Martin’s offer sheet specifies the price,
quantity, date of delivery, and other key terms. The sheet also states, “Offer is
made on these terms and no other.” Serge sends Martin his own purchase order,
naming the diamonds, price, and so forth, but adding a clause requiring any disputes
to be settled by a diamond-industry arbitrator. In the diamond industry, arbitration
by such a person is standard. Martin does not object to the arbitration clause.
Martin delivers the gems but Serge refuses to pay the full price, claiming that many
of the stones are of inferior quality. Martin sues for the balance due, but Serge
insists that any dispute must be settled by arbitration. May Martin litigate, or must
he arbitrate the case?
Strategy: Under the common law, there might not be a contract between these
parties, because Serge added a new term. However, this agreement concerns the sale
of goods, meaning that the UCC governs. Under UCC §2-207, when both parties are
merchants (as they are here), additional terms become part of the contract except in
three instances. Review those three instances, and apply them here.
Result: Additional terms become part of the agreement unless the original offeror
insisted on its own terms, the new term materially alters the offer, or the offeror promptly
rejects the new term.Martin’s offer insisted on its own terms and Serge’s arbitration clause
does not become part of the agreement. Martin may litigate his dispute.
19-3d Open Terms: §§2-305 and 2-306
OPEN PRICES
Under §2-305, the parties may conclude a contract even though they have not settled the
price. Again, this is a change from the common law, which required certainty of such an
important contract term. Under the Code, if the parties have not stated one, the price is a
reasonable price at the time of delivery. A court will use market value and other comparable
sales to determine what a reasonable price would have been. If the contract permits the
buyer or seller to determine the price during contract performance, §2-305 requires that she
do so in good faith, as the following case demonstrates.
because both parties intended to be bound. The time of
delivery should be settled under UCC Section 2-207 (2).
Courts in other states rule in a variety of wayswhen faced
with terms that differ. Rhode Island adopts the “knock-out”
rule: Conflicting contract terms knock each other out, leaving
a hole to be filled by the Code’s gap-filler provision. It is true
that this may result in a contract provision that neither party
wants; however, each sidemayprotect against this by insisting
that agreement be made on its own terms.
Section 2-309 states that if the parties do not agree
on the time for delivery, it should be a reasonable time.
Normally, it is for the factfinder to determine reason-
ableness from all of the circumstances surrounding the
transaction, including the parties’ earlier deals, standard
trade usage, and so on. See UCC Section 1-204 (2). In
this case, though, all of the evidence demonstrates that,
measured by industry standards, Superior’s performance
was reasonable.
CHAPTER 19 Introduction to Sales 437
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Code Provisions Discussed in This Case
Issue Relevant Code Sections
1. May the parties form a
binding agreement without
specifying the price?
UCC §2-305(1): The parties may conclude a contract even
though they have not settled the price.
2. May a contract permit one
party to settle the price?
UCC §2-305(2): “A price to be fixed by the seller or by the
buyer” requires that it be fixed in good faith.
3. What does good faith mean? UCC §§1-201(19), 1-203, and 2-103: For non-merchants,
good faith means honesty in fact. For a merchant, good faith
means honesty in fact plus the exercise of reasonable
commercial standards of fair dealing.
MATHIS V. EXXON CORPORATION
302 F.3d 448
Fifth Circuit Court of Appeals, 2002
C A S E S U M M A R Y
Facts: Exxon marketed gasoline to retailers in three
ways. Franchisees (who owned local gas stations) were
required to purchase a minimum number of gallons per
month. Exxon set the price each month, known as
the dealer tank wagon price (DTW). Jobbers (distributors
who could resell to dealers) paid the “rack price,” which
was generally lower than the DTW. Company-operated
retail stores (CORS) paid nothing because Exxon
owned them.
A group of 54 Texas franchisees sued, claiming that
Exxon set their gasoline prices artificially high. The plain-
tiffs alleged that Exxon wanted to drive them out of
business and replace their franchises with more profitable
CORS. The evidence indicated that the franchisees’
DTW was consistently higher than the rack price paid
by jobbers. Many plaintiffs testified that their franchises
had become unprofitable. One study showed that 62 per-
cent of franchisees in Corpus Christi, Texas, were selling
gas below the price they paid for it. Plaintiffs’ expert
testified that 75 percent of their competitors could buy
gasoline at a lower price.
The plaintiffs argued that this evidence demonstrated
that Exxon set the prices in bad faith. The jury agreed,
awarding the plaintiffs $5.7 million, plus $2.3 million in
attorney’s fees. Exxon appealed.
Issue: Did Exxon set the prices in bad faith?
Decision: Yes, Exxon set the prices in bad faith. Affirmed.
Reasoning: The UCC rejects the notion that a seller
may fix any price it wants. When a contract permits a
seller to set the price, it must do so in good faith. These
franchisees allege bad faith. Lawsuits like this are rare
because a mere allegation of bad faith is unpersuasive.
Here, though, the plaintiffs offered considerable evidence
of Exxon’s bad faith.
There was testimony and documentation indicating
that Exxon planned to replace many of its franchises with
CORS. The plaintiffs also showed that the DTW price
was higher than the rack price, and that Exxon prevented
franchisees from purchasing gas from jobbers. Because of
the unnaturally high price that franchisees were forced to
pay for their gas, many of their dealerships were unprofi-
table and uncompetitive.
An Exxon document stated the company’s “market-
ing strategy is to reduce Dealer stores.” Another company
paper indicated that Exxon wanted to reduce dealer stores
in Houston from 95 to 45. Exxon’s regional director
acknowledged that the company made greater profits
from CORS than from franchises. CORS with conveni-
ence stores were the most profitable and were considered
the wave of the future. The number of dealer stations
declined steadily. Even though Exxon was moving to
replace independent dealers with CORS, it never made
that position clear to its franchisees.
There was more than enough evidence to support the
jury’s conclusion that Exxon set its prices in bad faith.
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EXAM Strategy
Facts: Coffee Retailer sends a form to Cupper, ordering 100 cartons of specified
coffee cups to be delivered the first of each month for six months. The order form
says nothing about price. For three months, Cupper delivers on time and sends an
invoice, which Retailer pays. On the fourth month, Cupper’s invoice is 8 percent
higher than before. Retailer refuses to pay the increase and informs Cupper that it will
accept no more deliveries. Cupper sues. Retailer claims there was no enforceable
contract. Cupper says there was a bargain and that it has the right to determine the
price. Who is right?
Strategy: Retailer’s offer included no price. Under the common law, the absence of
such an essential term would mean there was no contract. However, these are goods,
and under the UCC the parties can make an enforceable deal without specifying the
price. This is a valid contract. The companies may, if they choose, permit one party to
determine the price. Did they do so here? If so, is Cupper’s conduct reasonable? If
the parties did not allow one side to set the price, how would a court do so?
Result: This contract neither stated a price nor allowed one party to determine it.
That means that the price is a reasonable one at the time of delivery. A court will use
market value, and any comparable sales, to determine the price.
OUTPUT AND REQUIREMENTS CONTRACTS
Under §2-306, an output contract obligates the seller to sell all of his output to the buyer,
who agrees to accept it. Suppose Joel has a small plant in which he manufactures large
plants; that is, handcrafted artificial flowers and trees, made of silk and other expensive
materials. Joel is not sure how many he can produce in a year, but wants a guaranteed
market. He makes an output contract with Yolanda, in which he promises to sell the entire
output of his plant, and she agrees to buy it all.
A requirements contract is the reverse, obligating a buyer to purchase all his needed
goods from the seller. Joel might sign a requirements contract with Worm Express, agreeing
to buy from Worm all the silk he needs. Both output and requirements contracts are valid
under the Code, although they create certain problems. By definition, the exact quantity of
goods is not specified. But then how much may one party demand? Is there any upper or
lower limit?
The UCC requires that the parties in an output or requirements contract make their
demands in good faith. For example, in a requirements contract, a buyer may not suddenly
increase her demand far beyond what the parties expected merely because there has been a
market change. Suppose the price of silk skyrockets. Joel’s requirements contract obligates
Worm Express to sell him all the silk he needs. Could Joel demand 10 times the silk he had
anticipated, knowing he could resell it at a big profit to other manufacturers? No. That
would be bad faith. Come on, Joel, play by the rules.
May the buyer reduce his demand far below what the parties anticipated? Yes, as long as
he makes the reduction in good faith.
The following case involves several issues, including a claim that an output contract
existed. Some contracts are meticulously written by veteran lawyers who use deliberate
and precise legal terms in every part of the agreement. Of course, agreements are
not always done so carefully. See what sense you can make of the “Weaner Pig Purchase
Agreement.”
CHAPTER 19 Introduction to Sales 439
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Code Provisions Discussed in This Case
Issue Relevant Code Section
1. Which law governs this agreement? UCC 2-102
2. Is there a writing sufficient to indicate a contract? UCC 2-201
3. Was an output contract formed? UCC 2-306
You Be the Judge
Facts: Legal research can
take you in odd directions.
Today, for example, we
learn that a “weaner pig”
is a very young pig that has
just been weaned from its
mother. You must raise
and sell a lot of them to make a living. Farmers who raise
pigs to full size need to sell fewer animals to get by.
Farmer Charles Lohman talked extensively with John
Wagner about raising weaner pigs for a new “pork net-
work” that Wagner, the owner of Swine Services, was
thinking of putting together. Lohman eventually decided
to join Wagner and convert his pig farm to one that
specialized in raising weaner pigs. He needed to borrow
money to remodel his farm, and he needed to convince
his bankers that, if they loaned him the necessary money,
he would be in a reasonable position to repay them.
He told Wagner that he “would need something to
show his banker.” Wagner faxed over a document with
several blanks entitled “Weaner Pig Purchase Agreement.”
It said, in part, “PRODUCER agrees to supply ____ weaner
pigs weekly.” When he received the fax, Lohman wrote
“300” in the blank. After showing the fax to his banker,
Lohman was able to secure his loan. He never sent Wagner
a copy of the document with the blank filled in.
For awhile, everyone was happy. Lohman shipped
weaner pigs to Wagner and was paid $28 each for them.
But eventually, problems arose. The price Wagner offered
for weaner pigs dropped to $18, and Wagner never
assembled the promised pork network, which Lohman
argued would have helped
to boost prices. Lohman
sued Wagner for breach
of contract.
The trial court found
that the agreement did not
meet the UCC’s require-
ment that a quantity term be included, that it was unen-
forceable, and that Lohman was entitled to nothing. Loh-
man appealed.
You Be the Judge: Does Lohman have an enforceable agree-
ment with Wagner?
Argument for Lohman: Your honor, I’m not a ham, and
I won’t “boar” you with a long story. Our arguments,
briefly stated, are these.
First, the UCC’s Statute of Frauds, and its require-
ment that a quantity term be included, should not apply.
This agreement is essentially one for services, and not for
goods. My client furnishes housing for weaner pigs, labors
to raise them, and ships them to the defendant. His
services are the largest part of this contract.
Even if this contract is deemed to be a sale of goods,
there is a quantity term included in the Weaner Pig
Purchase Agreement—300. The number was entered by
my client as a good-faith estimate of the number of ani-
mals he could produce.
In any event, UCC 2-306 does not require a quantity
term in this case. This agreement was an output contract.
Lohman sold every weaner pig he produced to Wagner,
and Wagner accepted and paid for them. Output con-
tracts, by definition, do not include specific quantity
LOHMAN V. WAGNER
862 A.2d 1042
Court of Special Appeals of Maryland, 2004
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440 U N I T 3 Commercial Transactions
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19-3e Modification
Another way in which the UCC is pro-contract and pro-business is in its treatment of
contract modifications. If two sides have a contract and seek to make changes, are the
changes enforceable?
Example 1. Being the best at almost anything pays well, and soccer is no exception.
Cristiano Ronaldo’s contract with Real Madrid runs through 2015 and averages a whopping
$20 million per season. Assume that this year, he leads Real to the fabled treble—a La Liga
championship, a victory in the Copa del Rey, and a win in the Champions League. After-
ward, the club offers him a raise to $28 million per season through 2015, and Ronaldo
accepts. If Spanish law is the same as American law, does the team have a legal obligation to
pay the extra millions? No.
This is a services contract, and not a sale of goods. Therefore, common law principles
would apply, and they require new consideration for contract modifications to stand. Since
Ronaldo did not agree to play any additional seasons or give any other new value to the
team, no consideration exists.
We hate to leave out fans of Spain’s other big club, so for the next example, we will pay
our 70 euros for a ticket on the AVE train and settle in for a three-hour, 500-kilometer trip
eastward to Barcelona.
Example 2. FC Barcelona is planning “Lionel Messi Bobblehead Day,” and the team
orders 10,000 units for the occasion. Unfortunately, the boat carrying the shipment from
China is boarded by Somali pirates, who are, it turns out, Barça supporters. The entire
shipment is stolen, and the headlines read, TRADE HOBBLED! PIRATES GOBBLE BOBBLES!
The manufacturer calls the team and asks for a three-week extension on the original
delivery deadline. The team is very understanding, agrees to the delay, and reschedules the
promotion for a later game. Is this modification which extends the delivery deadline now a
valid part of the contract? Yes.
In §2-209, the UCC does away with the consideration requirement for changes to
contracts, so long as both sides agree to the modification. In this example, no consideration
exists to support the extended deadline because the manufacturer gets all the benefit, and
the team gets nothing. But, that does not create a problem in enforcing the new deal.
Parties make a contract attempting to control their futures. But one party’s certainty can
be undercut by the ease with which the other party may obtain a modification. Section 2-209
acknowledges this tension by enabling the parties to limit changes. The UCC allows the
parties to modify some contracts orally, but they may agree to prohibit oral modifications
and insist that all modifications be in writing and signed. Between merchants, such a clause
is valid. But if either party is not a merchant, such a clause is valid only if the non-merchant
separately signs it.
terms; they merely obligate a seller to sell all of his output
to the buyer.
This case amounts to nothing more or less than a
greedy man trying to reap what he did not sow and
to use legal technicalities to hog all the profits for
himself.
Argument for Wagner: My counterpart has managed to
make several nifty pig-related references in his argument,
but nevertheless, no contract exists. The UCC does apply
to this agreement, because pigs are clearly goods. Most
products require some labor to assemble and bring to
market. Someone “labored” to make my shoes, my neck-
tie, and my pen. But all are goods.
In a UCC contract, a quantity must be written by the
defendants, but here the “300” was written by the plain-
tiff. It was never communicated to my client. He never
agreed to it, or even had a chance to review it. The same
holds true for the claim that this is an output contract. My
client never agreed to buy all the pigs that Lohman
produced.
My opponent is grasping at straws. Which pigs eat. I
think. Get it? Oh, forget it …
CHAPTER 19 Introduction to Sales 441
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Once again the Code gives greater protection to non-merchants than to merchants. Two
merchants may agree, as part of their bargain, that any future modifications will be valid only
if written and signed. But this limitation on modifications is not valid against a non-
merchant unless she separately signs the limiting clause itself. Suppose a furniture retailer
orders 200 beds from a manufacturer. The retailer’s order form requires any modifications to
be in writing. The manufacturer initials the retailer’s form at the bottom. The parties have a
valid agreement and no oral modifications will be enforced. But suppose the retailer sells a
bed to a customer. The sales form also bars oral modifications. That prohibition is void
unless the customer separately signs it.
EXAM Strategy
Question: Dale turns 18. For his birthday, he gets $500 cash and his
grandmother’s ancient station wagon. And yes, it is the kind with wood paneling
on the side. Dale cannot do much about how the car looks, but he decides that he
can at least make it sound awesome. So, he immediately takes the car to Big
Mike’s Custom Stereo.
At Big Mike’s, Dale makes a verbal agreement to buy an amplifier and two
Rockford Fosgate speakers and to have them installed at a cost of $499. The amp and
speakers come to $420, and the installation charge is $79. He decides to have them
installed while he waits.
After an hour, a clerk finds him and says, “Hey, man, we’re out of stock on those
speakers. But I can get you some Alpines right now—same size, same price, just as
loud.” Dale is eager to drive out with a new system, and agrees to the speaker
substitution. Moments later, Dale finds the clerk and says, “Wait, I’m not sure about
all of this. I don’t think I want to buy any of it after all.” Can Dale get his money back,
or is he stuck with his purchases?
Strategy: Under UCC principles, a contract is considered to be for the sale of goods
if the value of the items far exceeds the cost of the labor (installation), and the
contract’s predominant purpose is a sale of goods. The UCC Statute of Frauds does
not apply to a transaction under $500. A contract can be modified without
consideration.
Result: The UCC governs this contract because the speakers are much more
expensive than the labor. The contract does not have to be in writing because it is for
less than $500. The agreement to use Alpine speakers rather than Rockford Fosgates
is enforceable, even without consideration for the change. Dale will have to live with
the deal, including the Alpine speakers.4
4Bonus point from Chapter 13 material: Since this is Dale’s 18th birthday, if he were even one day
younger, he could back out of this deal on the grounds that he is a minor and has formed a voidable
agreement.
442 U N I T 3 Commercial Transactions
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Selected Code Provisions That Change the Common Law
Issue Common Law Rule UCC Sec. UCC Rule Example
Contract
formation
Offer must be followed
by acceptance that
shows meeting of the
minds on all important
terms.
§2-204 and
§2-305
Contract can be made in any
manner sufficient to show
agreement; moment of
making not critical; one or
more terms, including the
price, may be left open.
Tilly writes Meg, “I need a new
van for my delivery company.”
Meg delivers a van and Tilly
starts to use it. Under the
common law, there is no
contract, because no price was
ever mentioned; under the UCC,
the writing plus the conduct
show an intention to contract
(2-204). The price is a
reasonable one (2-305).
Writing
requirement
All essential terms
must be in writing.
§2-201 Any writing is sufficient if it
indicates a contract; terms
may be omitted or misstated;
“merchant” exception can
create a contract enforceable
against a party who receives
the writing and does nothing
within 10 days.
Douglas, a car dealer, signs and
sends to Michael, another
dealer, a memo saying,
“Confirming our deal for your
blue Rolls.” Michael reads it but
ignores it; 10 days later Douglas
has satisfied the Statute of
Frauds under the UCC’s
merchant exception.
Added terms in
acceptance
An acceptance that
adds or changes any
term is a counteroffer.
§2-207 Additional or different terms
are not necessarily
counteroffers; their presence
does not prevent a contract
from being formed, and in
some cases the new terms
will become a part of the
bargain.
Roberts sends a pre-printed
form to Julia, offering to buy 25
computers and stating a price;
Julia responds with her own pre-
printed form, accepting the offer
but adding a term that balances
unpaid after 30 days incur a
finance charge. The additional
term is not a counteroffer; there
is a valid contract; and the
finance charge is part of the
bargain.
Modification A modification is valid
only if supported by
new consideration.
§2-209 A modification needs
no consideration to be
binding.
Martin, a computer
manufacturer, agrees to sell
Steve, a retailer, 500
computers at a specified price,
including delivery. The next day
Martin learns that his delivery
costs have gone up 20 percent;
he calls Steve, who faxes a note
agreeing to pay 15 percent
extra. Under the common law,
the modification would be void;
under the Code, it is
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The following table concludes this chapter with an illustration of the Code’s impact on the common law.
CHAPTER 19 Introduction to Sales 443
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Chapter Conclusion
The Uniform Commercial Code (UCC) enables parties to create a contract quickly. While
this can be helpful in a fast-paced business world, it also places responsibility on executives.
Informal conversations may cause at least one party to conclude that it has a binding
agreement—and the law may agree.
EXAM REVIEW
1. UNIFORM COMMERCIAL CODE The Code is designed to modernize
commercial law and make it uniform throughout the country. (pp. 428–429)
2. SALE OF GOODS Article 2 applies to the sale of goods, which are movable things
other than money and investment securities. (p. 426)
Question: While shopping at his local mall, Fred buys an iPad for $499, a
barbecue grill for $509, and then pays $25 to have his watchband cleaned. Which
of Fred’s transactions are governed by Article 2 of the UCC?
Strategy: To answer this question, you must identify the transactions that
amount to a sale of goods. Land and buildings are not goods. Neither are money
and securities, but other moveable physical objects are. Also, be sure not to
confuse the question “Does Article 2 apply?” with the question “Does this
agreement need to be in writing?”
3. LEASING Article 2A governs the leasing of goods. (p. 426)
4. MIXED CONTRACTS In a mixed contract involving goods and services, the
UCC applies if the predominant purpose is the sale of goods. (p. 429)
5. MERCHANTS A merchant is someone who routinely deals in the particular goods
involved, or who appears to have special knowledge or skill in those goods, or who
uses agents with special knowledge or skill. The UCC frequently holds a merchant to
a higher standard of conduct than a non-merchant. (p. 429)
6. GOOD FAITH The UCC imposes a duty of good faith in the performance of all
contracts. (p. 429)
7. UNCONSCIONABILITY A contract is unconscionable if it is shockingly one-
sided and fundamentally unfair. A court is much likelier to use unconscionability to
protect a consumer than a corporation. (p. 429)
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Question: Jim Dan, Inc., owned a golf course that had trouble with crabgrass.
Jim Dan bought 20 bags of Scotts Pro Turf Goosegrass/Crabgrass Control for $835
and applied it to the greens. The Pro Turf caused over $36,000 in damage to the
greens. Jim Dan sued Scotts. Scotts defended by claiming that it sold the Pro Turf
with a clearly written, easy-to-read disclaimer that stated that in the event of
damage, the buyer’s only remedy would be a refund of the purchase price. Jim
Dan, Inc., argued that the clause was unconscionable. Please rule.
Strategy: There are two steps to deciding an issue of unconscionability. First,
does the contract involve a consumer, or is this an agreement between two
businesses? Second, is the agreement shockingly one-sided?
8. FORMATION UCC §2-204 permits the parties to form a contract in any manner
that shows agreement. (p. 430)
9. WRITING For the sale of goods worth $500 or more, UCC §2-201 requires some
writing that indicates an agreement. Terms may be omitted or misstated, but the
contract will be enforced only to the extent of the quantity stated. (pp. 431–432)
Question: To satisfy the UCC Statute of Frauds regarding the sale of goods,
which of the following must generally be in writing?
(a) Designation of the parties as buyer and seller
(b) Delivery terms
(c) Quantity of the goods
(d) Warranties to be made
Strategy: Okay, this may be overkill. But the question illustrates two basic points
of UCC law: First, the Code allows a great deal of flexibility in the formation of
contracts. Second, there is one term for which no flexibility is allowed. Make sure
you know which it is.
10. MERCHANT’S EXCEPTION When two merchants make an oral contract, and
one sends a confirming memo to the other within a reasonable time, and the memo
is sufficiently definite that it could be enforced against the sender herself, then the
merchant who receives it will also be bound unless he objects within 10 days.
(p. 432)
11. ADDITIONAL TERMS UCC §2-207 governs an acceptance that does not
“mirror” the offer. Additional terms usually, but not always, become part of the
contract. Different terms contradict a term in the offer. When that happens, most
courts reject both parties’ proposals and rely on gap-filler terms. (p. 435)
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Question: Cookie Co. offered to sell Distrib Markets 20,000 pounds of
cookies at $1.00 per pound, subject to certain specified terms for delivery.
Distrib replied in writing as follows: “We accept your offer for 20,000 pounds
of cookies at $1.00 per pound, weighing scale to have valid city certificate.”
Under the UCC:
(a) A contract was formed between the parties.
(b) A contract will be formed only if Cookie agrees to the weighing scale requirement.
(c) No contract was formed because Distrib included the weighing scale requirement
in its reply.
(d) No contract was formed because Distrib’s reply was a counteroffer.
Strategy: Distrib’s reply included a new term. That means it is governed by
UCC §2-207. Is the new term an additional term or a different term? An additional
term goes beyond what the offeror stated. Additional terms become a part of the
contract except in three specified instances. A different term contradicts one made
by the offeror. Different terms generally cancel each other out.
12. PRICE Under UCC §2-305 a contract is enforceable even if the price is not stated.
In such cases the price must be reasonable. (pp. 437–438)
13. MODIFICATION UCC §2-209 permits contracts to be modified even if there is
no consideration. The parties may prohibit oral modifications, but such a clause is
ineffective against a non-merchant unless she signed it. (pp. 441–442)
2. Result: The purchases of the iPad and the barbecue grill are covered by Article 2
of the UCC. Both agreements involve goods; $500 is a figure that is relevant to
whether the Statute of Frauds applies to the agreements, but it is not material to
the threshold question of whether Article 2 applies in the first place. All sales of
goods, from pencils to Ferarris, fall under Article 2.
The watch cleaning is a service, and not a sale of goods. It is not governed by
Article 2.
7. Result: This is a bargain between two businesses, and courts rarely find clauses
in such agreements unconscionable. The assumption is that sophisticated busi-
nesspeople understand what they are getting into and are able to protect
themselves. If Jim Dan could run a golf course, the company was sophisticated
enough to understand the simple disclaimer in this contract. Scotts wins.
9. Result: (c). The contract will be enforced only to the extent of the quantity stated.
11. Result: The “valid city certificate” phrase raises a new issue; it does not contra-
dict anything in Cookie’s offer. That means it is an additional term, and becomes
part of the deal unless Cookie insisted on its own terms, the additional term
materially alters the offer, or Cookie promptly rejects it. Cookie did not insist on its
terms, this is a minor addition, and Cookie never rejected it. The new term is part
of a valid contract and the answer is (a).
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MULTIPLE-CHOICE QUESTIONS
1. For a contract governed by the UCC sales article, which one of the following
statements is correct?
(a) Merchants and non-merchants are treated alike.
(b) The contract may involve the sale of any type of personal property.
(c) The obligations of the parties to the contract must be performed in good faith.
(d) The contract must involve the sale of goods for a price of $500 or more.
2. Which of the following transactions is not governed by Article 2 of the UCC?
(a) Purchasing an automobile for $35,000
(b) Leasing an automobile worth $35,000
(c) Purchasing a stereo worth $501
(d) Purchasing a stereo worth $499
3. Fred assembles computers in his garage and sells them. He makes an agreement with
Alpha Company under which Alpha will deliver 100 keyboards. The agreement does
not specify when payment is due. Which of the following is true?
(a) Fred has no obligation to pay, because there was no “meeting of the minds” and
no contract was formed.
(b) Fred must pay within 10 days of making the agreement.
(c) Fred must pay within10 days of accepting the keyboards.
(d) Fred must pay within a commercially reasonable time.
4. Under the UCC Statute of Frauds, a contract must be signed by the to
count as being “in writing.” Also, the of the goods must be written.
(a) plaintiff; price
(b) plaintiff; quantity
(c) defendant; price
(d) defendant; quantity
5. Assume that a contract is modified. New consideration must be present for the
modification to be binding if the deal is governed by which of the following?
(a) The common law
(b) The UCC
(c) Both (a) and (b)
(d) Neither (a) nor (b)
CHAPTER 19 Introduction to Sales 447
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ESSAY QUESTIONS
1. The Massachusetts Bay Transit Authority (MBTA) awarded the Perini Corp. a large
contract to rehabilitate a section of railroad tracks. The work involved undercutting
the existing track, removing the ballast and foundation, rebuilding the track, and
disposing of the old material. Perini solicited an offer from Atlantic Track & Turnout
Co. for Atlantic to buy whatever salvageable material Perini removed. Perini
estimated the quantity of salvageable material that would be available. Atlantic
offered to purchase “all available” material over the course of Perini’s deal with the
MBTA, and Perini accepted. But three months into the project, the MBTA ran short
of money and told Perini to stop the undercutting part of the project. That was the
work that made Perini its profit, so Perini requested that the MBTA terminate the
agreement, which the agency did. By that point Perini had delivered to Atlantic only
about 15 percent of the salvageable material that it had estimated. Atlantic sued. What
kind of contract do the parties have? Who should win and why?
2. Hasbro used to manufacture a toy called “Wonder World Aquarium.” The toy
included a powder that, when mixed with water, formed a gel that filled a plastic
aquarium. Children could then place plastic fish in the aquarium and create
underwater scenes. Cloud Corporation supplied the powder to Hasbro. The toy sold
poorly, and Hasbro’s need for the powder diminished.
The two companies discussed changing the powder’s formula. Cloud believed the
conversation amounted to an indication that Hasbro would continue to buy powder, so it
produced large quantities. Although it did not receive an order fromHasbro, Cloud sent an
order acknowledgment for 9.5 million packets to Hasbro. Hasbro made no objection to it.
Did the order acknowledgment create an enforceable agreement? What specific
facts determine your answer?
3. Nina owns a used car lot. She signs and sends a fax to Seth, a used car wholesaler who
has a huge lot of cars in the same city. The fax says, “Confirming our agrmt—I pick
any 15 cars fr yr lot—30% below blue book.” Seth reads the fax, laughs, and throws it
away. Two weeks later, Nina arrives and demands to purchase 15 of Seth’s cars. Is he
obligated to sell?
4. The Brugger Corp. owned a farm, operated by Jason Weimer, who acted as the
company’s business agent. Tri-Circle, Inc., was a farm equipment company. On
behalf of Brugger, Weimer offered to buy from Tri-Circle certain equipment for use
on the farm. Tri-Circle accepted the offer, using a pre-printed form. The form
included a finance charge for late payment. Weimer’s offer had said nothing about
finance charges, but he made no objection to the new term. Tri-Circle supplied the
farm equipment but later alleged that Brugger had refused to pay for $12,000 worth of
the supplies. Tri-Circle sued. In deciding whether Tri-Circle was entitled to finance
charges, the court first inquired whether Brugger, Weimer, and Tri-Circle were
merchants. Why did it look into that issue? Were they merchants?
5. YOU BE THE JUDGE WRITING PROBLEM Brewster manufactured plastic
bottles. Dial made personal care products at many plants around the country, including
one in Salem, Virginia. The companies agreed that Dial would purchase from Brewster
all of the plastic bottles it needed for its Salem factory. Dial estimated its requirements
for one year at 7,850,000 bottles, but added a clause stating that “quantities are
estimated only and do not bind Dial to purchase any minimum quantity.” A few
448 U N I T 3 Commercial Transactions
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months later, Dial concluded that its Salem plant was unprofitable. The company
closed the factory and notified Brewster that it would buy no bottles at all. Brewster
sued. Did Dial have the right to reduce its orders to zero? Argument for Brewster: The
parties had a clear contract for a massive number of bottles. Dial knew that this contract
was extremely important to Brewster. Although Dial had some right to adjust its
orders, it had no right to reduce them to zero. Argument for Dial: The issue is whether
Dial acted in good faith. It did. The company had a legitimate reason for closing the
factory—it was losing money—and with no factory it certainly did not need any bottles.
DISCUSSION QUESTIONS
Apply the following facts to the next two questions.
The publication of the original UCC in 1952 sparked
an expansion of the Statute of Frauds in the United
States to cover sales of goods of $500 or more. At about
the same time (in 1954), the British Parliament repealed
its longstanding Statute of Frauds as applied to sales
of goods. Some have argued that we should scrap UCC
§2-201 on the grounds that it encourages misdealing as
much as it prevents fraud. Consider the following two
hypotheticals:
(In the United States) Johnny is looking at a used Chevy
Tahoe. He knows that the $7,000 price is a good one, but
he wants to go online and see if he can find an even better
deal. In the 20 minutes he has been with the car’s current
owner, the owner has received three phone calls about the
car. Johnny wants to make sure that no one else buys the car
while he is thinking the deal over, so he makes a verbal
agreement to buy the car and shakes the seller’s hand. He
knows that because of the Statute of Frauds and the fact
that nothing is in writing, he does not yet have any
enforceable obligation to buy the car.
(In the United Kingdom) Nigel sells used Peugeots in
Liverpool. When he senses interest from customers, he
aggressively badgers them until they verbally commit to
buy. If the customers later get cold feet and try to back
out of the deal, he holds them to the verbal contracts.
Because there is no longer a UCC-style Statute of Frauds
in Britain, the buyers are stuck.
1. Rate the degree to which you believe Johnny and
Nigel acted wrongfully. Did one behave more
wrongfully than the other? If so, which one, and why?
2. Do you think that the UCC Statute of Frauds as it
currently exists is more likely to prevent fraud, or
is it more likely to encourage misunderstandings
and deception? Why? Overall, is it sensible to
require that purchases of big-ticket items be in
writing before they are final?
3. The Uniform Commercial Code (UCC) was written
by a group of scholars and adopted by elected state
legislators. But many contracts that do not involve
a sale of goods are still governed by old common
law principles that have been created by judges
over a period of centuries. Who makes for better
lawmakers—judges or legislators? Do you prefer
the way in which common law principles or UCC
rules were created?
4. Under UCC §2-207, “added terms” in an
acceptance can become part of a contract between
merchants. Does this seem reasonable to you? Are
businesses likely to take advantage of it?
5. This chapter revisits the idea of unconscionability.
Courts will sometimes refuse to enforce deals that
are, as UCC §2-302 states it, “shocking and
fundamentally unfair.” Consider the following two
cases. In each, an electronics store sells an HDTV
with a fair market value of $600 for $1,500.
(a) Sale #1 is made to Ann. She has a terrible credit
score, and is willing to pay $1,500 because the
store offers to finance the TV, and she has no
other available credit.
(b) Sale #2 is made to Franklin J. Moneypenny, a very
wealthy investment banker, on Christmas Eve. He
knows the price is much too high, but he is in a
big hurry to finish his last minute shopping.
In both cases, the consumers paid 2.5 times the fair
value of the TV. In your opinion, is either
transaction unconscionable? If so, why? If not,
why not?
CHAPTER 19 Introduction to Sales 449
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CHAPTER20
OWNERSHIP,
RISK, AND
WARRANTIES
He drove his truck fast along the rough country
road, hurrying through the shadows of the Cascade
Mountains, passing close to the Rogue River. The
door panel, freshly painted, read, “Ernest Jenkins,
Cattle Buyer.” Spinning the wheel hard left, he
drove through an impressive gate and under a
wooden sign that read, “Double Q Ranch.”He
knew the ranch by reputation and quickly saw that it was
prosperous—a goodplace for aman like him to dobusiness.
He introduced himself to Kate Vandermeer, the
Double Q’s business manager, and expressed an interest
in buying 300 head of cattle. Vandermeer and the man
mounted horses and rode out to inspect the herd. Van-
dermeer noticed that his boots were brand new and that
he rode awkwardly.
He was satisfied with the cattle, so the two bar-
gained, sitting on horseback and looking into the sun-
set. Vandermeer started at $310,000 and was surprised at how quickly they reached an
agreement, at $285,000, a price she considered excellent. They agreed that Vandermeer
would deliver the cattle by truck, in one week, in a nearby town. He would pay with a
cashier’s check and take possession of the cattle and all ownership documents, such as
brand inspection certificates and veterinarian’s certificates. Back at the ranch, Vandermeer
offered him a drink, but he said he had to hurry to another appointment.
The next week, right on schedule, he arrived on Thursday and presented his cashier’s
check for the full amount. When they had transferred the livestock, Vandermeer suggested
they talk over some future business, but he was again in a rush. They shook hands and
parted, the man heading due east, fast.
The Double Q’s bank sent the cashier’s check for collection but learned early the
following week that it was forged. Vandermeer called the State Police, who traced the man’s
movements to the state line. Three weeks later and 1,600 miles east, the FBI located the
Vandermeer noticed that
his boots were brand new
and that he rode
awkwardly.
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cattle, with the prominent “QQ” brand, in stockyards in Omaha. Ned Munson
had purchased the cattle from the man for $225,000, which he considered a
bargain. He had paid with a cashier’s check. Ernest Jenkins, of course, had
disappeared—literally. The truck’s freshly painted door now read, “Ted J.
Pringle, Grain Merchant,” and it was parked a long, long way from Omaha.
20-1 LEGAL INTEREST
Who owns the cows? The Double Q wanted its cattle back or $285,000. If Munson was
foolish enough to pay money to a thief, that was not the ranch’s problem. But Ned Munson
claimed the cows were his. He had paid a fair price to a man who appeared to own them. If
Vandermeer was so foolish as to give up the cattle to a con artist, let the ranch suffer the
consequences. The Double Q sued. Both parties to this lawsuit are unhappy, but fortu-
nately for us, they have illustrated the theme for our chapter: When two parties claim a
conflicting legal interest in particular goods, who wins? Who obtains the law’s protection?
These are disputes over conflicting interests in goods.
An interest is a legal right in something. More than one party can have an interest in
particular goods. Suppose you lease a new car from a dealer, agreeing to pay $400 per month for
three years. Several parties will have legal interests in the car. The dealer still owns the car—
interest number one. At the end of three years, the dealer gets it back. For three years, you
have the use of the car—interest number two. You may use the car for all normal purposes, and
you are obligated to make monthly payments. Your payments go to a finance agency, which has
made an arrangement with the dealer to obtain the right to your $400 monthly payment. The
finance agency has a security interest in the car—interest number three. If you fail to pay on time,
the finance company has the right to repossess your car. If you take the car to a garage for
maintenance, the garage has temporary possession of the car—interest number four. The garage
has the right to keep the car locked up overnight, to work on it, and to test-drive it. Sometimes
legal interests clash, and it is those conflicts we look at here.
Often the parties will claim ownership, each arguing that his interest is stronger than the
other’s. But in this chapter, we also consider cases where each party argues that the other one owns
the goods. Suppose a seller manufactures products for a buyer, but while the goods are being
shipped, they are destroyed in a fire. The seller may argue that it no longer owned the goods, and
the fire is the buyer’s misfortune. But the buyer will claim it had not yet acquired the items.
In other cases, a third party will be involved. You pay $30,000 cash to buy a new car and
expect to pick it up in three days. But the day before you arrive, the dealer’s bank seizes all
of the cars on the lot, claiming the dealer has defaulted on loans. Now the fight over legal
interest is between you and the bank, with the dealer a relatively passive observer.
In the cattle case, three parties had a legal interest in the goods. The Double Q ranch
originally had valid title to the cattle, meaning the normal rights of ownership. Ernest
Jenkins, the con artist, acquired a lesser interest. His contract with Double Q was fraudulent
because Jenkins intended to cheat the ranch. Nonetheless, he did have an agreement. He
obtained voidable title, meaning limited rights in the goods, inferior to those of the owner.1
Finally, Ned Munson makes a claim to the cattle based on his payment and his possession
of the cows and all documents.
The court will use various sections of the Uniform Commercial Code (UCC) to
determine who keeps the cows and who ultimately bears the loss. Ned Munson should
win the cattle. He was acting in good faith and a commercially reasonable manner when he
1We discuss voidability in detail in Chapter 13, on capacity and consent.
Voidable title
Limited rights in goods, inferior
to those of the owner.
CHAPTER 20 Ownership, Risk, and Warranties 451
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bought the cows from a man who appeared to be a lawful cattle buyer. The Double Q must
bear the loss. If, however, the Double Q can convince a court that Munson acted irrespon-
sibly because he had specific grounds for suspecting Jenkins, the court might order Munson
to pay for the cattle.2
20-2 IDENTIFICATION, TITLE, AND
INSURABLE INTEREST
Historically, courts settled disputes about legal interest by looking at one thing: title. But
the drafters of the UCC concluded that “title” was too abstract an answer for the assorted
practical questions that arose. It sometimes could be hard to prove exactly who did have
title, and it made no sense to settle a wide variety of business problems with one legal idea.
Today, title is only one of several issues that a court will use to resolve conflicting interests
in goods. Identification and insurable interest have become more important, and title has
diminished in significance. We can begin to understand all three doctrines if we examine
how title passes from seller to buyer.
20-2a Existence and Identification
Title in goods can pass from one person to another only if the goods exist and have been
identified to the contract.
EXISTENCE
Goods must exist before title can pass.3 Although most goods do exist when people buy and
sell them, some have not yet come into being, such as crops to be grown later or goods that
have not yet been manufactured. A farmer may contract to sell corn even before it is
planted, but title to the corn cannot pass until it actually exists.
IDENTIFICATION
Goods must be identified to the contract before title can pass.4 This means that the parties
must have designated the specific goods being sold. Often, identification is obvious. If
Dealer agrees to sell to Buyer a 60-foot yacht with identification number AKX472, the
parties have identified the goods. But suppose Paintco agrees to sell Brushworks 1,000
gallons of white base paint at a specified price. Paintco has 25,000 gallons in its warehouse.
Title cannot pass until Paintco identifies the specific gallons that will go to Brushworks.
The parties may agree in their contract how and when they will identify the goods.5
They are free to identify them to the contract in any way they want. Paintco and Brush-
works might agree, for example, that within one week of signing the sales agreement,
Paintco will mark appropriate gallons. If the gallons are stored 50 to a crate, then Paintco will
have a worker stick a “Brushworks” label on 20 crates. Once the label is on, the goods are
identified to the contract.
2For a cattle case that raises these and other issues, see Rudiger Charolais Ranches v. Van De Graaf
Ranches, 994 F.2d 670, 1993 U.S. App. LEXIS 12412 (9th Cir. 1993).
3UCC §2-105(2).
4UCC §2-401(1).
5UCC §2-501(1).
452 U N I T 3 Commercial Transactions
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If the parties do not specify any particular method, identification will occur according to
these rules:
• Identification occurs when the parties enter into a contract if the agreement describes
specific goods that already exist. If the Dealer agrees to sell a yacht and the parties
include the ID number in their contract, the goods are identified (even though the
parties never use the term “identify”).
• For unborn animals, identification generally takes place when they are conceived; for
crops, identification normally happens when they are planted.
• For other goods, identification occurs when the seller marks, ships, or in some other
way indicates the exact goods that are going to the buyer.6
EXAM Strategy
Question: Arielle, an artist, has 25 hand-painted room screens in her studio. She
contracts to sell five of them to Retailer for $5,000 each. The contract allows Arielle to
choose which five she will sell. Arielle moves five screens from her studio to a
warehouse, but a week later, a fire destroys the building and its contents. Two
insurance companies dispute whether title to the screens has passed to Retailer. The
warehouse insurer claims the goods were identified and title passed; Retailer’s insurer
says the goods were not identified and title never passed. The contract says nothing
about identification. Have the goods been identified?
Strategy: Title cannot pass until the goods have been identified to the contract.
Identification can occur in three ways: The parties describe specific goods that already
exist; animals are conceived or crops planted; or the seller marks, ships, or otherwise
indicates which are going to the buyer. Did any of those things happen?
Result: The parties never described the goods. The goods are neither animals nor
crops. However, when Arielle moved five of the screens to the warehouse, she
“indicated which goods were going to the buyer.” The goods were identified.
20-2b Passing of Title
Once goods exist and are identified to the contract, ownership can pass from one person to
another. Title may pass in any manner on which the parties agree (UCC §2-401). Once
again, the Code allows the parties to control their affairs with commonsense decisions.
The parties can agree, for example, that title passes when the goods leave the manufac-
turer’s factory, or when they reach the shipper who will transport them, or at any other time
and place. If the parties do not agree on passing title, §2-401 decides. There are
three possibilities:
• When the goods are being moved, title passes to the buyer when the seller
completes whatever transportation it is obligated to do. Suppose Seller is in
Milwaukee and Buyer is in Honolulu. The contract requires Seller to deliver
the goods to a ship in San Francisco. Title passes when Seller completes its
6UCC §2-501.
CHAPTER 20 Ownership, Risk, and Warranties 453
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last contractually required step. In this example, that happens when the goods
reach the ship in San Francisco.
• When the goods are not being moved and a contract calls for delivery of ownership
documents, title passes when the seller delivers these documents to the buyer.
Suppose Seller, located in Louisville, has manufactured 5,000 baseball bats, which are
stored in a warehouse in San Diego. Under the terms of their contract, Buyer will take
possession of the bats at the warehouse. When Seller gives Buyer ownership
documents, title passes.
• When the goods are not being moved and the contract does not call for delivery of
ownership documents, title passes when the parties form the contract. For
example, if the Buyer owns the warehouse where the bats are stored, Buyer
needs no documents to take possession; title passes when the parties reach
agreement.
20-2c Insurable Interest
Anyone buying or selling expensive goods should make certain that the goods are
insured. There are some limits, though, on who may insure goods, and when. As we
saw in Chapter 12, a party may insure something such as property or a human life
only when she has a legitimate interest in it. If the person buying the policy lacks a real
interest in the thing insured, the law regards the policy as a gambling agreement and
considers it void.
When does someone have an insurable interest in goods? The UCC gives one answer
for buyers and one for sellers. A buyer obtains an insurable interest when the goods are
identified to the contract (UCC §2-501). Suppose that in January, Grain Broker contracts
with Farmer to buy his entire wheat crop. Neither party mentions “identification.” In
January, the crop is not identified and Broker has no insurable interest. In May, after weeks
of breaking the soil, Farmer plants his wheat crop. Once he has planted it, the goods are
identified. The Broker now has an insurable interest and purchases insurance. In July, a
drought destroys the crop, and the Broker never gets one grain of wheat. The Broker need
not worry: His insurance policy will cover his losses.
The seller’s insurable interest is different. The seller retains an insurable interest in goods
as long as she has either title to the goods or a security interest in them (UCC §2-501).
“Security interest” refers to cases in which the buyer still owes money for the goods and the
seller can repossess the goods if payment is not made. Suppose Flyola Manufacturing sells a
small aircraft to WingIt, a dealer, for $300,000. WingIt pays $30,000 cash and agrees to pay
interest on the balance until it sells the plane. Flyola has an insurable interest even while the
aircraft is in WingIt’s showroom and may purchase insurance anytime until WingIt pays off
the last dime.
And so, a seller and buyer can have an insurable interest in the same goods
simultaneously. Suppose the heavy-metal band Flulike Symptoms hires Inkem Corp.,
in Minneapolis, to make 25,000 T-shirts with the band’s logo, for sale at rock concerts.
The parties agree that the T-shirts are identified as soon as the logo is printed, and that
title will pass when Inkem delivers the T-shirts to the office of the Symptoms’ manager
in Kansas City. Inkem obviously has an insurable interest while the company is making
the T-shirts and continues to have an interest until it delivers the T-shirts in Kansas
City. But the Flulike Symptoms’ insurable interest arises the moment their logo is
stamped on each shirt, so the Symptoms could insure the goods while they are still
stored in Inkem’s factory.
In the following case, a car accident leads several insurance companies to
dispute who owned the damaged auto. Each company wants to claim that the car belonged
to—someone else.
454 U N I T 3 Commercial Transactions
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Code Provisions Discussed in This Case
Issue Relevant Code Section
1. Which party had title to the
car?
UCC §2-401: Title to goods may pass in
any manner on which the parties agree.
2. Did the seller have an insurable
interest in the car?
UCC §2-501: The seller retains an
insurable interest in the goods as long as it
holds title to or a security interest in them.
20-3 IMPERFECT TITLE
20-3a Bona Fide Purchaser
In the chapter opener we saw a scam artist purchase cattle from a respectable ranch and sell
them to an honest dealer. The bad guy skipped town, leaving a dispute between two
innocent parties. Either the original owner (the ranch) or the buyer (the cattle dealer) must
bear the loss. Who loses?
VALLEY FORGE INSURANCE CO. V. GREAT AMERICAN
INSURANCE CO.
1995 Ohio App. LEXIS 3939
Ohio Court of Appeals,1995
C A S E S U M M A R Y
Facts: On a Friday afternoon, Karl and Linda Kennedy
went to John Nolan Ford to buy a new Ford Mustang. The
parties signed all necessary documents, including a New
Vehicle Buyer’s Order, an Agreement to Provide Insurance,
and credit applications. The Kennedys made a down pay-
ment but could not arrange financing before the dealership
closed. JohnNolan Ford determined that the Kennedys were
creditworthy and allowed them to take the car home for the
weekend. That evening, Karl Kennedy permitted his
brother-in-law, Cella, to take the car for a drive, along with
a passenger namedCampbell. Cella wrecked the car, injuring
his passenger. Campbell sued, and the question was which
insurance company was liable for all of the harm: John Nolan
Ford’s insurer (Milwaukee Mutual), Cella’s insurer (Valley
Forge), or Kennedy’s insurer (Great American). The trial
court ruled that title had never passed to Kennedy and found
Milwaukee Mutual liable. The company appealed.
Issue: Had title passed to Kennedy at the time of the
accident?
Decision: No. Title had not yet passed to Kennedy.
Affirmed.
Reasoning: Milwaukee Mutual asserted that the risk of
loss passed to the Kennedys when the car was delivered
to them. However, the signed contract stated that the
buyer acquires “no right, title, or interest” in the automo-
bile until it was delivered and either the full purchase
price was paid in cash or satisfactory financing was
arranged. At the time of the accident, the Kennedys had
neither paid cash nor signed a financing agreement. Title
never passed.
Milwaukee also argued that the Kennedys agreed to
insure the automobile. The contract, though, did not state
when the Kennedys were obligated to obtain insurance. It
would be logical for them to do so after they had obtained
title. Because the contract was ambiguous on this point,
the agreement must be interpreted against the party who
wrote it—namely, the automobile dealer. John Nolan
Ford still had the risk of loss when the accident occurred.
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CHAPTER 20 Ownership, Risk, and Warranties 455
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The Question: Who Must Suffer the Loss?
Owner Bad Guy Buyer
(has valid title) (obtains goods from Owner and sells) (buys goods from Bad Guy)
Let’s consider a new example, from the beginning. First, we need to know what kind of
title Bad Guy obtains: Is it void or voidable? The key is this: Did Bad Guy take the item
against the will of the owner, or did he fraudulently trick the owner into voluntarily handing
the item to him?
Abe steals Marvin’s BMW in the middle of the night and promptly sells it to Elaine for
$35,000 cash. Two weeks later, the police locate the car. When Abe stole it, he obtained
void title, which is no title at all. When Bad Guy sells the goods to Buyer, she also gets no
title at all. Elaine must return the car to Marvin and suffer the $35,000 loss for Abe’s theft.
This policy makes sense because Marvin has done nothing wrong. If the law permitted
Elaine to get valid title, it would encourage theft.
If Bad Guy attempts to purchase the goods from Owner using fraud or deception, he
obtains voidable title, meaning limited rights in the goods, inferior to those of the owner.
The owner should be able to recover the goods from Bad Guy (if he can be found), but not
from anyone else who ends up with them. Suppose Connie agrees to buy Mark’s Jeep. She
gives him a check for $20,000 and he signs the vehicle over to her. Connie knows her check
will bounce; she has used fraud to obtain the car. As a result, Connie obtains only voidable
title. If Mark learns of the deception before Connie sells the car to someone else, he will get
his Jeep back.
Unfortunately, Connie is slippery, not stupid. She quickly sells the Jeep to Seth for
cash. By the time Connie’s check bounces, she is long gone, and Seth has the car. Who
keeps the Jeep? Seth wins the car if he is a bona fide purchaser. A person with voidable title
has power to transfer valid title for value to a good faith purchaser, generally called a bona
fide purchaser or BFP.7
Seth can prove that he is a bona fide purchaser by showing two things:
• That he gave value for the goods, and
• That he acted in good faith.
It is generally easy for purchasers to show that they gave value. The buyer could give
cash or a check or could agree to extinguish a debt; that is, to forgive some money that
Bad Guy owed. The real issue becomes whether the buyer acted in good faith. If Seth paid
a reasonable purchase price and Connie showed him convincing identification and
signed over to him all purchase documents, Seth acted in good faith. He keeps the Jeep
and Mark loses.
On the other hand, suppose Seth knows the brand-new Jeep is worth more than
$28,000. Connie seems in a frantic hurry to sell the car. She cannot produce the car’s
registration but promises to send it within three days. Connie’s conduct, together with the
$8,000 discount, would make a reasonable person suspicious. Seth is not acting in good faith
and therefore is not a bona fide purchaser. Mark receives the car back, and Seth pays dearly
for his automotive lust.
In the following case, German soldiers confiscated property during World War II.
What kind of title did they obtain? Could ownership of looted art be passed on to
someone else?
7UCC §2-403(1).
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20-3b Entrustment
Your old Steinway grand piano needs a complete rebuilding. You hire Fred Showpan, Inc.,
a company that repairs and sells instruments. Showpan hauls your piano away and promises to
return it in perfect shape. Two months later, you are horrified to spot Showpan’s showroom
boarded up and pasted with bankruptcy notices. Worse still, you learn that Fred sold your
beloved instrument to a customer, Frankie List. When you track down List, he claims he paid
$18,000 for the piano and likes it just fine. Is he entitled to keep it?
Quite likely he is. Section 2-403(1), the BFP provision we just discussed, would not
apply because Showpan did not purchase the piano from you. But §2-403(2) does apply. This
is the “entrustment” section, and it covers cases in which the owner of goods voluntarily
leaves them with a merchant, who then sells the goods without permission. According
to UCC §2-403(2), any entrusting to a merchant who deals in goods of that kind gives
him power to transfer all rights of the entruster to a buyer in the ordinary course of
business (BIOC).
Entrusting means delivering goods to a merchant or permitting the merchant to retain
them.8 In the piano example, you clearly entrusted goods to a merchant. If you buy a used
car from Fast Eddie’s and then leave it there for a week while you obtain insurance, you
have entrusted it to Eddie.
BAKALAR V. VAVRA
619 F.3d 136
Second Circuit Court of Appeals, 2010
Facts: Franz Grunbaum was a Jewish man who lived in
Vienna before World War II. In 1938, the Nazis impri-
soned him in the Dachau concentration camp, where he
died three years later. The Nazis also confiscated his
property, which included a valuable drawing by Austrian
artist Egon Schiele.
This drawing changed hands several times until it was
eventually sold to David Bakalar in 1963. Years later,
Grunbaum’s heirs, Milos Vavra and Leon Fischer, argued
that they were the true owners of the picture, which was
worth an estimated $675,000 at that point. The trial court
disagreed, finding that Bakalar was the drawing’s owner.
Vavra and Fischer appealed.
Issue: If artwork was taken illegally from the original owner,
could a subsequent bona fide purchaser rightfully own it?
Decision: No. A thief cannot pass good title.
Reasoning: New York does not allow a thief to pass
good title because this great city does not want to become
a marketplace for stolen goods. In other words, the law
has long protected the right of the owner whose property
has been stolen to recover that property, even if it is in the
possession of a bona fide purchaser who acted in good
faith. An artwork stolen during World War II still belongs
to the original owner, even if there have been subsequent
buyers and even if each of those buyers was completely
unaware that he was buying stolen goods.
For Bakalar to be judged the rightful owner, he must
prove that the Nazis did not steal the drawing from Grun-
baum. We are remanding this case the lower court to give
Bakalar that opportunity.
8For a discussion of who is and who is not a merchant, see Chapter 19.
CHAPTER 20 Ownership, Risk, and Warranties 457
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DEALS IN GOODS OF THAT KIND
The purpose of the section is to protect innocent buyers who enter a store, see the goods
they expect to find, and purchase something, having no idea that the storekeeper is illegally
selling the property of others. Shoppers should not have to demand proof of title to every-
thing in the store. Further, if someone has to bear the risk, let it be the person who has
entrusted her goods; she is in the best position to investigate the merchant’s integrity. But
this protection does not extend to a buyer who arrives at a vacuum cleaner store and buys an
$80,000 mobile home parked in the lot.
IN THE ORDINARY COURSE OF BUSINESS
A buyer in the ordinary course of business (BIOC) is one who acts in good faith, without
knowing that the sale violates the owner’s rights. If Frank List buys your piano assuming
that Showpan owns it, he has acted in good faith. If Frank was your neighbor, recognized
your instrument, and bought it anyway, he is not buying in the ordinary course of business
and must hand over the piano.
Of course, a merchant who violates the owner’s rights is liable to that owner. If Showpan
were still in business when you discovered your loss, you could sue and recover the value of
the piano. The problems arise when the merchant is bankrupt or otherwise unable to
reimburse the owner.
EXAM Strategy
Question: Pamela went to University Used Auto and asked if the company had a
Lincoln Navigator. University had no such SUV, but a sales representative told
Pamela that he would find her one. The representative contacted Royal auto
dealership, which sold new and used cars. Royal agreed to supply University with
a car, on the understanding that an interested buyer would pay Royal, which in
turn would give a finder’s fee to University. The companies had worked this way
in the past. Royal delivered a Navigator as requested. But when the used car
company sold the vehicle to Pamela, the company instructed her to pay
University directly, which she did. Royal sued Pamela, seeking the car, and the
court had to determine whether there had been an entrustment. Royal argued that
it never entrusted the Navigator to University because the parties agreed to
require payment to Royal.
Strategy: Entrustment means delivering goods to a merchant who routinely deals in
such articles.
Result: Royal delivered a used car to a used car dealer. That is entrustment. It is true
that both dealers understood that Pamela was to pay Royal—but she did not know
that. Entrustment protects good faith buyers, and Pamela wins.
20-4 RISK OF LOSS
Many of the issues we have looked at thus far involve someone doing something wrong.
Now we turn to cases where there may be no wrongdoer.
Accidents hurt businesses. When goods are damaged, the law may again need to
decide whether it is the seller or buyer who must suffer the loss. In the cases we
Buyer in the ordinary
course of business (BIOC)
One who acts in good faith,
without knowing that the sale
violates the owner’s rights.
458 U N I T 3 Commercial Transactions
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have seen thus far, the parties were arguing, “It’s mine!”—“Like heck it is, it’s mine!”
In risk of loss cases, the parties are generally shouting, “It was yours!”—“No way, dude,
it was yours!”
Athena, a seafood wholesaler, is gearing up for the Super Bowl, which will bring 150,000
hungry visitors to her city for a week of eating and gabbing. Athena orders 25,000 lobsters
from Poseidon’s Fishfoods, 500 miles distant, and simultaneously contracts with a dozen
local restaurants to resell them. Poseidon loads the lobsters, still kicking, into refrigerated
railcars owned by Demeter Trucking. But halfway to the city, the train collides with a prison
van. None of the convicts escape, but the lobsters do, hurtling into swamps from which they
are never recaptured. Athena loses all of her profits and sues. As luck would have it,
Demeter Trucking had foolishly let its insurance lapse. Poseidon claims the goods were
out of its hands. Who loses?
The common law answered this problem by looking at which party had title to the
goods at the time of loss. But the UCC again rejects the old concept, striving once
more for a practical solution. The UCC permits the parties to agree on who bears the
risk of loss. UCC §2-509(4) states that the parties may allocate the risk of loss any way
they wish.
Often the parties will do just that, avoiding arguments and litigation in the event of an
accident. As part of her agreement with Poseidon, Athena should have included a one-
sentence clause, such as “Seller bears all risk of loss until the lobsters are delivered to
Athena’s warehouse.” So long as the parties make their risk allocation clear, the Code will
enforce their terms.
20-4a Shipping Terms
The parties can quickly and easily allocate the risk of loss by using common shipping terms that
the Code defines. FOB means free on board; CIF stands for cost, insurance, and freight. By
combining these designations with other terms, the parties can specify risk in a few words:
• FOB place of shipment. The seller is obligated to put the goods into the possession
of the carrier at the place named. The seller bears the expense and risk until
they are in the carrier’s possession. From that moment onward, the buyer bears
the risk.
• FOB place of destination. The seller must deliver the goods at the place named and
bears the expense and risk of shipping.
• CIF. The price includes in a lump sum: the cost of the goods and the insurance and
freight to the named destination. The risk of loss passes from the seller to the buyer
when the seller delivers the goods to the port of shipment.
• C & F. This designation is similar to CIF, but the price does not include insurance.
20-4b When the Parties Fail to Allocate the Risk
If the parties fail to specify when the risk passes from seller to buyer, the Code provides the
answer. When neither party breached the contract, §2-509 determines the risk; when a party has
breached the contract, §2-510 governs. The full analysis of risk is somewhat intricate, so we first
supply you with a short version: When neither party has breached the contract, the risk of loss
generally passes from seller to buyer when the seller has transported the goods as far as he is
obligated to. When a party has breached, the risk of loss generally lies with that party.
And now, for the courageous student, the full version of how the UCC allocates the risk
of loss when the parties fail to specify it in advance.
CHAPTER 20 Ownership, Risk, and Warranties 459
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WHEN NEITHER PARTY BREACHES
In the example of Athena and Poseidon, both parties did what they were supposed
to do, so there was no breach of contract. To settle these cases, we need to know
whether the contract obligated the seller to ship the goods or whether the goods
were handled in some other way. There are three possibilities: (1) the contract
required the seller to ship the goods, or (2) the contract involved a bailment, or
(3) other cases.
If the Seller Must Ship the Goods Most contracts require the seller to arrange
shipment of the goods. In a shipment contract, the seller must deliver the goods to a
carrier, which will then transport the goods to the buyer. The carrier might be a
trucking company, railroad, airline, or ship, and is generally located near the seller’s
place of business. In a shipment contract, the risk passes to the buyer when the seller
delivers the goods to the carrier. Suppose Old Wood, in North Carolina, agrees to sell
$100,000 worth of furniture to Pioneer Company, in Anchorage. The contract requires
Old Wood to deliver the goods to Great Northern Railroad lines in Chicago. From
North Carolina to Chicago, Old Wood bears the risk of loss. If the furniture is damaged,
stolen, or destroyed, Old Wood is out of luck. But once the furniture is on board the
train in Chicago, the risk of loss passes to Pioneer. If the train derails in Montana and
every desk and chair is smashed to kindling, Pioneer must nevertheless pay the full
$100,000 to Old Wood.
In a destination contract, the seller is responsible for delivering the goods to the buyer,
and risk passes to the buyer when the goods reach the destination. If the contract
required Old Wood to deliver the furniture to Pioneer’s warehouse in Anchorage, then
Old Wood bears the loss for the entire trip. If the train travels 3,000 miles and then
plunges off a bridge in Alaska, 45 feet from its destination, Old Wood picks up
the tab.
If There Is a Bailment Freezem Corp. produces 500 room air conditioners and
stores them in Every-Ware’s Warehouse. This is a bailment, meaning that one person
or company is legally holding goods for the benefit of another. Freezem is the bailor,
the one who owns the goods, and Every-Ware is the bailee, the one with temporary
possession. Suppose Freezem agrees to sell 300 of its air conditioners to KeepKool
Appliances. KeepKool does not need the machines in its store for six months, so it
plans to keep them at Every-Ware’s until then. But two weeks after Freezem and
KeepKool make their deal, Every-Ware burns to the ground. Who bears the loss of the
300 air conditioners? If the contract requires a bailee to hold the goods for the buyer,
the risk passes when the buyer obtains documents entitling her to possession, or
when the bailee acknowledges her right to the goods. If fire broke out in Every-Ware’s
before KeepKool received any documents enabling it to take the air conditioners away,
then the loss would fall on Freezem.
Other Cases The great majority of contracts involve either shipment by the seller or a
bailment. In the remaining cases, if the seller is a merchant, risk passes to the buyer on
receipt. This means that a merchant is only off the hook if the buyer actually accepts the
goods. If the seller is not a merchant, risk passes when the seller tenders the goods, meaning
that she makes them available to the buyer. The Code is giving more protection to buyers
when they deal with a merchant.
Bailor
The one who owns goods legally
held by another.
Bailee
The one with temporary
possession of another’s goods.
460 U N I T 3 Commercial Transactions
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WHEN ONE PARTY BREACHES
We now look at how the Code allocates risk when one of the parties does breach. Again there
are three possibilities: (1) seller breaches and buyer rejects; (2) seller breaches, buyer
accepts, but then revokes; or (3) buyer breaches.
Seller Breaches and Buyer Rejects PlayStore, a sporting goods store, orders
75 canoes from Floataway. PlayStore specifies that the canoes must be 12 feet long, light-
weight metal, dark green. Floataway delivers 75 canoes to Truckit, a trucking company.
When Truckit’s trucks arrive, PlayStore finds that the canoes are the right material and
color, but 18 feet long. PlayStore rejects the craft, and Truckit heads back to Floataway. But
one of the trucks is hijacked and the 25 canoes it carries are never recovered. Floataway
demands its money for the 25 lost canoes. Who loses?
Floataway had delivered nonconforming goods; that is, merchandise which differs from
that specified in the contract. A buyer has a right to reject such goods. When the buyer
rejects nonconforming goods, the risk of loss remains with the seller until he cures the defect
or the buyer decides to accept the goods. In our example, Floataway must suffer the loss for
the stolen canoes. If PlayStore had decided to accept the canoes, even though they were the
wrong size, then the risk would have passed to the sports store.
Seller Breaches, Buyer Accepts, but Then Revokes PlayStore orders 200 tennis
rackets from High Strung. When the rackets arrive, they seem fine, so the store accepts them.
But then a salesperson notices that the grips are loose. Every racket has the same problem.
PlayStore returns the rackets to High Strung, but they are destroyed when a blimp crashes
into the delivery truck. When a buyer accepts goods but then rightfully revokes acceptance,
the risk remains with the seller to the extent that the buyer’s insurance will not cover the loss.
If PlayStore’s insurance covers the damaged rackets, there is no problem. If PlayStore’s
insurance does not cover the loss of goods in transit, High Strung must pay.
Buyer Breaches One last time. PlayStore orders 60 tents from ExploreMore. About
the time the tents leave the factory, PlayStore decides to drop its line of camping goods and
specialize in team sports. PlayStore notifies ExploreMore that it wants to explore less
and will not pay. The tents are destroyed in a collision involving a prison van and a train
carrying lobsters. This time, PlayStore is liable. When a buyer breaches the contract before
taking possession, it assumes the risk of loss to the extent that the seller’s insurance is
deficient.
Exhibit 20.1 should clarify.
In the following case, neither party breached, so §2-509 governs.
Code Provisions Discussed in This Case
Issue Relevant Code Section
1. Did the parties create a
bailment?
In a bailment, one person legally holds goods for the
benefit of another.
2. Which party bore the risk of
the horse’s death?
UCC §2-509(2): If the contract requires a bailee to
hold the goods for the buyer, the risk passes when
the buyer obtains documents entitling her to
possession, or when the bailee acknowledges her
right to the goods.
Nonconforming goods
Merchandise that differs from
that specified in the contract.
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CHAPTER 20 Ownership, Risk, and Warranties 461
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Start
Here
Did the Parties Allocate the Risk
in Their Contract?
If the parties have allocated the risk in their contract, that agreement will control
and everything on this chart is gloriously irrelevant.
If the parties have not allocated the risk of loss, then §2-509 and §2-510
will determine who suffers the loss.
In using the two Code sections to determine the risk, the first question is whether
either party has breached the contract.
No Breach (§2-509)
If neither party breaches, there are
three possibilities:
Breach (§2-510)
If a party breaches, there are
three possibilities:
1
Contract requires
Seller to ship
goods by carrier.
2
Contract requires
a bailee to hold
goods for Buyer.
3
Other cases.
1
Seller breaches.
The goods are
nonconforming
and the Buyer
rightfully
rejects them.
2
Seller breaches.
The buyer
accepts but
then revokes
his acceptance.
3
Buyer breaches.
Buyer repudiates
conforming goods
or in some other
way breaches the
contract before he
takes possession
of the goods.
Risk remains
with the Seller
until he cures
the defects or
the Buyer decides
to accept
the goods.
Risk remains
with the Seller
to the extent
that the Buyer’s
own insurance
is deficient.
Risk passes to the
Buyer to the
extent that the
Seller’s insurance
is deficient, for a
commercially
reasonable time.
Risk passes to
Buyer when she
obtains docu-
ments entitling
her to possession,
or when Bailee
acknowledges
she is entitled
to possession.
a Shipment
Contract requires
Seller to deliver
the goods to a
carrier.
a
If Seller is
a merchant
Risk passes to
Buyer on receipt
of goods.
b Destination
Contract requires
Seller to deliver
goods to a speci-
fied destination.
b
If Seller is not
a merchant
Risk passes to
Buyer when carrier
tenders goods at
the destination.
Risk passes to
Buyer on tender
of delivery.
Risk passes to
Buyer when Seller
delivers goods
to carrier.
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EXHIB IT 20.1
462 U N I T 3 Commercial Transactions
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20-5 WARRANTIES
The Harmon case illustrates what happens when an accident destroys the goods sold and
neither party is at fault. But what if Harmon had guaranteed Scarbrough a healthy horse
and delivered a sick one? The UCC also addresses this issue in its warranty provisions. A
warranty is a promise that goods will meet certain standards. Normally a manufacturer or a
seller gives a warranty and a buyer relies on it. A warranty might be explicit and written:
“The manufacturer warrants that the light bulbs in this package will illuminate for 2,000
hours.” Or a warranty could be oral: “Don’t worry, this machine can harvest any size of
wheat crop ever planted in the state.”
Sometimes a manufacturer offers a warranty as a means of attracting buyers: “We
provide the finest bumper-to-bumper warranty in the automobile industry.” Other times,
the law itself imposes a warranty on goods, requiring the manufacturer to meet certain
standards whether it wants to or not. We will first consider express warranties.
HARMON V. DUNN
1997 Tenn. App. LEXIS 217
Tennessee Court of Appeals,1997
C A S E S U M M A R Y
Facts: Bess Harmon owned a two-year-old Tennessee
Walking Horse named Phantom Recall. Harmon, who lived
in Tennessee, boarded her horse with Steve Dunn at his
stables in Florence, Alabama. Dunn cared for Phantom
Recall and showed him at equestrian events. Harmon
instructed Dunn to sell the horse for $25,000, and Dunn
arranged for his friend Scarbrough to buy the colt. On June
30, Dunn delivered Scarbrough’s $25,000 check to Harmon,
who handed over the horse’s certificate of registration and a
“transfer of ownership” document. That night at a horse
show, Dunn told Scarbrough that he had delivered the check
and had the ownership papers in his car. Dunn did not
actually give the documents to his friend. Scarbrough knew
that Phantom Recall was at Dunn’s stable, where Scarbrough
had boarded other horses. Sadly, the colt developed colitis
and died suddenly, on July 4. Scarbrough stopped payment
on his check, and Harmon sued for her money. The trial
court found for Harmon, and Scarbrough appealed.
Issue: Did Scarbrough bear the risk of Phantom Recall’s
death?
Decision: Yes. Scarbrough bore the risk of loss.
Affirmed.
Reasoning: UCC §2-509(2) governs those cases where
there is no breach of contract and the goods are held by
a bailee to be delivered without being moved. Dunn was
certainly Harmon’s bailee. He worked for Harmon,
trained Phantom Recall, and transported the horse to
various shows. Because the agreement between Scar-
brough and Harmon did not require Phantom Recall to
be moved anywhere for delivery, this section of the Code
applies. Under UCC §2-509(2), the risk of loss passes to
the buyer:
(a) On his receipt of a negotiable document of title covering
the goods, or
(b) On acknowledgment by the bailee of the buyer’s right to
possession of the goods.
Scarbrough argued that he did not bear the risk of the
horse’s loss because he never received physical possession
of the ownership documents. But Scarbrough obtained
control of the horse when Dunn told him that he, as
bailee, had the transfer papers—four days before the
horse’s death. He did not receive the ownership docu-
ments then, but the papers were already in Dunn’s hands,
and all parties knew it. Because nothing prevented Scar-
brough from exercising complete ownership of Phantom
Recall as of that date, he also acquired the risk of loss.
Unfortunately for Scarbrough, he was left with nothing
but the phantom of Phantom Recall.
Warranty
A contractual assurance
that goods will meet certain
standards.
CHAPTER 20 Ownership, Risk, and Warranties 463
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20-6 EXPRESS WARRANTIES
An express warranty is one that the seller creates with his words or actions.9 Whenever a
seller clearly indicates to a buyer that the goods being sold will meet certain standards, she has
created an express warranty. For example, if the sales clerk for a paint store tells a
professional house painter that “this exterior paint will not fade for three years, even in
direct sunlight,” that is an express warranty and the store is bound by it. Or, if the clerk
gives the painter a brochure that makes the same promise, the store is again bound by its
express warranty. On the other hand, if the salesperson merely says, “I know you’re going to
be happy with this product,” there is no warranty because the promise is too vague. The
UCC establishes that the seller may create an express warranty in three ways: (1) with an
affirmation of fact or a promise; (2) with a description of the goods; or (3) with a sample or
model. In addition, the buyer must demonstrate that what the seller said or did was part of
the basis of the bargain.
20-6a Affirmation of Fact or Promise
Any affirmation of fact—or any promise—can create an express warranty.10 An affirmation of
fact is simply a statement about the nature or quality of the goods, such as “this scaffolding
is made from the highest grade of steel available at any price” or “this car will accelerate
from 0 to 60 in 5.3 seconds.” A promise can include phrases such as, “we guarantee you that
this air conditioning system will cool your building to 72 degrees, regardless of the outdoor
temperature.”
A common problem in cases of express warranty is to separate true affirmations of fact
from mere sales puffery or seller’s opinion, which creates no express warranty.
A statement is more likely to be an affirmation of fact if:
• It is specific and can be proven true or false. Suppose the brochures of a home builder
promise to meet “the strictest building codes.” Since there is a code on file, the
builder’s work can be compared to it, and his promise is binding.
• It is written. An oral promise can create an express warranty. But promises in
brochures are more likely to be taken seriously. Statements in a written contract are the
likeliest of all to create a binding warranty.
• Defects are not obvious. If a used car salesman tells you that a car is rust-free when the
driver’s door is pockmarked with rust, you should not take the statement seriously—
since a court will not, either.
• Seller has greater expertise. If the seller knowsmore than the buyer, his statements will be
more influential with buyer and court alike. If your architect assures you that the newporch
will be warm in winter, the law recognizes that you will naturally rely on her expertise.
20-6b Description of Goods
Any description of the goods can create an express warranty.11 The statement can be oral or
written. A description might be a label on a bag of seed, referring to the seed as a particular
variety of tomato; it could be a tag on airplane parts, assuring the buyer that the goods have
met safety tests. Wherever the words appear, if they describe the goods as having particular
characteristics or qualities, the seller has probably created an express warranty.
9UCC §2-313.
10UCC §2-313(1)(a).
11UCC §2-313(1)(b).
Express warranty
One that the seller creates with
his words or actions.
464 U N I T 3 Commercial Transactions
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20-6c Sample or Model
Any sample or model can create an express warranty.12 A sample can be a very effective way
of demonstrating the quality of goods to a customer. However, a seller who uses a sample is
generally warranting that the merchandise sold will be just as good.
20-6d Basis of Bargain
The seller’s conduct must have been part of the basis of the bargain. To prove an express
warranty, a buyer must demonstrate that the two parties included the statements or acts in their
bargain. Some courts have interpreted this tomean that the buyermust have relied on the seller’s
statements. There is logic to this position. For example, suppose a sales brochure makes certain
assurances about the quality of goods, but the buyer never sees the brochure until she files suit.
Should the seller be held to an express warranty? Some courts would rule that the seller is not
liable for breach of warranty.
Other courts, however, have ruled that a seller’s statement can be part of the basis of the
bargain even when the buyer has not clearly relied on it. These courts are declaring that a seller
who chooses tomake statements about his goodswill be held to themunless the seller can convince a
court that he should not be liable.This is a policy decision, taken by many courts, to give the buyer
the benefit of the doubt since the seller is in the best position to control what he says.
20-7 IMPLIED WARRANTIES
Sean decides to plow driveways during the winter. Emily sells him a snowplow and installs it on
his truck, but she makes no promises about its performance. When winter arrives, Sean has
plenty of business, but he finds that the plow cannot be raised or lowered whenever the
temperature falls below 40 degrees. He demands a refund fromEmily, but she declines, saying,
“I never said that thing would work in the winter. Tough luck.” Is she off the hook? No. It is
true she made no express warranties. But many sales are covered by implied warranties.
Implied warranties are those created by the Uniform Commercial Code itself, not by any
act or statement of the seller. The Code’s drafters concluded that goods should generally
meet certain standards of quality, regardless of what the seller did or did not say. So the
UCC creates both an implied warranty of merchantability and an implied warranty of fitness.
20-7a Implied Warranty of Merchantability
This is the most important warranty in the UCC. Buyers, whether individual consumers or
billion-dollar corporations, are more likely to rely on this than any other section, and sellers must
understand it thoroughly when they market goods. Unless excluded or modified, a warranty that
the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant
with respect to goods of that kind. Merchantable means that the goods are fit for the ordinary
purposes for which they are sold.13 This rule contains several important principles:
• Unless excluded or modified means that the seller does have a chance to escape this
warranty.
• Merchantability requires that goods be fit for their normal purposes. To be
merchantable, a ladder must be able to rest securely against a building and support
someone who is climbing it. The ladder need not be serviceable as a boat ramp.
12UCC §2-313(1)(c).
13UCC §2-314(1).
Merchantable
Means that the goods are fit for
the ordinary purposes for which
they are sold.
CHAPTER 20 Ownership, Risk, and Warranties 465
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• Implied means that the law itself imposes this liability on the seller even if it is not
written down.
• A merchant with respect to goods of that kind means that the seller is someone who
routinely deals in these goods or holds himself out as having special knowledge about
these goods. If it is selling vehicles, a car dealer is acting as a merchant. An accountant
who sells his used car by listing it online is not a merchant.
Dacor Corp. manufactured and sold scuba diving equipment. Dacor ordered air hoses from
Sierra Precision, specifying the exact size and couplings so that the hose would fit tightly and
safely into Dacor’s oxygen units. Within about one year, customers returned a dozen Dacor
units, complaining that the hose connections had cracked or sheared and were unusable. Dacor
recalled 16,000 units and refit themwith safe hoses, at a cost of more than $136,000. Dacor sued
Sierra, claiming a breach of the implied warranty of merchantability. The Illinois court ruled
that Sierra was a merchant with respect to scuba hoses because it routinely manufactured and
sold them. Further, the court ruled that since use of the faulty hose assemblies under water
would be life-threatening, they were clearly not fit for the purpose for which they were sold—
which was, after all, scuba diving! The court ordered Sierra to pay the cost of Dacor’s recall.14
The scuba equipment was not merchantable because a properly made scuba hose
should never crack under normal use. But what if the product being sold is food, and the
food contains something that is harmful—yet quite normal?
GOODMAN V. WENCO FOODS, INC.
333N.C. 1, 423 S.E.2d 444,1992 N.C. LEXIS 671
Supreme Court of North Carolina, 1992
C A S E S U M M A R Y
Facts: Fred Goodman and a friend stopped for lunch
at a Wendy’s restaurant in Hillsborough, North Caro-
lina. Goodman had eaten about half of his double
hamburger when he bit down and felt immediate pain
in his lower jaw. He took from his mouth a triangular
piece of cow bone, about one-sixteenth to one-quarter
inch thick and one-half inch long, along with several
pieces of his teeth. Goodman’s pain was intense, and
his dental repairs took months.
The restaurant purchased all of its meat from Green-
sboro Meat Supply Company (GMSC). Wendy’s required
its meat to be chopped and “free from bone or cartilage
in excess of 1/8 inch in any dimension.” GMSC beef
was inspected continuously by state regulators and
was certified by the United States Department of
Agriculture (USDA). The USDA considered any bone
fragment less than three-quarters of an inch long to be
“insignificant.”
Goodman sued, claiming a breach of the implied war-
ranty of merchantability. The trial court dismissed the claim,
ruling that the bone was natural to the food and that the
hamburger was therefore fit for its ordinary purpose. The
appeals court reversed this, holding that a hamburger could
be unfit even if the bone occurred naturally. Wendy’s
appealed to the state’s highest court.
Issue: Was the hamburger unfit for its ordinary purpose
because it contained a harmful but natural bone?
Decision: Yes. Even if the harmful bone occurred
naturally, the hamburger could be unfit for its ordinary
purpose. Affirmed.
Reasoning: When an object in food harms a consumer,
the injured person may recover even if the substance
occurred naturally, provided that a reasonable consumer
would not expect to encounter it. A triangular, one-half-
inch bone shaving may be inherent to a cut of beef, but
14Dacor Corp. v. Sierra Precision, 1993 U.S. Dist. LEXIS 8009 (N.D. Ill. 1993).
466 U N I T 3 Commercial Transactions
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20-7b Implied Warranty of Fitness for a Particular
Purpose
The other warranty that the UCC imposes on sellers is the implied warranty of fitness for a
particular purpose. This cumbersome name is often shortened and referred to as simply the
warranty of fitness. Where the seller at the time of contracting knows about a particular
purpose for which the buyer wants the goods, and knows that the buyer is relying on the
seller’s skill or judgment, there is (unless excluded or modified) an implied warranty that the
goods shall be fit for the purpose.15 Here are the key points:
• Particular purpose. The seller must know about some special use that the buyer plans
for the goods. For example, if a lumber salesman knows that a builder is purchasing
lumber to construct houses in a swamp, the UCC implies a warranty that the lumber
will withstand water.
• Seller’s skill. The buyer must be depending upon the seller’s skill or judgment in
selecting the product, and the seller must know it. Suppose the builder says to the
lumber salesman, “I need four-by-eights that I will be using to build a house in the
swamp. What do you have that will do the job?” The builder’s reliance is obvious, and
the warranty is established. By contrast, suppose that an experienced Alaskan sled
driver offers to buy your three huskies, telling you she plans to use them to pull sleds.
She has the experience and you do not, and if the dogs refuse to pull more than a one-
pound can of dog food, you have probably not breached the implied warranty of fitness.
• Exclusion or modification. Once again, the seller is allowed to modify or exclude any
warranty of fitness.
20-7c Warranty of Title
Strapped for cash, Maggie steals her boyfriend’s rusty Chevy and sells it to Paul for $2,500. As we
saw earlier in this chapter, Maggie gets no valid title by her theft, and therefore Paul receives no
title either. When the boyfriend finds his car parked at a nightclub, he notifies the police and gets
his wheels back. Poor Paul is out of pocket $2,500 and has no car to show for it. That clearly is
unjust, and the UCC provides Paul with a remedy: The seller of goods warrants that her title is
valid and that the goods are free of any security interest that the buyer knows nothing about unless
the seller has clearly excluded or modified this warranty.16 Once again, the Code is imposing a
warranty on any seller except thosewho explicitly exclude ormodify it.WhenMaggie sells the car
to Paul, she warrants her valid title to the car and simultaneously breaches that warranty since she
obviously has no title. If he can find her, Paul will win a lawsuit against Maggie for $2,500.
whether a reasonable consumer would anticipate it is
normally a question for the jury.
Wendy’s hamburgers need not be perfect, but
they must be fit for their intended purpose. It is
difficult to imagine how a consumer could guard
against bone particles, short of removing the hambur-
ger from its bun, breaking it apart, and inspecting its
small components.
Wendy’s argued that because its meat complied
with federal and state standards, the hamburgers were
merchantable as a matter of law. However, while com-
pliance with legal standards is evidence for the juries to
consider, it does not ensure merchantability. A jury
could still conclude that a bone this size in hamburger
meat was reasonably unforeseeable and that an injured
consumer was entitled to compensation.
15UCC §2-315.
16UCC §2-312(1).
CHAPTER 20 Ownership, Risk, and Warranties 467
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20-8 DISCLAIMERS AND DEFENSES
There are several limitations on warranties. A seller may disclaim warranties, meaning that
he eliminates express or implied warranties covering the goods. Or the seller may limit the
buyer’s remedy, which means that even if there is a breach of warranty, the buyer still may
have only a very limited chance to recover against the seller.
20-8a Disclaimers
A disclaimer is a statement that a particular warranty does not apply. The Code permits the
seller to disclaim most warranties.
ORAL EXPRESS WARRANTIES
Under the Code, a seller may disclaim an oral express warranty. Suppose Traffic Co. wants
to buy a helicopter from HeliCorp for use in reporting commuter traffic. HeliCorp’s sales-
man tells Traffic Co., “Don’t worry, you can fly this bird day and night for six months with
nothing more than a fuel stop.” HeliCorp’s contract may disclaim the oral warranty. The
contract could say, “HeliCorp’s entire warranty is printed below. Any statements made by
any agent or salesperson are disclaimed and form no part of this contract.” That disclaimer is
valid. If the helicopter requires routine servicing between flights, HeliCorp has not brea-
ched an oral warranty.
WRITTEN EXPRESS WARRANTIES
This is the one type of warranty that is almost impossible to disclaim. If a seller includes an
express warranty in the sales contract, any disclaimer is definitely invalid. Suppose HeliCorp
sells an industrial helicopter for use in hauling building equipment. The sales contract
describes the aircraft as “operable to 14,000 feet.” Later, in the contract, a limited warranty
disclaims “any other warranties or statements that appear in this document or in any other
document.” That disclaimer is invalid and does not cancel the assurance that the helicopter
can operate to 14,000 feet. The Code will not permit a seller to take contradictory positions
in a document. The goal is simply to be fair, and the UCC assumes that it is confusing and
unjust for a seller to say one thing to help close a deal and the opposite to limit its losses.17
What if the express written statement is in a different document, such as a sales
brochure? The disclaimer is void if it would unfairly surprise the buyer. Assume, again, that
HeliCorp promises a helicopter that requires no routine maintenance for six months, but
this time, the promise appears in a sales brochure that Traffic Co. reads and relies on. If
HeliCorp attempts to disclaim the written warranty, it will probably fail. Most people take
written information seriously, and courts usually find that consumers would be unfairly
surprised if a company tried to go back on promises made in a sales brochure.
IMPLIED WARRANTIES
A seller may disclaim the implied warranty of merchantability provided he actually mentions
the word merchantability and makes the disclaimer conspicuous. Courts demand to see the
specific word merchantability in the disclaimer to be sure the buyer realized she was giving
up this fundamental protection. If the word is there, and the disclaimer is conspicuous
enough that the buyer should have seen it, she has forfeited the warranty. A seller may
disclaim the implied warranty of fitness with any language that is clear and conspicuous.
To make life easier, the UCC permits a seller to disclaim all implied warranties by
conspicuously stating that the goods are sold “as is” or “with all faults.” Notice the tension
17UCC §2-316(1).
Disclaimer
A statement that a particular
warranty does not apply.
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between this provision and the one just discussed. A seller who wants to disclaim only the
warranty of merchantability must explicitly mention that term; but a seller wishing to
exclude all implied warranties may do so with a short expression, such as “sold as is.”
Many states, though, prohibit a seller from disclaiming implied warranties in the sale of
consumer goods. In these states, if a home furnishings store sells a bunk bed to a consumer,
and the top bunk tips out the window on the first night, the seller is liable. Even if the sales
contract clearly stated “no warranties of merchantability,” the court would reject the clause
and find that the seller breached the implied warranty of merchantability.
EXAM Strategy
Question: Marcos’s backyard pool, which measured 35 feet by 18 feet, needed a
new filter. A sales brochure stated, “This filter will keep any normal backyard pool,
up to 50 feet by 25, clean and healthy all summer for a minimum of 5 years.” Marcos
signed a sales contract, which included this disclaimer: “The filter will work to normal
industry standards. This is the only warranty. No other statements, written or oral,
apply. Pools vary widely, and the Seller cannot guarantee any specific level of
performance or cleanliness. Buyer agrees to this disclaimer.” The filter failed to keep
Marcos’s pool clean, and he sued for breach of warranty. Who should win?
Strategy: Sellers are often able to disclaim oral warranties, but written warranties are
difficult to disclaim. Here, the initial promise and the disclaimer were in different
documents. Does that change the outcome? Finally, Marcos was a consumer. Courts
treat consumers differently from corporate buyers.
Result: It is difficult or impossible for sellers to disclaim written warranties, even if
the promise and disclaimer are in different documents. A disclaimer that would
unfairly surprise the buyer is void. Marcos relied on the sales brochure—as the
company intended—and the seller will probably lose. Furthermore, most states give
extra protection to consumers, knowing that they are less sophisticated buyers. A
court is likely to find in favor of Marcos based on the seller’s express warranty, as well
as the implied warranties of merchantability and fitness.
20-8b Remedy Limitations
Simon Aerials, Inc., manufactured boomlifts, the huge cranes used to construct multistoried
buildings. Simon agreed to design and build eight unusually large machines for Logan
Equipment Corp. Simon delivered the boomlifts late, and they functioned poorly. Logan
requested dozens of repairs and modifications, which Simon attempted to accomplish over
manymonths, but the equipment never worked well. Logan gave up and sued for $7.5 million,
representing the profits it expected to make from renting the machines and the damage
to its reputation. Logan clearly had suffered major losses, and it recovered—nothing.
How could that be?
Simon had negotiated a limitation of remedy clause, by which the parties may limit or
exclude the normal remedies permitted under the UCC.18 These important rights are
entirely distinct from disclaimers. A disclaimer limits the seller’s warranties and thus affects
whether the seller has breached her contract in the first place. A remedy limitation, by
18UCC §2-719. A few states prohibit remedy limitations, but most permit them.
CHAPTER 20 Ownership, Risk, and Warranties 469
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contrast, states that if a party does breach its warranty, the injured party will not get all of the
damages the Code normally allows.
In its contract, Simon had agreed to repair or replace any defective boomlifts, but that
was all. The agreement said that if a boomlift was defective, and Logan lost business,
profits, and reputation, Simon was not liable. The court upheld the remedy limitation. Since
Simon had repeatedly attempted to repair and redesign the defective machines, it had done
everything it promised to do. Logan got nothing.19
We compare disclaimers and remedy limitations in the table below.
19Logan Equipment Corp. v. Simon Aerials, Inc., 736 F. Supp. 1188, 1990 U.S. Dist. LEXIS 5720
(D. Mass. 1990).
Comparison of Disclaimers and Remedy Limitations
Code Section Purpose Setting Contract Language Result
Disclaimers: UCC
§2-316
Limits warranties,
whether express
or implied. This
section will
determine
whether there has
been a breach.
Seller sells Buyer a used
“tire shredding machine.”
UCC §2-314 implies a
warranty of
merchantability, meaning
that the machine will be
good for its ordinary
purpose, which is
shredding tires in a
commercial recycling
business.
Seller includes in the
contract a clause
stating that the tire
shredder is sold “as
is.” Under §2-316,
this phrase excludes
all implied warranties,
meaning that the
implied warranty of
merchantability will
NOT apply here.
One tire goes through
the machine, the tire
emerges completely
intact, and the machine
falls to pieces. Result:
Seller has NOT
breached the contract,
and Buyer gets no
damages.
Remedy
limitations: UCC
§2-719
Limits the
remedies available
when one party
has breached the
contract.
Seller sells Buyer
10,000 computer
circuit boards at $200
each, which Buyer uses
in its laptops.
Seller requires a
clause limiting Buyer’s
remedies to “replace
orrepair.” If theboards
fail, Seller will replace
or repair themfor free.
But Buyer is permitted
NO OTHER REMEDY.
Buyer may not seek
consequential
damages,whichwould
include lost profits and
injured reputation.
All of the boards
malfunction, and Buyer’s
customers are angry at
Buyer. Buyer must take
the computers back,
losing all of its expected
profits and also suffering
a serious loss of
reputation in the high-
tech world. Seller IS in
breach of the contract
and must repair or
replace all circuit boards
at its expense. But Seller
owes NOTHING for
Buyer’s lost profits or
injured reputation.
20-8c Privity
When two parties contract, they are in privity. If Lance buys a chainsaw from the local
hardware store, he is in privity with the store. But Lance has no privity with Kwiksaw, the
manufacturer of the chainsaw. Under traditional contract law, a plaintiff injured by a breach
of contract could sue only a defendant with whom he had privity. This rule hurt consumers
because the local retailer might have lacked assets to compensate for serious injuries.
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470 U N I T 3 Commercial Transactions
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Today, privity is gradually disappearing as a defense. Various states are approaching the
issue in different ways, so there is no single rule. We can, however, highlight the trends.
PERSONAL INJURY
Where a product causes a personal injury, most states permit a warranty lawsuit even
without privity. If the chain on Lance’s power saw flies off and slashes his arm, he has
suffered a personal injury. Of course, he may sue the store, with which he has privity. But he
will want to sue the manufacturer, which has more money. In the majority of states, he will
be able to sue the manufacturer for breach of warranty even though he had no privity with
it. (Note that Lance is sure to make other claims against the manufacturer, including
negligence and strict liability, both discussed in Chapter 6.)
ECONOMIC LOSS DOCTRINE
If the buyer suffers only economic loss, privity may still be required to bring a suit for
breach of warranty. If the buyer is a business, the majority of states require privity. Fab-Rik
makes fabric for furniture and drapes, which it sells to various wholesalers. Siddown makes
sofas. Siddown buys Fab-Rik fabric from a wholesaler and, after installing it on 200 sofas,
finds the material defective. Siddown may sue the wholesaler but, in most states, will be
unable to sue Fab-Rik for breach of any warranties. There was no privity.
By contrast, when the buyer is a consumer, more states will permit a suit against the
manufacturer, even without privity. Lance, the consumer, buys his power saw to landscape
his property. This time, the saw malfunctions without injuring him, but Lance must buy a
replacement saw for considerably more money. Many states—but not all—will permit him
to recover his losses from Kwiksaw, the manufacturer, on the theory that Kwiksaw intends
its product to reach consumers and is in the best position to control losses.
In the following case, a jailhouse tragedy prompts a product liability suit.
REED V. CITY OF CHICAGO
263 F.Supp.2d 1123
United States District Court for the Northern District of Illinois, 2003
C A S E S U M M A R Y
Facts: J.C. Reed was arrested and brought to Chicago’s
Fifth District Police Station. Police were allegedly aware
that he was suicidal, having seen him slash his wrists earlier.
They removed his clothing and dressed him in a paper
isolation gown. Sadly, Reed used the gown to hang himself.
Reed’s mother, on his behalf, sued the police (for
failing to monitor a suicidal inmate) and also Cypress
Medical Products, the manufacturer of the isolation gown.
The claim was that the gown should have been made of
material that would tear if someone attempted to hang
himself with it.
Cypress moved to dismiss the suit, claiming that
Reed had no privity with the company.
Issue: Could Reed maintain a lawsuit against Cypress
despite lack of privity?
Decision: Yes. Privity was not required. Reed could
have sued Cypress.
Reasoning: Historically, a plaintiff lost a breach of
warranty suit if he lacked privity with the defendant.
However, UCC §2-318 now extends an express or
implied warranty to any injured person who is in the
family or household of the buyer, or who is a guest in
the home, if it is reasonable to expect that he might
use the goods or be affected by a breach of warranty.
What is more, Illinois decisions have expanded the
class of potential plaintiffs beyond those mentioned in
§2-318.
Most of the successful suits have arisen in employ-
ment cases. For example, a plaintiff was injured using a
bandsaw that his employer had purchased. The court held
that the worker was a third party beneficiary of the sales
Economic loss doctrine
When an injury is purely
economic, and arises from a
contract made by two
businesses, the injured party
may only sue under the UCC.
CHAPTER 20 Ownership, Risk, and Warranties 471
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20-8d Buyer’s Misuse
Misuse by the buyer will generally preclude a warranty claim.20 Common sense tells
us that the seller only warrants its goods if they are properly used. Lord & Taylor
warranted that its false eyelashes would function well and cause no harm. But when
Ms. Caldwell applied them, they severely irritated one eye. She sued, but the store
prevailed. Why? Caldwell applied the eyelashes improperly, getting the glue into one
eye. On her other eye, she used the product correctly and suffered no harm. Her
misuse proved painful to her eye—and fatal to her lawsuit.
Chapter Conclusion
Bad things happen. Deals fall through. Purchased goods disappear. Products injure. Unfor-
tunately, people often fail to consider these possibilities when making a contract. In that
case, the UCC steps in with default rules that address critical issues in commercial transac-
tions, such as when an insurable interest exists, the risk of loss shifts, and warranties are
made. But these default rules will not always be in a party’s best interest. The good news is
that the UCC gives buyers and sellers the freedom to change its default settings. Business-
people who understand the UCC can tailor the rules to their own advantage. Armed with
this chapter’s information, they will know how and when to alter the UCC’s rules to suit
their business purposes and protect themselves if and when bad things do happen.
EXAM REVIEW
1. INTEREST AND TITLE An interest is a legal right in something. Title means the
normal rights of ownership. (pp. 451– 452)
2. IDENTIFICATION Goods must exist and be identified to the contract before title
can pass. The parties may agree in their contract how and when they will identify
goods; if they do not specify, the Code stipulates when it happens. The parties may
contract and that his safety was part of the basis of the
bargain made by the employer. The employee could sue
the manufacturer. By contrast, in a case not related to
employment, a court refused to allow a warranty claim
by a university football player injured because of a defec-
tive helmet that the school had purchased.
The facts of this case indicate that the class of plain-
tiffs who can sue for breach of warranty must be expanded
to include injured parties such as Reed. The only users of
the gowns that Cypress manufactures will be potentially
suicidal detainees. Their safety was necessarily part of the
bargain between seller and buyer, whether expressed or
implied. If such a detainee is not covered by the warranty,
no one will be. A detainee covered by the warranty must
be able to enforce it.
Cypress’s motion to dismiss was denied.
20Some courts characterize the misuse as “comparative negligence” or “contributory negligence” or
“failure of proximate cause.” These tort terms are discussed in Chapter 6, dealing with negligence and
strict liability. For our purposes here, though, it is enough to understand that misuse generally
precludes a warranty claim.
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also state when title passes, and once again, if they do not, the Code provides rules.
(pp. 452–453)
3. INSURABLE INTEREST A buyer obtains an insurable interest when the goods
are identified to the contract. A seller retains an insurable interest in goods as long as
she has either title or a security interest in them. (pp. 454–455)
4. VOID AND VOIDABLE TITLE Void title is no title at all. Voidable title means
limited rights in the goods, inferior to those of the owner. A person with voidable
title has power to transfer good title to a bona fide purchaser (BFP); that is, someone
who purchases in good faith, for value. (pp. 455–456)
5. ENTRUSTING Any entrusting of goods to a merchant who deals in goods of that
kind gives him the power to transfer all rights of the entruster to a buyer in the
ordinary course of business. (pp. 457–458)
6. BIOC A buyer in the ordinary course of business generally takes goods free and
clear of any security interest. (p. 458)
7. RISK OF LOSS In their contract, the parties may allocate the risk of loss any way
they wish. If they fail to do so, the Code provides several steps to determine who
pays for any damage. When neither party has breached, the risk of loss generally
passes from seller to buyer when the seller has transported the goods as far as he is
obligated to. When a party has breached, the risk of loss generally lies with the party
that has breached. (pp. 458 –463)
8. EXPRESS WARRANTY Seller can create an express warranty with any
affirmation or promise, with any description of the goods, or with any
sample or model, provided the words or sample is part of the basis of the
bargain. (pp. 464 – 465)
9. IMPLIED WARRANTY OF MERCHANTABILITY With certain exceptions,
the Code implies a warranty that the goods will be fit for their ordinary purpose.
(pp. 465 –466)
10. IMPLIED WARRANTY OF FITNESS FOR A PARTICULAR
PURPOSE With some exceptions, the Code implies a warranty that the goods
are fit for the buyer’s special purpose, provided that the seller knows of that purpose
when the contract is made and knows of the buyer’s reliance. (p. 467)
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION On Monday, Wolfe paid Aston Co., a furniture retailer, $500 for a
table. On Thursday, Aston notified Wolfe that the table was ready to be picked up.
On Saturday, while Aston was still in possession of the table, it was destroyed in a fire.
Who bears the loss of the table?
(a) Wolfe, because Wolfe had title to the table at the time of loss
(b) Aston, unless Wolfe is a merchant
(c) Wolfe, unless Aston breached the contract
(d) Aston, because Wolfe had not yet taken possession of the table
CHAPTER 20 Ownership, Risk, and Warranties 473
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2. Sheri signs a contract with Farmer Charlie on February 1. Under the deal, she will pay
$25,000 for Charlie’s entire pumpkin crop on October 1. Charlie plants pumpkin seeds
on March 1, and they begin to sprout on April 1. When are the pumpkins identified?
(a) February 1
(b) March 1
(c) April 1
(d) October 1
3. Sam obtains a Patek Philippe watch from Greg by fraud. It has a retail price of $10,000.
He sells it to Melissa for $9,000. She believes he owns the watch. Melissa a
bona fide purchaser. Sam disappears. If Greg discovers that she has the watch and
demands that it be returned, Melissa have to give the watch to Greg.
(a) is; will
(b) is; will not
(c) is not; will
(d) is not; will not
4. CPA QUESTION Vick bought a used boat from Ocean Marina that disclaimed
“any and all warranties.” Ocean was unaware the boat had been stolen from Kidd.
Vick surrendered it to Kidd when confronted with proof of the theft. Vick sued
Ocean. Who prevails?
(a) Vick, because the implied warranty of title has been breached
(b) Vick, because a merchant cannot disclaim implied warranties
(c) Ocean, because of the disclaimer of warranties
(d) Ocean, because Vick surrendered the boat to Kidd
5. CPA QUESTION Which of the following conditions must be met for an implied
warranty of fitness for a particular purpose to arise?
I. The warranty must be in writing.
II. The seller must know that the buyer was relying on the seller in selecting the goods.
(a) I only
(b) II only
(c) Both I and II
(d) Neither I nor II
ESSAY QUESTIONS
1. Franklin Miller operated Miller Seed Co. in Pea Ridge, Arkansas. He bought,
processed, and sold fescue seed, which is used for growing pasture and fodder grass.
Farmers brought seed to Miller, who would normally clean, bag, and store it. In some
cases, the farmers authorized Miller to sell the seed, in some cases not. Miller mixed
together the seed that was for sale with the seed in storage so that a customer could
not see any difference between them. Miller defaulted on a $380,000 loan from the
First State Bank of Purdy. First State attempted to seize all of the seed in the store.
474 U N I T 3 Commercial Transactions
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Tony Havelka, a farmer, protested that his 490,000 pounds of seed was merely in
storage and not subject to First State’s claim. Who is entitled to the seed?
2. Universal Consolidated Cos. contracted with China Metallurgical Import and Export
Corp. (CMIEC) to provide CMIECwith new and used equipment for a cold rolling steel
mill. Universal then contracted with Pittsburgh Industrial Furnace Co. (Pifcom) to
engineer and build much of the equipment. The contract required Pifcom to deliver the
finished equipment to a trucking company, which would then transport it to Universal.
Pifcom delivered the goods to the trucking company as scheduled. But before all of the
goods reachedUniversal, CMIEC notified Universal it was canceling the deal. Universal,
in turn, notified Pifcom to stop work, but all goods had been delivered to the shipper and
ultimately reached Universal. Pifcom claimed that it retained title to the goods, but
Universal claimed that title had passed to it. Who is right?
3. YOU BE THE JUDGE WRITING PROBLEM Construction Helicopters paid
Heli-Dyne Systems $315,000 for three helicopters that were in Argentina. Two were
ready to fly, and one was disassembled for routine maintenance. The contract said
nothing about risk of loss (the parties could have saved a lot of money by reading this
chapter). Heli-Dyne arranged for an Argentine company to oversee their loading on
board the freight ship Lynx. The two helicopters and 25 crates containing the
disassembled craft were properly loaded, but when the ship arrived in Miami, only
7 of the crates appeared. Heli-Dyne refused to supply more parts, and Construction
sued. Who bears the loss? Argument for Construction: Construction had no control
over the goods until they reached Miami. Although we do not know exactly what
happened to the crates, we know the one party that had nothing to do with the loss:
Construction. The company should not pay for damage it never caused. Argument for
Heli-Dyne: Because the contract failed to specify risk of loss, it is a shipment contract.
In such an agreement, risk of loss passes to the buyer when the seller delivers the
goods to a carrier. Heli-Dyne delivered the goods and has no further responsibility.
4. Leighton Industries needed steel pipe to build furnaces for a customer. Leighton sent
Callier Steel an order for a certain quantity of “A 106 Grade B” steel. Callier
confirmed the order and created a contract by sending an invoice to Leighton, stating
that it would send “A 106 Grade B” steel, as ordered. Callier delivered the steel, and
Leighton built the furnaces, but they leaked badly and required rebuilding. Tests
demonstrated that the steel was not in fact “A 106 Grade B,” but an inferior steel.
Leighton sued. Who wins?
5. Boboli Co. wanted to promote its “California-style” pizza, which it sold in
supermarkets. The company contracted with Highland Group, Inc., to produce
2 million recipe brochures, which would be inserted in the carton when the freshly
baked pizza was still very hot. Highland contracted with Comark Merchandising to
print the brochures. But when Comark asked for details concerning the pizza, the
carton, and so forth, Highland refused to supply the information. Comark printed the
first lot of 72,000 brochures, which Highland delivered to Boboli. Unfortunately, the
hot bread caused the ink to run, and customers opening the carton often found red or
blue splotches on their pizzas. Highland refused to accept additional brochures, and
Comark sued for breach of contract. Highland defended by claiming that Comark had
breached its warranty of merchantability. Please comment.
CHAPTER 20 Ownership, Risk, and Warranties 475
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DISCUSSION QUESTIONS
1. In the Bakalar case, do you agree with the court’s
decision? Should the heirs get a chance to recover
the drawing that was stolen from their ancestor? Or
should Bakalar, who has owned the drawing for
50 years and knew nothing about its origin, be able
to keep ownership?
2. Imagine that your laptop gets a virus, and you take
it to a local computer repair shop. The shop sells
your computer to Heidi. Under the entrustment
rules in the UCC, Heidi is a buyer in the ordinary
course of business. And so, even if you find Heidi
and demand that she return your laptop, she gets to
keep it. Is this fair? Does the law give too much
protection to purchasers in this situation, and not
enough to victims?
3. You are about to move, and you take your furniture
to a consignment shop. The shop’s creditors seize
everything in the store, including your furniture.
You demand that the creditors give back your stuff,
but under UCC §2-326, they do not have to. Is this
fair? Should the law change?
4. A seller can disclaim all implied warranties by
stating that goods are sold “as is” (or by using
other, more specific language). Is this fair? The
UCC’s implied warranties seem reasonable—that
goods are fit for their normal purposes, for
example. Should it be so easy for sellers to escape
their obligations?
5. After learning more about implied warranties and
disclaimers, would you ever buy an item sold “as
is”? Imagine a car salesman who offers you a car for
$8,000, but who also says that he can knock the
price down to $6,500 if you will buy the car “as is.”
If you live in a state that does not give consumers
special protections, which deal would be more
appealing?
476 U N I T 3 Commercial Transactions
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CHAPTER21
PERFORMANCE
AND REMEDIES
Was it a 1930s roadster? A drag racing car from the
1950s? Both. When the Plymouth Prowler first hit
the road, with its motorcycle-styled front fenders
and low-slung hot rod body, it was nearly impossi-
ble to get your hands on one. Dealers were
swampedwith orders, but they did not know if they
would receive a single car from the manufacturer.
Donald Hessler wanted a Prowler—and he
was a determined man. Hessler went to Crystal
Lake Chrysler-Plymouth, met with its owner, Gary
Rosenberg, and signed an agreement to buy a Prowler
anytime during the next year for $5,000 over the manu-
facturer’s list price. Three months later, Rosenberg
revealed that the list price would be $39,000. However,
the car dealer also entered into a contract to sell a
Prowler to another customer for $50,000.
The next time they spoke, Rosenberg told Hessler
that Crystal Lake would not be allotted any Prowlers.
The eager buyer, though, responded that a Chrysler
representative had told himCrystal Lake would receive at least one car. Rosenberg was furious
with a customer who had “gone behind his back” to contact Chrysler, and said he would not
sell Hessler a car, even if he did receive one.
Hessler telephoned 38 Chrysler dealers, but none would promise him a car. One month
later, at a promotional event for the car, he saw a new Prowler—with Crystal Lake’s name
on it! He located Rosenberg, offered to buy the car on the spot—and was again rebuffed.
Frustrated and angry, but still determined, Hessler somehow found a Prowler later the
same day from another dealer, and bought it—for $77,706.
Ecstatic with his new car, Hessler drove straight to court, where he sued Crystal Lake.
Was Rosenberg within his rights, refusing to sell a car to Hessler? Was the customer
entitled to compensation for spending so much more on the coveted auto? These are
typical issues of contract performance under the Uniform Commercial Code. We look at the
issue in this chapter, along with principles of remedy. When Hessler bought a car elsewhere,
Donald Hessler wanted a
Prowler—and he was a
determined man.
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he was covering. Did he act reasonably in spending almost $40,000 above list
price? You will have to wait a few pages to find out, but we promise to give
you the answer before anyone else gets it.
21-1 OBLIGATION ON ALL PARTIES:
GOOD FAITH
Surely it is a good idea to begin this final chapter on sale of goods issues in good faith.
The R. G. Ray Corp. needed T-bolts to use in automobile parts it was manufacturing
for the Garrett Co. Ray contracted for Maynard Manufacturing to deliver 57,000 T-bolts and
provided Maynard with detailed specifications. The contract stated that Ray would be the
“final judge” of whether the T-bolts conformed to its specifications and that Ray had the
right to return any or all non-conforming bolts. Conforming goods satisfy the contract terms.
Non-conforming goods do not.1
Unfortunately, Ray rejected the 57,000 bolts and sued, demanding every penny it had
paid as well as additional damages for its lost business with Garrett. Ray moved for summary
judgment, pointing out that the contract explicitly allowed it to judge the bolts, to reject any
it found unsatisfactory, and to cancel the contract. The court acknowledged that the contract
did give Ray these one-sided powers, yet it denied summary judgment. There was still an
issue of good faith.
The UCC requires good faith in the performance and enforcement of every contract.
Good faith means honesty in fact. Between merchants, it also means the use of reasonable
commercial standards of fair dealing.2 So Ray’s right to reject the T-bolts was not absolute.
There was some evidence that Ray had lost its contract with Garrett for reasons having nothing
to do withMaynard’s T-bolts. If that was true, and Ray had rejected theT-bolts simply because
it no longer needed them, then Ray acted in bad faith and would be fully liable on the contract.
The court ruled that Maynard should have its day in court to prove bad faith.3
21-2 SELLER’S RIGHTS AND OBLIGATIONS
The seller’s primary obligation is to deliver conforming goods to the buyer.4 But because a
buyer might not be willing or able to accept delivery, the UCC demands only that the seller
make a reasonable attempt at delivery. The seller must tender the goods, which means to
make conforming goods available to the buyer.5 Normally, the contract will state where and
when the seller is obligated to tender delivery. For example, the parties may agree that
Manufacturer is to tender 1,000 printers at a certain warehouse on July 3. If Manufacturer
makes the printers available on that date, Buyer is obligated to pick them up then and there
and is in breach if it fails to do so.
Although a seller must always tender delivery, that does not mean a seller always
transports the goods. Sometimes the contract will require the buyer to collect the goods.
1UCC §2-106(2).
2UCC §§1-203, 2-103(1)(b).
3R. G. Ray Corp. v. Maynard Manufacturing Co., 1993 U.S. Dist. LEXIS 15754 (N.D. Ill. 1993).
4UCC §2-301.
5UCC §2-503.
478 U N I T 3 Commercial Transactions
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Regardless of where delivery is being made, however, the seller must (1) make the goods
available at a reasonable time, (2) keep the goods available for a reasonable period, and (3)
deliver to the buyer any documents that it needs to take possession. And as we have said,
the seller is expected to deliver conforming goods, which brings us to the next rule.
21-2a Perfect Tender Rule
Under the perfect tender rule, the buyer may reject the goods if they fail in any respect to
conform to the contract.6
Stanley and Joan Jakowski agreed to buy a new Camaro automobile from Carole
Chevrolet. The contract stated that Carole would apply a polymer undercoating. The
Jakowskis paid in full for the car, but the next day, they informed Carole that the car lacked
the undercoating. Carole acknowledged the defect and promised to apply the undercoating,
but before it could do so, a thief stole the car. The Jakowskis demanded their money back,
but Carole refused, saying that the risk of loss had passed to the Jakowskis when Carole
tendered delivery. The Jakowskis sued, claiming that they had rejected the Camaro as non-
conforming. Carole responded that this was absurd: The car was perfect in every respect
except for the very minor undercoating, which Carole had promised to fix promptly. Carole
Chevrolet lost the case because of the perfect tender rule.
The New Jersey court found that the defect was minor but said that “despite seller’s
assertion to the contrary, the degree of their nonconformity is irrelevant in assessing the
buyer’s right to reject them…. [N]o particular quantum of nonconformity is required.” The
Jakowskis had lawfully rejected non-conforming goods, and Carole Chevrolet was forced to
pay them the full value of the missing car.7
21-2b Restrictions on the Perfect Tender Rule
The UCC includes sections that limit the perfect tender rule’s effect. Indeed, courts often
apply the limitations more enthusiastically than the rule itself, and so while perfect tender is
the law, it must be understood in the context of other provisions. We will look at the most
common ways that the law undercuts the perfect tender rule. In doing so, we will see the
typically flexible approach that the Code takes to a business transaction.
USAGE OF TRADE, COURSE OF DEALING, AND COURSE OF
PERFORMANCE
The Uniform Commercial Code takes the commonsense view that a contract for the sale of
goods does not exist in a vacuum. It requires courts to consider three things when they
apply the perfect tender rule.
“Usage of trade” means any practice that members of an industry expect to be part of
their dealings.8 The perfect tender rule may not permit a buyer to reject goods with minor
flaws. For example, the textile industry interprets the phrase “first-quality fabric” to permit
a limited number of flaws in most materials. If a seller delivers 1,000 bolts of fabric and 5 of
them have minor defects, the seller has not violated the perfect tender rule.
The course of dealing between the two parties may also limit the rule. The term course
of dealing refers to previous commercial transactions between the same parties.9 The UCC
requires that a current contract be interpreted in the light of any past dealings that have
6UCC §2-601.
7Jakowski v. Carole Chevrolet, Inc., 180 N.J. Super. 122, 433 A.2d 841, 1981 N.J. Super. LEXIS 635 (N.J.
Super. Ct. 1981).
8UCC §1-205(2).
9UCC §1-205(1).
CHAPTER 21 Performance and Remedies 479
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created reasonable expectations. Suppose a buyer orders 20,000 board feet of “highest-
grade pine” from a lumber company, just as it has in each of the three previous years.
In the earlier deliveries, the buyer accepted the lumber even though 1 or 2 percent was
not the highest grade. That course of dealing will probably control the present contract,
and the buyer will not be permitted suddenly to reject an entire shipment because 1
percent is a lower grade of pine. Such a tender is not “perfect,” but it would be good
enough.
The course of performance has the same effect on contract interpretation. The term
course of performance refers to the history of dealings between the parties in a single contract,
and thus assumes that it is the kind of contract demanding an ongoing relationship.10
Suppose a newspaper company signs a deal to purchase 5 tons of newsprint from a paper
company every week for a year, and the contract also specifies the grade of paper to be
delivered. If, during the first three months, the newspaper company routinely accepts paper
containing a small number of flaws, that course of performance will control the contract.
During the final month, the newspaper may not suddenly reject the type of paper it had
earlier accepted.
PARTIES’ AGREEMENT
The parties may also choose to limit the effect of the perfect tender rule themselves by
drafting a contract that permits imperfection in the goods. In some industries, this
practice is routine. For example, contracts requiring the seller to design or engineer
goods especially for the buyer will generally state a level of performance that the
equipment must meet. If the goods meet the level described, the buyer has no right
to reject, even if the product has some flaws.
CURE
A basic goal of the UCC is a fully performed contract that leaves both parties satisfied.
The seller’s right to cure helps achieve this goal. When the buyer rejects non-
conforming goods, the seller has the right to cure by delivering conforming goods
before the contract deadline.11 LightCo is obligated to deliver 10,000 specially manu-
factured bulbs to Burnout Corp. by September 15. LightCo delivers the bulbs on
August 20, and on August 25, Burnout notifies the seller that the bulbs do not meet
contract specifications. If LightCo promptly notifies Burnout that it intends to cure and
then delivers conforming lightbulbs on September 15, it has fulfilled its contract
obligations and Burnout must accept the goods. The seller may even cure after the
contract deadline if the seller (1) reasonably believed the original goods were acceptable
and (2) promptly notified the buyer of his intent to cure within a reasonable time. This
gives the seller a second chance to replace defective goods. Suppose Chip Co. delivers
25,000 computer chips to Assembler one day before the contract deadline, and two days
later, Assembler notifies Chip that the goods are defective. If Chip had tested the chips
thoroughly before they left its factory and reasonably believed they met contract
specifications, then Chip may cure by promptly notifying Assembler that it will supply
conforming goods within a reasonable period. Thus, even if the conforming chips arrive
two weeks after the contract deadline, Chip will have cured unless Assembler can show
that the delay caused it serious harm.
What if a shipment of goods has several nonconformities and the seller offers to fix some
of the problems? The following case addresses the issue.
10UCC §2-208(1).
11UCC §2-508.
480 U N I T 3 Commercial Transactions
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ZION TEMPLE FIRST PENTECOSTAL CHURCH OF
CINCINNATI, OHIO, INC. V. BRIGHTER DAY
BOOKSTORE & GIFTS & MURPHY CAP & GOWN CO.
2004 WL 23150323
Court of Appeals of Ohio, 2004
C A S E S U M M A R Y
Facts: Zion Temple First Pentecostal Church needed
new choir robes. Brighter Day Bookstore was a retailer
that sold robes manufactured by Murphy Cap & Gown.
Rosalind Bush of Brighter Day showed Glenda Evans
of Zion a Murphy robe and a sample board of various
Murphy fabrics and colors. A disclaimer on the board
said, “all shades subject to dye lot variations.” Evans
ordered choir robes and overlays in colors and fabrics
that she selected.
Murphy then sent sample swatches to Brighter Day,
stating they were cut from the actual cloth that would be
used for the Zion robes. Bush called Evans to see if she
wished to see the swatches, but Evans declined, saying
she trusted Bush’s judgment. Bush told Murphy to pro-
ceed with the order.
When Brighter Day delivered the robes to Zion,
Evans and other church members found many faults.
They did not like the color or material, which they con-
sidered very different from the board sample. The sleeves
had been attached facing the wrong way. And on the
overlays, the Velcro and tags were visible.
Zion complained to Murphy. The manufacturer
offered to repair the sleeves, but Zion declined the offer
because of the other problems. Zion returned the robes.
When it failed to get its money back, Zion filed suit
against both Brighter Day and Murphy.
Zion claimed Murphy breached its warranty by
delivering goods that differed from the sample board,
and had the sleeve and overlay problems. Because
Brighter Day failed to answer Zion’s complaint, the
court issued a judgment against the retailer (which
had certainly seen brighter days). But then trial court
gave summary judgment for Murphy, and Zion
appealed.
Issues: Did Murphy breach its warranty? Did Zion afford
Murphy a chance to cure?
Decision: Murphy breached its warranty by sending
robes with the wrong sleeves. It is unclear whether Mur-
phy offered to cure all the problems and whether Zion
afforded the company an adequate chance to remedy
them. Remanded to the trial court.
Reasoning: Brighter Day showed Glenda Evans a
typical Murphy robe and offered her actual fabric
swatches before going forward with the order. These
two samples became part of the contract, creating
express warranties from Murphy to Zion. As to the
color and feel of the fabric, the delivered robes in fact
conformed to the contract samples the company had
sent. Zion had no right to reject the robes based on
either of those qualities.
However, there were other problems with the gar-
ments. The sleeves clearly did not match the pictures
in the catalog. Zion also claimed that Velcro was visi-
ble on the reversible overlays, and that tags could be
seen when the overlays were reversed. The sample
robe that Glenda Evans inspected had no such pro-
blems. The one acknowledged defect (sleeves) and
two alleged problems (tags and Velcro) gave Zion the
right to reject the goods, and the church promptly
did so.
At that point, Murphy had a right to cure within a
reasonable time. The company indicated its willing-
ness to remedy the defective sleeves, but it said noth-
ing about curing the problems concerning the tags and
the Velcro.
The court did not have enough information to
determine whether the delivered robes were noncon-
forming when compared to the sample robe and
whether Zion gave Murphy fair time to cure. These
were critical facts and for that reason, summary judg-
ment for Murphy was reversed and the case was
remanded to the trial court.
CHAPTER 21 Performance and Remedies 481
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EXAM Strategy
Question: Xuberant Inc., orders 2000 wristwatches from Timely Co. The watches,
with Xuberant’s logo on the face, are to be delivered by September 15 so that
Xuberant can give them away at its September 25 sales convention. Timely tests the
watches and is satisfied they work. But when Xuberant receives them, on September
15, the company rejects them because its name is misspelled. Timely offers to correct
the error and deliver the new watches by September 22, but Xuberant refuses and
sues. Likely outcome?
Strategy: Timely has delivered nonconforming goods, and Xuberant is entitled to
reject them. However, the seller has the right to cure by delivering conforming goods
before the contract deadline. Timely is offering to deliver shortly after the deadline.
Is it entitled to do so?
Result: If the seller reasonably believed the goods were conforming, it may cure
within a reasonable time after the deadline. If the court believes that Timely’s
spelling error was unreasonable, the company has no right to cure. However, a basic
goal of the code is a fully performed contract. A court is likely to declare that the error
was excusable and the new delivery date adequate for Xuberant’s purpose. Timely
will probably win.
SUBSTANTIAL IMPAIRMENT
Sometimes the UCC holds buyers to a higher standard and makes it more difficult to refuse
goods. Perfect tender is the usual rule, but in two circumstances, a buyer who claims goods
are non-conforming must show that the defects substantially impair their value. This
standard applies: (1) if the buyer is revoking acceptance of goods or (2) if the buyer is
rejecting an installment.
For example, a buyer who initially accepts a dozen cement mixers but later discovers
problems with their engines may revoke his acceptance only by showing that the defects
have caused him serious problems. Similarly, if a contract requires a buyer to accept one
shipment of diesel fuel each month for two years, the buyer may reject one monthly
installment only if the problem with the fuel substantially lowers its value.
DESTRUCTION OF THE GOODS
A farmer contracts to sell 250,000 pounds of sunflower seeds to a broker. The contract
describes the 125 acres that the farmer will plant to grow the sunflowers. He plants his crop
on time, but a drought destroys most of the plants and he is able to deliver only 75,000
pounds. Is the farmer liable for the seeds he could not deliver? No. Is the broker required to
accept the smaller crop? No. If identified goods are totally destroyed before risk passes to the
buyer, the contract is void. If identified goods are partially destroyed, the buyer may choose
whether to accept the goods at a reduced price or void the contract.12
The crop of sunflowers was identified to the contract when the farmer planted it. When
a drought destroyed most of the crop, the contract became voidable. The buyer had the
right to accept the smaller crop, at a reduced price, or to reject the crop entirely. The farmer
is not liable for the shortfall because the destruction was not his fault.13
12UCC §2-613. Identification of goods is discussed in Chapter 20, on ownership, risk, and warranties.
13Based on Red River Commodities, Inc. v. Eidsness, 459 N.W.2d 805, 1990 N.D. LEXIS 159 (N.D.
1990).
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COMMERCIAL IMPRACTICABILITY
Commercial impracticability means that a supervening event excuses performance of a
contract, if the event was not within the parties’ contemplation when they made the agree-
ment.14 An event is “supervening” if it interrupts the normal course of business and
dominates performance of the contract. But a supervening event will excuse performance
only if neither party had thought there was a serious chance it would happen.
Harris RF Systems was an American company that manufactured radio equipment.
Svenska, a Swedish corporation, bought Harris radio systems and sold them in many
countries, including Iran. One contract required Harris to ship a large quantity of spare
radio parts, which Svenska would pay $600,000 for and then resell in Iran. Harris attempted
to ship the parts to Svenska, but U.S. Customs seized the goods, and the U.S. Department
of Defense notified Harris that it believed the parts would be of military value to Iran.
The Defense Department acknowledged that technically, Harris was licensed to ship the
goods, but it made two things clear: First, that it would litigate rather than permit the goods to
reach Iran; and second, that if Harris attempted to complete the sale in Iran, the department
would place all of Harris’s future radio shipments on a Munitions List, making it difficult to ship
them anywhere in the world. Svenska, on the other hand, pointed out that it had binding
contracts to deliver the radio parts to various customers in Iran. If the parts were not forthcoming,
Svenska would hold Harris liable for all of its losses. Harris attempted to reach a satisfactory
compromise with all parties but failed and eventually agreed not to ship the parts overseas.
Svenska sued. Harris defended, relying on commercial impracticability. Harris per-
suaded the court that neither party had foreseen the government’s intervention and that
both parties realized it would be virtually impossible to export goods the Defense Depart-
ment was determined to block. The court dismissed Svenska’s suit.15
Sellers offer many excuses to avoid contracts. In the following case, you decide
whether the seller’s problem was “within the parties’ contemplation” when they made
the agreement.
You Be the Judge
Facts: United Aluminum
Corporation (UAC) manu-
factured aluminum coil.
For many years, Linde
supplied UAC with the
nitrogen it needed for its
manufacturing processes.
The companies signed a
long-term contract in 1997, which said, in part:
Linde agrees that at UAC’s sole option, UAC may extend
the term of this Agreement for a maximum of five years
commencing upon August 31, 2008.
The contract also called for a price of $0.23 per unit of
nitrogen.
In 2007, UAC sent
Linde a letter which sta-
ted, in part, “UAC
intends to exercise its
option to extend the term
for an additional five years
from September 1, 2008
to August 31, 2013.”
Linde replied that the price of nitrogen had risen signifi-
cantly over the life of the contract and that it would have
to increase prices by 38 percent.
UAC sued, seeking the right to continue buying
nitrogen from Linde at $0.23 per unit. Linde defended
on the grounds of commercial impracticability.
UNITED ALUMINUM
CORPORATION V. LINDE, INC.
2009 U.S. Dist. LEXIS 74259
United States District Court for the
District of Connecticut, 2009
14UCC §2-615.
15Harriscom Svenska AB v. Harris Corp., 1990 U.S. Dist. LEXIS 20006 (W.D.N.Y. 1990).
CHAPTER 21 Performance and Remedies 483
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The accompanying chart outlines the seller’s obligations.
Basic Obligation: The seller’s basic obligation is to deliver conforming goods. The perfect
tender rule permits the buyer to reject the goods if they are in any way non-conforming.
But many Code provisions limit the harshness of the perfect tender rule.
Limitation on Seller’s
Obligation
Code Provision Effect on Seller’s Obligations
Good faith §1-201(19) and
§2-103(1)(b)
Prohibits the buyer from using the
perfect tender rule as a way out of a
contract that has become unprofitable.
Course of dealing, usage of
trade, and course of
performance
§1-205(1),
§1-205(2),
and §2-208
If applicable, will limit the buyer’s right to
reject for relatively routine defects.
The parties’ agreement §2-106 May describe tolerances for
imperfections in the goods.
Cure §2-508 Allows the seller to replace defective goods
with conforming goods, if time permits.
Revocation of acceptance §2-608 Abuyerwho has accepted goodsmay later
revoke them only if she can show that the
defects substantially impair its value.
Installment contracts §2-612 Abuyermay reject an installment only if the
defects substantially impair its value.
Destruction of goods §2-613 If goods identified to the contract are
destroyed, the contract is void.
Commercial
impracticability
§2-615 A supervening event excuses performance
of a impracticability contract, if the event
was not within the parties’ contemplation
when they made the agreement.
You Be the Judge: Should Linde be discharged on the
grounds of commercial impracticability?
Argument for Linde: Your honor, our industry has seen
substantial increases in costs since 1997. The price of
nitrogen is much higher, but that is just the tip of the
iceberg. We must pay our workers more, our property
taxes have increased, and, because of the rising price of
gasoline, our transportation costs are much higher.
We did not anticipate these increases when wemade the
original agreement. At that time, costs in our industry had
been fairly stable formany years.We have smallmargins even
under ideal circumstances. To continue selling at 1997 prices
forces us to operate at a substantial loss. Our request for a 38
percent price increase is reasonable.
It is commercially impracticable for use to ship nitro-
gen for another five years at the prices quoted in the
original contract.
Argument for UAC: The Uniform Commercial Code
does not allow for a claim of commercial impracticability
every time prices increase. It allows such a claim only in
the case of an event that was not in the parties’ contem-
plation when they made an agreement.
In some exceptional circumstances, excusing perfor-
mance is entirely reasonable. But nothing unusual or
unforeseeable has happened here. Nitrogen prices have
gone up. But over a decade, the price of nearly everything
increases. Gasoline, groceries, cable television—the list
goes on. Surely Linde knew that price increases were
possible.
We made the original contract because Linde offered
us long-term stability on the price of nitrogen. Without
that part of the bargain, we would likely have sought
another supplier. It is not right to allow Linde to back
out of its clear contractual obligations.
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21-3 BUYER’S RIGHTS AND OBLIGATIONS
The buyer’s primary obligation is to accept conforming goods and pay for them.16 The buyer
must also provide adequate facilities to receive the goods.17 For example, if the contract
requires the seller to deliver to the buyer’s warehouse, and the parties anticipate that delivery
will be by rail, then the buyer must have facilities for unloading railcars at its warehouse.
21-3a Inspection and Acceptance
The buyer generally has the right to inspect the goods before paying or accepting.18 If the
contract is silent on this issue, the buyer may inspect. Typically, a buyer will insist on this
right, but contracts can be created which do not give the parties a right to inspect—for
example, a contract allowing shipment C.O.D., which means “cash on delivery.” In that
case, the buyer must pay upon receipt and do her inspecting later.
Along with the right of inspection comes the obligation to do it within a reasonable time
and to notify the seller promptly if the buyer intends to reject the goods. The buyer accepts
goods if (1) after a reasonable opportunity to inspect, she indicates to the seller that the goods
are conforming or that she will accept them in spite of non-conformity; or (2) she has had a
reasonable opportunity to inspect the goods and has not rejected them; or (3) she performs some
act indicating that she now owns the goods, such as altering or reselling them.19
PARTIAL ACCEPTANCE
A buyer has the right to accept some goods while rejecting others if the goods can be
divided into commercial units. Such a unit is any grouping of goods that the industry normally
treats as a whole. For example, one truckload of gravel would be a commercial unit. If the
contract called for 100 truckloads of gravel, a buyer could accept 10 that conformed to
contract specifications while rejecting 90 that did not.
REVOCATION
As we mentioned earlier, a buyer has a limited right to revoke acceptance of goods. A buyer
may revoke acceptance but only if the non-conformity substantially impairs the value of the
goods and only if she had a legitimate reason for the initial acceptance.20 This means the
perfect tender rule does not apply: A buyer in this situation may not revoke because of
minor defects. Further, the buyer must show that she had a good reason for accepting the
goods originally. Acceptable reasons would include defects that were not visible on inspec-
tion or defects that the seller promised but failed to cure.
REJECTION
The buyer may reject non-conforming goods by notifying the seller within a reasonable
time.21 Huntsville Hospital purchased electrocardiogram equipment from Mortara Instrument
for $155,000. The equipment failed to work properly, and the hospital notifiedMortara within a
reasonable time that it was rejecting. The hospital askedMortara to pick up the equipment and
refund the full purchase price, but Mortara did neither. When the hospital sued, Mortara
claimed that the hospital should have returned the equipment toMortara and that its failure left
it liable for the full cost. The court of appeals was unpersuaded and gave judgment for the
16UCC §2-301.
17UCC §2-503(1)(b).
18UCC §2-513.
19UCC §2-606.
20UCC §§2-607, 608.
21UCC §§2-601, 602.
CHAPTER 21 Performance and Remedies 485
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hospital, declaring that the hospital’s only obligation was to notify the seller of a rejection and
hold the goods for the seller to collect.22
The rule is different in the case of an installment contract. An installment contract is
one that requires goods to be delivered in separate lots. If Bus Co. contracts for Oil Co. to
deliver 5,000 gallons of gasoline every week for one year, that is an installment contract. A
buyer may reject a non-conforming installment but only if it substantially impairs the value of
that installment and cannot be cured.23The perfect tender rule does not apply. Bus Co. has no
right to reject an installment containing 4,900 gallons of gasoline because the minor shortfall
does not impair the shipment’s substantial value. On the other hand, if Oil Co. delivered
gasoline with lead in it, Bus Co. could reject it since Bus Co. would be legally prohibited from
using the gas. (Remember, though, that Oil Co., like all sellers, has the right to cure.)
The following case deals with rejection and revocation. Have a peek inside the trailer,
but mind the slippery puddles.
LILE V. KIESEL
871 N.E. 2d 995
Indiana Court of Appeals, 2007
C A S E S U M M A R Y
Facts: Edward and Kelly Kiesel bought a new pull-
behind trailer from James Lile, the owner of Lile’s Trailer
Sales. That same day, the couple took their new trailer on
its first outing. Because this was a camping trip, it rained all
night, and in the morning, the Kiesels noticed water inside
the trailer, near the door. The next time it rained, Edward
noticed more water pooling in various parts of the trailer. A
week later, Edward brought the trailer in for repairs.
Lile repaired the roof, using new silicone. However, a
week later the trailer again leaked, and Kelly reported this
to Lile, demanding a full refund. Lile refused a refund
but offered to seal any leaks, replace interior walls, and
sand and paint the exterior. The Kiesels instead took the
trailer to a different auto body shop, where the owner said
that extensive interior rust indicated the trailer had leaked
longer than the Kiesels owned it. The Kiesels sued. Lile
claimed that the Kiesels had accepted the vehicle and
unfairly refused repairs. The trial court awarded the Kie-
sels the full price of the trailer, and Lile appealed.
Issue: Were the Kiesels entitled to the trailer’s purchase price?
Decision: Yes, they were entitled to the full purchase
price. Affirmed.
Reasoning: The Kiesels lost their right to reject the trai-
ler when they accepted it. But under the UCC, a buyer
may revoke an acceptance if non-conforming goods have a
substantial problem that cannot easily be discovered.
The leaks and subsequent water damage substan-
tially reduced the value of the trailer. The plaintiffs could
not have discovered them by making a reasonable inspec-
tion prior to the sale.
Lile argues that the Kiesels acted in bad faith when
they declined his offer to make repairs. But the UCC only
gives sellers a right to cure defects when buyers reject
goods. The Kiesels accepted the trailer. They did not
reject it—they revoked their acceptance. Lile therefore has no
right to cure.
The Kiesels are entitled to a refund of the trailer’s price.
22Huntsville Hospital v. Mortara Instrument, 57 F.3d 1043, 1995 U.S. App. LEXIS 16925 (11th Cir.
1995).
23UCC §2-612.
Installment contract
A contract that requires goods
to be delivered in separate lots.
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21-4 SELLER’S REMEDIES
When a buyer breaches a contract, the UCC provides the seller with a variety of potential
remedies. Exactly which ones are available depends upon who has the goods (buyer or
seller) and what steps the seller took after the buyer breached. The seller can always cancel
the contract. She may also be able to:
• stop delivery of the goods,
• identify goods to the contract,
• resell and recover damages,
• obtain damages for non-acceptance, or
• obtain the contract price.
21-4a Stop Delivery
Sometimes a buyer breaches before the seller has delivered the goods (for example, by
failing to make a payment due under the contract or perhaps by repudiating the contract). A
party repudiates when it indicates that it will not perform, which it can do either by its
conduct or by failing to answer a written demand for assurances that it intends to perform.
If a buyer breaches, the seller may refuse to deliver the goods.24 If, when the buyer
breaches, the seller has already placed the goods in the hands of a carrier (such as UPS), the
seller may instruct the carrier not to deliver the goods, provided the shipment is at least a
carload or larger.
21-4b Identify Goods to the Contract
If the seller has not yet identified goods to the contract when the buyer breaches, he may
do so as soon as he learns of the breach.25 Suppose an electronics manufacturer, with 5,000
Blu-ray players in its warehouse, learns that a retailer refuses to pay for the 800 units it
contracted to buy. The manufacturer may now attach a label to 800 units in its warehouse,
identifying them to the contract. This will help it recover damages when it resells the
identified goods or uses one of the other remedies described below.
21-4c Resale
A seller may resell goods that the buyer has refused to accept, provided she does it
reasonably. If the resale is commercially reasonable, the seller may recover the difference
between the resale price and contract price, plus incidental damages, minus expenses saved. 26
Incidental damages are expenses the seller incurs in holding the goods and reselling
them—costs such as storage, shipping, and advertising for resale. The seller must deduct
expenses saved by the breach. For example, if the contract required the seller to ship heavy
machinery from Detroit to San Diego, and the buyer’s breach enables the seller to sell its
goods in Detroit, the seller must deduct from its claimed losses the transportation costs that
it saved.
24UCC §2-705.
25UCC §2-704.
26UCC §2-706.
Repudiation
A party’s indication that it will
not perform its contractual
obligations.
CHAPTER 21 Performance and Remedies 487
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A seller who acts in a commercially reasonable manner is
entitled to the following damages:
Contract price (the price Seller expected from the
original contract)
– the resale price (the money Seller got at resale)
+ incidental damages (storage, advertising, etc.)
– expenses saved
= Seller’s damages
A seller is also permitted to resell goods privately; that is, by simply negotiating a deal
with another party. But if the seller does so, she must first give the buyer reasonable notice
of the private resale.
EXAM Strategy
Question: Fork manufactures forklift trucks. Fork agrees to sell 10 trucks, for
$30,000 each, to McKnife. Fork will store the trucks in a warehouse near McKnife for
3 months, when the buyer will collect them. Storage will cost Fork $2,000 per month.
A week after signing the deal, before Fork has moved the trucks to the warehouse,
McKnife notifies Fork it cannot pay for the trucks. Fork spends $2,000 advertising the
machines and sells them for $25,000 each in a commercially reasonable manner. Fork
then sues McKnife. Fork will win—but how much?
Strategy: Apply the formula outlined above.
Result: Fork is entitled to:
The contract price $300,000
– the resale price 250,000
+ incidental damages 2,000
– expenses saved 6,000
= Fork’s damages 46,000
21-4d Damages for Non-Acceptance
A seller who does not resell, or who resells unreasonably, may recover the difference between
the original contract price and the market value of the goods at the time of delivery.27 Oilko
agrees to sell Refinery 100,000 barrels of oil for $100 per barrel, to be delivered on
November 1. Oilko tenders the oil on November 1 but Refinery refuses to accept it. Three
months later, on February 20, Oilko resells the oil to another purchaser for $92 per barrel
and sues Refinery for $800,000 (the difference between its contract price and what it finally
obtained), plus the cost of storage. Will Oilko win? No. Oilko’s resale was unreasonable.
Because there is a ready market for oil, Oilko should have resold immediately. Because
27UCC §2-708.
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Oilko acted unreasonably, it will not obtain damages under the Code’s resale provision.
Oilko will be forced to base its damages on market value.
Often this remedy will be less valuable to the seller than resale damages. Suppose that
on November 1, the market value of Oilko’s oil was $99 per barrel. Oilko’s contract with
Refinery was actually worth only $1 per barrel to Oilko—the amount by which its contract
price exceeded the market value. That is all that Oilko will get in court.28 A seller with a
reasonable chance to resell should be certain to do it.
The following chart compares resale and non-acceptance damages:
Resale Damages §2-706 Non-Acceptance Damages §2-708
Contract price $10,000,000 Contract price $10,000,000
Resale price – 9,200,000 Market value of goods 9,900,000
$ 800,000 $100,000
21-4e Action for the Price
The seller may recover the contract price if (1) the buyer has already accepted the goods or
(2) the seller’s goods are conforming and the seller is unable to resell after a reasonable
effort.29 Royal Jones was a company that constructed rendering plants—factories that use
sophisticated equipment to extract valuable minerals from otherwise useless material. Royal Jones
contracted for First Thermal to construct three rendering tanks, at a cost of $64,350. First Thermal
built the tanks toRoyal Jones’s specifications, but Royal Jones never accepted or paid for them, and
First Thermal sued. Royal Jones argued that First Thermal deserved nomoney because it had not
attempted to resell the goods, but the court awarded the full contract price, stating:
First Thermal proved that any effort at resale would have been unavailing because these were the
only rendering tanks First Thermal ever made, the tanks were manufactured according to Royal
Jones’s specifications, First Thermal had no other customers to which it could resell the tanks,
and it was unaware how the tanks could have been marketed for resale.30
Resale is normally the safest route for an injured seller to recover the maximum amount,
but when it is unrealistic, as in the First Thermal case, a lawsuit for the full price is appropriate.
All of the seller’s remedies are summarized in the chapter review at the end of the
chapter. We now move on to the buyer’s remedies.
21-5 BUYER’S REMEDIES
The buyer, too, has a variety of potential remedies. If a seller fails to deliver goods,
repudiates, or if the buyer rightfully rejects the goods, the buyer is entitled to cancel the
contract. She may also recover money paid to the seller, assuming she has not received the
goods. In addition, she may be entitled to:
28Based on Baii Banking Corp. v. Atlantic Richfield Co., 1993 U.S. Dist. LEXIS 14107 (S.D.N.Y. 1993).
29UCC §2-709.
30Royal Jones & Associates, Inc. v. First Thermal Systems, Inc., 566 So. 2d 853, 1990 Fla. App. LEXIS 6596
(Fla. Ct. App. 1990).
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CHAPTER 21 Performance and Remedies 489
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• incidental and consequential damages,
• specific performance,
• cover,
• damages for non-delivery,
• accept the non-conforming goods and seek
damages, or
• liquidated damages.
21-5a Incidental Damages and
Consequential Damages
An injured buyer is generally entitled to incidental and consequential damages. Incidental
damages for buyers include such costs as advertising for replacements, sending buyers to
obtain new goods, and shipping the replacement goods. Consequential damages, or losses
that are caused by a breach, can be much more extensive and may include lost profits
caused by the seller’s failure to deliver.
A buyer, however, only gets consequential damages for harm that was unavoidable.
Suppose Wholesaler has a contract to sell 10,000 rosebushes at $10 per bush to
FloraMora. Wholesaler contracts to buy 10,000 rosebushes from Growem at $6 per bush,
but Growem fails to deliver. Wholesaler in fact could obtain comparable roses at $8 per
bush but fails to do so and loses the chance to sell to FloraMora. Wholesaler sues
Growem, seeking the $4-per-bush profit it would have made on the FloraMora deal.
The company will receive only $2 per bush, representing the difference between its
contract price and the market value of the plants. Wholesaler will be denied the
additional $2 per bush.
In the following case, the court decided whether future profits may be too speculative to
award as consequential damages.
SMITH V. PENBRIDGE ASSOCIATES, INC.
440 Pa. Super. 410, 655 A.2d 1015, 1995 Pa. Super. LEXIS 574
Superior Court of Pennsylvania, 1995
C A S E S U M M A R Y
Facts: Donna and Alan Smith wanted to raise emus,
which are flightless Australian birds that look like ostriches.
The creatures produce rapidly in almost any terrain and are
sold for their meat, which is high in protein and low in fat,
and for their oil, leather, and feathers. The Smiths paid
Tomie Clark, the manager of Penbridge Farms, $4,000 as a
down payment for “Andrew” and “Rachel,” which the
farm called a “proven breeder pair.” Since it is impossible
to discern an emu’s gender by looking, the Smiths asked
Clark several times if the two birds were male and female,
and he assured them that the pair had successfully pro-
duced chicks the previous breeding season.
The Smiths placed the prospective lovebirds in the
same pen, but the breeding season passed without a hint of
Consequential damages
Losses caused by the breach of
contract
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21-5b Specific Performance
If the contract goods are rare or unique, the buyer may be allowed specific performance, which
means a court order requiring the seller to deliver those particular goods.31 This remedy is
most common when the goods are one-of-a-kind. Suppose Gallery agreed to sell to Trisha
an original Corot painting for $120,000 but then refused to perform (because another buyer
offered more money). Trisha can obtain specific performance because the painting cannot
be replaced: The court will order Gallery to deliver the work. By contrast, a car rental
company stymied by a dealer’s refusal to sell 500 new Ford Mustangs will not obtain
specific performance since the rental company can simply buy the same cars from another
dealer and sue for the difference.
21-5c Cover
If the seller breaches, the buyer may “cover” by reasonably obtaining substitute goods; it may
then obtain the difference between the contract price and its cover price, plus incidental and
consequential damages, minus expenses saved.32 Casein, a protein derived from milk, is used
to make cheese and to process many other foods. Erie Casein Co. contracted with Anric
Corp. to supply several hundred thousand pounds of casein for about $1 per pound. Half
was to be delivered in March of the first year and the other half in March of the second year.
By May of the first year, Anric had not finished its first delivery because it was having
difficulty obtaining the casein, but Erie told Anric to keep trying. Anric delivered some of
the casein later the same year, but by March of the second year was forced to admit it could
not meet the second delivery. Anric suggested that it might be able to obtain more casein in
the autumn of that second year.
Erie waited until August of the second year, but it finally obtained its casein elsewhere
at a price of $1.45 per pound. Erie sued Anric for the extra money it had paid, about
$66,000. Anric argued that Erie had no right to the difference because Erie had waited until
the price of casein was sky-high before obtaining substitute goods.
romance. Donna Smith noticed that both birds were grunt-
ing, something that only male emus do. She phoned Pen-
bridge Farms, which advised her to “vent sex” the animals,
a manual procedure used to determine gender. Donna
performed this agreeable task and learned that Andrew
and Rachel were both gentlemen. The would-be breeders
asked for their money back, but Penbridge refused, so the
Smiths flew into court. The trial judge awarded the couple
$105,215, representing lost profits from their anticipated
chicks. Penbridge appealed, arguing that a buyer cannot
count her chicks before they have hatched.
Issue: Did the trial court err by awarding lost profits?
Decision: No. The Smiths were entitled to lost profits.
Affirmed.
Reasoning: Penbridge argued that the evidence was
too speculative to award consequential damages for lost
profits. The company claimed that since breeding
emus is a new business, there are no reliable data from
which to project profits. However, §2-715(2) of the
UCC permits consequential damages for any loss
resulting from requirements that the seller knew about
at the time of contracting, if the loss could not be
prevented by cover.
The “proven breeder pair” had supposedly produced
16 chicks the previous season. The trial court found that
the value of a 3-month-old emu chick produced that year
was $5,000. The court then calculated incidental and
consequential damages at $90,000, based on conservative
estimations of chick production. This was a reasonable
approach. Although the amount is not absolutely certain,
the breaching party should not escape liability merely
because damages cannot be calculated with perfect
accuracy.
31UCC §2-716.
32UCC §2-712.
CHAPTER 21 Performance and Remedies 491
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The court found for Erie. Even though the company might have covered a year
earlier, when the price was much lower, it was reasonable for the buyer to wait
because Anric indicated it might be able to supply
the goods later. Erie had acted in good faith, and when
it ultimately covered, it did so at the best price it could
find. An injured buyer does not have to do a perfect
job of covering, only a reasonable job, and Erie got its
full $66,000.33
Note that an injured buyer may also be awarded con-
sequential damages, which we discuss below. Finally, if
covering saves expense, the savings are deducted from any
damages.
We hope that you recall Donald Hessler, whom we
met in the chapter opener. We last saw him circling the
courthouse in his Plymouth Prowler, anxiously awaiting
the outcome of his suit against the dealership that promised him the same car for a lot
less money. It has been a long wait; you and Donald deserve an answer.
An injured buyer does
not have to do a perfect
job of covering, only a
reasonable job.
HESSLER V. CRYSTAL LAKE CHRYSLER-PLYMOUTH, INC.
Ill.App.3d 1010, 788 N.E.2d 405, 273 Ill.Dec. 96
Appellate Court of Illinois, 2003
C A S E S U M M A R Y
Facts: The facts are provided in the chapter opener.
The trial court awarded Hessler $29,853, representing
the difference between his contract with Crystal Lake
and the sum he ultimately spent purchasing a new Prow-
ler. Crystal Lake appealed, arguing that Hessler covered
unreasonably.
Issue: Did Hessler cover reasonably?
Decision: Yes, Hessler covered reasonably. Affirmed.
Reasoning: Crystal Lake contracted to deliver a Prowler to
Hessler as quickly as possible. But shortly thereafter, the
company told Hessler—repeatedly— that it would not in fact
sell him a car. In doing so,Crystal Lake breached the contract.
The dealer argues that the trial court damages were
excessive, claiming that Hessler covered unreasonably.
The company contends that, after it refused to sell Hess-
ler a car, the buyer should have re-contacted the 38 deal-
ers that he had called in September.
Instead, the same day that Hessler learned he would
not obtain a car from Crystal Lake, he visited another
dealer and bought a Prowler for about $40,000 above list
price.
Comment 2 to §2-712 of the UCC provides, in rele-
vant part:
The test of proper cover is whether at the time and place
the buyer acted in good faith and in a reasonable manner,
and it is immaterial that hindsight may later prove that the
method of cover used was not the cheapest and most
effective.
The lower court heard testimony from both parties
about the Prowler’s limited supply. It also heard the
plaintiff’s testimony about his unsuccessful efforts to
obtain a car one month earlier. The court concluded that
Hessler ultimately paid the “best price” available and had
covered reasonably. The evidence supports that finding,
and the judgment is affirmed.
33Erie Casein Co. v. Anric Corp., 217 Ill. App. 3d 602, 577 N.E.2d 892, 1991 Ill. App. LEXIS 1429 (Ill.
App. Ct. 1991).
492 U N I T 3 Commercial Transactions
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Devil’s Advocate It is fine for a buyer to cover, but Hessler’s conduct is
absurd. He bought a car for nearly double the
contract price. A buyer’s behavior must be reasonable, and no court should reward
conduct that is clearly obsessive. This purchase was not required by business or financial
pressures. We have here a man who believes he is entitled to whatever he wants. If Hessler
decides he must have a Prowler at any price, then in fairness he should be the one to pay
that price.
21-5d Non-Delivery
In some cases, the buyer does not cover, or fails to cover reasonably, leaving it with damages
for non-delivery. The measure of damages for non-delivery is the difference between the
market price at the time the buyer learns of the breach and the contract price, plus incidental
and consequential damages, minus expenses saved.34 Suppose that in the case described
above, Erie had not covered but simply filed suit against Anric. Instead of its $66,000, Erie
would have obtained the difference between its contract price with Anric and the market
value on the date of breach. That market price was probably only a few pennies higher than
the contract price, and Erie would have obtained less than $10,000.
21-5e Acceptance of Non-Conforming Goods
A buyer will sometimes accept non-conforming goods from the seller, either because no
alternative is available or because the buyer expects to obtain some compensation for the
defects. Where the buyer has accepted goods but notified the seller that they are non-
conforming, he may recover damages for the difference between the goods as promised and
as delivered, plus incidental and consequential damages.35
21-5f Liquidated Damages
Liquidated damages are those that the parties agree, at the time of contracting, will
compensate the injured party. They are enforceable, but only in an amount that is reason-
able in light of the harm, the difficulties of proving actual loss, and the absence of other
remedies.36 A clause that establishes unreasonably large or unreasonably small liquidated
damages is void. Courts only enforce a liquidated damages clause if it would have been
difficult to estimate actual damages when the parties reached the agreement.
Cessna Aircraft agreed to build a “Citation V” business jet and sell it to Aero Consulting
for $3,995,000. Cessna’s contract required Aero to pay an initial deposit of $125,000, a
second deposit of $300,000 six months prior to delivery, and the balance upon delivery.
The contract also stated that if Aero failed to pay the balance due, Cessna would keep all
deposited monies by way of liquidated damages.
Aero made both deposits, and Cessna built the plane and tendered it to Aero, but Aero
refused to pay the full balance due. Cessna notified Aero that it would keep the $425,000
deposited. When Aero sued, seeking a return of the deposits, the issue was whether this
liquidated damage was fair. The court concluded that it was. At the time Cessna entered
into the deal, it was difficult to estimate actual damages in the event of Aero’s breach. The
long period required to build a jet aircraft and the uncertainties about supply and demand in
34UCC §2-713.
35UCC §2-714.
36UCC §2-718.
Liquidated damages
Damages to which the parties
agree at the time of
contracting.
CHAPTER 21 Performance and Remedies 493
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the marketplace meant that neither party could say for sure how much Cessna would lose
should Aero breach. Further, the liquidated damage here was about 10 percent of the total
cost, not an unreasonably high figure. Cessna kept the money (and the plane).37
EXAM Strategy
Question: You have a red wine problem. Your California vineyard has strong sales
throughout the United States, and it is time to expand into Europe. To penetrate foreign
markets, you offer your product at steep discounts to a Swiss importer. Your intent is that
the importer will sell your wine inexpensively to retailers, so that low prices will entice
consumers. The danger, though, is that the importer will return the wine to the United
States and undersell your own product in an established market, taking advantage of your
advertising and infuriating established dealers. Such a resale could occur before your wine
ever left the country. What can you do to keep this problem from fermenting?
Strategy: A liquidated damages clause can put teeth into your plan to sell the wine to
overseas consumers. You might specify substantial compensation if any of your
exported wine finds its way back home. However, an overly aggressive clause will be
declared a penalty—and void. How can you avoid such a disaster?
Result: Liquidated damages are enforceable in an amount that is reasonable in light
of the harm and the difficulties of proving actual loss. Your clause may certainly
compensate you for lost goodwill among domestic retailers and for harm to your
efforts at establishing the brand in Europe. Make good faith estimates of those losses—
if the clause gives you too much compensation, a court may void it altogether. Lost
profits per case sold in the United States are probably easy to calculate and should not
be part of the liquidated damages clause.
Chapter Conclusion
The drafters of the UCC intended the law to reflect contemporary commercial practices but
also to require a satisfactory level of sensible, ethical behavior. For example, the Code allows
numerous exceptions to the perfect tender rule so that a buyer may not pounce on minor
defects in goods to avoid a contract that has become financially burdensome. Similarly, a
seller forced to resell his goods must do so in a commercially reasonable manner. Good faith
and common sense are the hallmarks of contract performance and remedies.
EXAM REVIEW
1. GOOD FAITH The Code requires good faith in the performance and enforcement
of every contract. (p. 478)
2. CONFORMING GOODS Conforming goods are those that satisfy the contract
terms; non-conforming goods fail to do so. (p. 478)
37Aero Consulting Corp. v. Cessna Aircraft Co., 867 F. Supp. 1480, 1994 U.S. Dist. LEXIS 16668 (D. Kan.
1994).
494 U N I T 3 Commercial Transactions
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3. TENDER The seller must tender the goods, which means make conforming goods
available to the buyer. The perfect tender rule permits a buyer to reject goods that are
non-conforming in any respect, although there are numerous exceptions. (p. 478)
4. USAGE OF TRADE Usage of trade, course of dealing, and course of performance
may enable a seller to satisfy the perfect tender rule even though there are some
defects in the goods. (pp. 479–480)
5. CURE When the buyer rejects non-conforming goods, the seller has the right to
cure by delivering conforming goods before the contract deadline. (pp. 480–481)
Question: Allied Semi-Conductors International agreed to buy 50,000 computer
chips from Pulsar, for a total price of $365,750. Pulsar delivered the chips, which
Allied then sold to Apple Computer. But at least 35,000 of the chips proved
defective, so Apple returned them to Allied, which sent them back to Pulsar. Pulsar
agreed to replace any defective chips, but only after Allied, at its expense, tested each
chip and established the defect. Allied rejected this procedure and sued. Who wins?
Strategy: The chips were non-conforming goods, and Allied was entitled to reject
them. Pulsar, in turn, had a right to cure the defects; that is, to solve the problem that
it created. Did Pulsar offer to cure? (See the “Result” at the end of this section.)
6. DESTRUCTION OF THE GOODS If identified goods are destroyed before risk
passes to the buyer, the contract is void. (p. 482)
CPA Question: Under a contract governed by the UCC sales article, which of the
following statements is correct?
(a) Unless both the seller and the buyer are merchants, neither party is obligated to
perform the contract in good faith.
(b) The contract will not be enforceable if it fails to expressly specify a time and a place
for delivery of the goods.
(c) The seller may be excused from performance if the goods are accidentally destroyed
before the risk of loss passes to the buyer.
(d) If the price of the goods is less than $500, the goods need not be identified to the
contract for title to pass to the buyer.
Strategy: (a) Sounds unlikely. Remind yourself which contracts must be
performed in good faith. (b) As we learned in Chapter 19, the Code permits open
terms. What are they? (c) Review the rules on destruction of the goods. (d) Goods
must be identified to the contract before title can pass. Is there an exception for
goods under $500? (See the “Result” at the end of this section.)
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CHAPTER 21 Performance and Remedies 495
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7. COMMERCIAL IMPRACTICABILITY Under commercial impracticability, a
supervening event excuses performance if it was not within the parties’
contemplation when they made the contract. (pp. 483–484)
8. INSPECTION The buyer generally has the right to inspect goods before paying or
accepting. If the buyer does not reject goods within a reasonable time after inspecting
them, she may be deemed to have accepted them. (pp. 485–486)
CPA Question: Smith contracted in writing to sell Peters a used personal
computer for $600. The contract did not specifically address the time for payment,
place of delivery, or Peters’s right to inspect the computer. Which of the following
statements is correct?
(a) Smith is obligated to deliver the computer to Peters’s home.
(b) Peters is entitled to inspect the computer before paying for it.
(c) Peters may not pay for the computer using a personal check unless Smith agrees.
(d) Smith is not entitled to payment until 30 days after Peters receives the computer.
Strategy: This question should be no problem. Three of the four possible answers
offer rules that appear nowhere in the Code. (a) There is no reference in the Code to
“home delivery” of goods. (b) The buyer has the right to inspect goods before
paying or accepting, unless the contract specifies otherwise. (c) Nowhere does the
UCC prohibit payment by check. (d) You have never read in the Code any
presumption of a 30-day delay in payment—so do not imagine one. (See the
“Result” at the end of this section.)
9. REVOCATION A buyer may revoke his acceptance of non-conforming goods, but
only if the defects substantially impair the value of the goods. (p. 485)
10. REJECTION A buyer may reject non-conforming goods by notifying the seller
within a reasonable time. (pp. 486–486)
The following chart summarizes the contrasting remedies available to the two parties.
Seller’s Remedies Issue Buyer’s Remedies
§2-705: The seller generally
may stop delivery, whether it
was to be done by the seller
herself or a carrier.
Delivery §2-716: Specific performance:
buyer may obtain specific
performance only if the goods
are unique.
§2-706: Resale: If the resale is
made in good faith and a
commercially reasonable
manner, the seller may recover
When the
injured party
makes an
§2-712: Cover: The buyer may
purchase alternate goods and
obtain the difference in price,
plus incidental and
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496 U N I T 3 Commercial Transactions
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the difference between the
resale price and the contract
price, plus incidental costs,
minus savings.
alternate
contract
consequential damages, minus
expenses saved.
§2-708: Non-acceptance: The
measure of damages for non-
acceptance is the time and
place of tender and the contract
price (plus incidental damages
minus expenses saved).
When the goods
have not
changed hands
§2-713: Non-delivery: If the
seller fails to deliver, the
buyer’s damages are the
difference between the market
price at the time he learned of
the breach and the contract
price (plus incidental and
consequential damages, minus
expenses saved).
§2-709: The seller may sue for
the price.
When the buyer
has accepted the
goods
§2-714: A buyer who has
accepted non-conforming
goods and notified the seller
may recover damages for
resulting losses.
§§2-706, 2-708, 2-709, and
2-710: The seller is entitled
to incidental damages but
not consequential damages.
Incidental and
consequential
damages
§2-715: The buyer is entitled
to incidental and
consequential damages.
LIQUIDATED DAMAGES
§2-718: Either party may obtain
liquidated damages but only in
an amount that is reasonable at
the time of the contract.
5. Result: Pulsar never offered a true cure. When the seller delivers defective
goods and wishes to cure, it must take all steps—at its expense—to fix the problem.
Pulsar could cure only by delivering, at its expense and in a timely manner, 50,000
conforming chips. Pulsar failed to cure, and Allied recovers the entire purchase
price.
6. Result: Answer (a) is wrong because all contracts must be performed in good
faith. Answer (b) is wrong because a contract with open terms is enforceable.
Answer (c) is right because it correctly states the rule on destruction of goods.
Answer (d) is wrong because title never passes unless the goods were identified to
the contract.
8. Result: Answer (b) is correct. Peters is entitled to inspect the computer unless
the contract states otherwise, which it did not.
CHAPTER 21 Performance and Remedies 497
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MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Cara Fabricating Co. and Taso Corp. agreed orally that Taso would
custom-manufacture a compressor for Cara at a price of $120,000. After Taso completed
the work at a cost of $90,000, Cara notified Taso that the compressor was no longer
needed. Taso is holding the compressor and has requested payment from Cara. Taso has
been unable to resell the compressor for any price. Taso incurred storage fees of $2,000. If
Cara refuses to pay Taso and Taso sues Cara, the most Taso will be entitled to recover is:
(a) $92,000
(b) $105,000
(c) $120,000
(d) $122,000
2. CPA QUESTION On February 15, Mazur Corp. contracted to sell 1,000 bushels of
wheat toGoodBread, Inc., at $6 per bushel, with delivery to bemade on June 23. On June 1,
Good advised Mazur that it would not accept or pay for the wheat. On June 2, Mazur sold
thewheat to another customer at themarket price of $5 per bushel.Mazur had advisedGood
that it intended to resell the wheat. Which of the following statements is correct?
(a) Mazur can successfully sue Good for the difference between the resale price and
the contract price.
(b) Mazur can resell the wheat only after June 23.
(c) Good can retract its anticipatory breach at any time before June 23.
(d) Good can successfully sue Mazur for specific performance.
3. Under the UCC, to tender delivery, a seller must:
(a) make the goods available at a reasonable time
(b) keep the goods available for a reasonable period
(c) deliver to the buyer any documents that it needs to take possession
(d) All of the above
(e) None of the above
4. Blackburn FC (go Rovers!) orders 10,000 soccer jerseys from Alpha Co. to sell in its
stadium store. They are to be delivered on July 10. When they arrive early on July 2,
Blackburn is disappointed because the collars, which are supposed to be white, are blue.
Blackburn notifies Alpha of the error. Alpha says that it wants a chance to “make it right.”
If Alpha delivers another shipment of 10,000 conforming jerseys on July 10, Blackburn…
(a) absolutely must accept the new shipment
(b) must accept the new shipment if Alpha offers a reasonable discount
(c) must accept the new shipment if it has suffered no measureable losses
(d) may accept the new shipment, but has the option to reject it
5. Assume that a year has passed, and Blackburn FC once again orders 10,000 soccer
jerseys from Alpha, to be delivered on July 10. This time, nonconforming jerseys are
delivered on July 10. Alpha thoroughly inspected the shirts before shipping and had no
reason to spot the error. When Blackburn notifies Alpha of the problem, Alpha says that
it intends to cure the defect. If Blackburn cannot show that it will suffer any serious
harm, does the UCC require Blackburn to give Alpha a chance to cure this time?
498 U N I T 3 Commercial Transactions
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(a) No, because the contract’s deadline has passed.
(b) Yes, it must give Alpha until July 17 to cure.
(c) Yes, it must give Alpha until July 20 to cure.
(d) Yes, it must give Alpha a reasonable amount of time to cure.
ESSAY QUESTIONS
1. Jewell-Rung was a Canadian corporation that imported and sold men’s clothing
wholesale. Haddad was a New York corporation that manufactured and sold men’s
clothing under the “Lakeland” label. The companies agreed that Haddad would sell
2,325 Lakeland garments to Jewell-Rung for $250,000. Jewell-Rung began to take
orders for the garments from its Canadian customers. Jewell-Rung had orders for
about 372 garments when it learned that Haddad planned to allow another company,
Olympic, the exclusive Canadian right to manufacture and sell Lakeland garments.
Jewell-Rung sued Haddad for its lost profits. Haddad moved for summary judgment,
claiming that Jewell-Rung could not recover lost profits because it had not covered. Is
Haddad right? If so, why might Jewell-Rung not have covered?
2. Mastercraft Boat manufactured boats and often used instrument panels and electrical
systems assembled or manufactured by Ace Industries. Typically, Ace would order
electrical instruments and other parts and assemble them to specifications that
Mastercraft provided. Mastercraft decided to work with a different assembler, M & G
Electronics, so it terminated its relationship with Ace. Mastercraft then requested that
Ace deliver all of the remaining instruments and other parts that it had purchased for
use in Mastercraft boats. Ace delivered the inventory to Mastercraft, which inspected
it and kept some of the items, but returned others to Ace, stating that the shipment
had been unauthorized. Later, Mastercraft requested that Ace deliver the remaining
parts (which Mastercraft had sent back to Ace) to M & G, which Ace did. Mastercraft
then refused to pay for these parts, claiming that they were non-conforming. Is Ace
entitled to its money for the parts?
3. Lewis River Golf, Inc., grew and sold sod. It bought seed from defendant, O. M. Scott
& Sons, under an express warranty. But the sod grown from the Scott seeds developed
weeds, a breach of Scott’s warranty. Several of Lewis River’s customers sued, unhappy
with the weeds in their grass. Lewis River lost most of its customers, cut back its
production from 275 acres to 45 acres, and destroyed all remaining sod grown from
Scott’s seeds. Eventually, Lewis River sold its business at a large loss. A jury awarded
Lewis River $1,026,800, largely for lost profits and loss of goodwill. Scott appealed,
claiming that a plaintiff may not recover for lost profits and goodwill. Comment.
4. The AM/PM Franchise association was a group of 150 owners of ARCO Mini-
Market franchises in Pennsylvania and New York. Each owner had an agreement
to operate a gas station and mini-market, obtaining all gasoline, food, and other
products from ARCO. The association sued, claiming that ARCO had
experimented with its formula for unleaded gasoline, using oxinol, and that the
poor-quality gas had caused serious engine problems and a steep drop in
customers. The association demanded (1) lost profits for gasoline sales, (2) lost
profits for food and other items, and (3) loss of goodwill. The trial court dismissed
the case, ruling that the plaintiff’s claims were too speculative, and the association
appealed. Please rule.
CHAPTER 21 Performance and Remedies 499
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5. YOU BE THE JUDGE WRITING PROBLEM Clark Oil agreed to sell Amerada
Hess several hundred thousand barrels of oil at $24 each by January 31, with the sulfur
content not to exceed 1 percent. On January 26, Clark tendered oil from various ships.
Most of the oil met specifications, but a small amount contained excess sulfur. Hess
rejected all of the oil. Clark recirculated the oil, meaning that it blended the high-
sulfur oil with the rest, and it notified Amerada that it could deliver 100 percent of the
oil, as specified, by January 31. Hess did not respond. On January 30, Clark offered to
replace the oil with an entirely new shipment, due to arrive February 1. Hess rejected the
offer. On February 6, Clark retendered the original oil, all of which met contract terms,
and Hess rejected it. Clark sold the oil elsewhere for $17.75 per barrel and filed suit. Is
Clark entitled to damages? Argument for Clark: A seller is entitled to cure any defects.
Clark did so in good faith and offered all of the oil by the contract deadline. Clark went
even further, offering an entirely new shipment of oil. Hess acted in bad faith, seeking to
obtain cheaper oil. Clark is entitled to the difference between the contract price and its
resale price.Argument for Hess:Hess was entitled to conforming goods, and Clark failed
to deliver. Under the perfect tender rule, that is the end of the discussion. Hess had the
right to reject non-conforming goods, and it promptly did so. Hess chose not to deal
further with Clark because it had lost confidence in Clark’s ability to perform.
DISCUSSION QUESTIONS
1. ETHICS Laura and Bruce Trethewey hired
Basement Waterproofing Nationwide, Inc.
(BWNI) to waterproof the walls in their basement
for a fee of $2,500. BWNI’s contract stated:
“BWNI will service any seepage in the areas
waterproofed at no additional cost to the customer.
All labor and materials will be at the company’s
expense. Liability for any damage shall be limited
to the total price paid for this contract.” The
material that BWNI used to waterproof the
Tretheweys’ walls swelled and caused large cracks
to open in the walls. Water poured into the
basement, and the Tretheweys ultimately spent
$38,000 to repair the damage. They sued, claiming
negligence and breach of warranty, but BWNI
claimed its liability was limited to $2,500. Please
rule. Apart from the legal ruling, comment on
ethics. BWNI wanted to protect itself against
unlimited damage claims. Is this a legitimate way
to do it? Is this how BWNI would wish to be
treated itself? If you think BWNI did behave
ethically, what advice would you have for
consumers who hire home improvement
companies? If you believe the company did not
behave ethically, imagine that you are a
BWNI executive, charged with drafting a standard
contract for customers. How would you protect
your company’s interests while still acting in a way
you consider moral?
2. Consider the UCC’s exceptions to the perfect
tender rule: usage of trade, course of dealing, and
course of performance. Do these all seem
reasonable, or are they too lenient on sellers who
deliver non-conforming goods?
3. Are the UCC’s rules related to cure sensible? If
a seller ships goods that are not what you ordered,
should you (in many circumstances) be required to
give them a chance to make it right?
4. The opening scenario presented the true story of
a man who paid a great deal of money for a Plymouth
Prowler. Do you agree with the court’s decision to
award him nearly $30,000 in damages? Or do you
agree with the Devil’s Advocate feature and think
that he was overcompensated for foolish spending?
5. Review the section “Damages for Non-
Acceptance.” In that section’s example, Refinery
refused Oilko’s shipment on November 1, when
the oil was worth $99 per barrel. Oilko waited three
months to resell the oil, and at that time, it
received only $92 per barrel. In such a case, the
UCC allows Oilko to receive only $1 per barrel in
damages rather than the $8-per-barrel reduction in
price it actually received. Is this fair? Would it be
more sensible to allow a company like Oilko to
receive $8 per barrel in damages?
500 U N I T 3 Commercial Transactions
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CHAPTER22
NEGOTIABLE
INSTRUMENTS
When Calvin was in love with Leann, he kept
lending her small amounts of money, which
eventually added up to $500. Then Calvin saw a
photo on Facebook of Leann and Hugh hooking
up. After a huge fight, Calvin demanded that
Leann pay him what she owed. She said she had
no cash, so she wrote and signed an IOU that
said, “I am giving Calvin five hundred dollars.”
But still Leann did not pay! And more photos
appeared on Hugh’s timeline! Fed up, Calvin took
Leann to small claims court, where he discovered that
the paper was not enforceable because Leann had not
actually promised to pay him. He was out of luck.
Calvin tracked Leann down (at Hugh’s apartment)
and persuaded her to write him a check for five hundred
dollars. But he did not notice until he tried to deposit
the check that Leann never signed it. The bank refused
the check.
Calvin felt that he had learned a costly lesson on
negotiable instruments, but his education was about to
get a lot more expensive. He answered his phone one day to hear a gruff voice demanding
that he pay the $2,000 Leann owed on a car she had bought last year. Calvin had forgotten
that he had agreed to do Leann a favor and co-sign the note on the car. Calvin got indignant
and shouted, “You have to go after Leann first! I can give you her address.” Calvin was
wrong. When he signed the note, he became an accommodation party and was every bit as
liable as Leann, even though he had never even ridden in the car. As the poem says,
“A sadder and wiser man he rose the morrow morn.”
After a huge fight,
Calvin demanded that
Leann pay him what she
owed.
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22-1 COMMERCIAL PAPER
The law of commercial paper is important to anyone who borrows money or writes
checks (or takes the CPA exam). In early human history, people lived on whatever
they could hunt, grow, or make for themselves. Imagine what your life would be like
if you had to subsist only on what you could make yourself. Over time, people
improved their standard of living by bartering for goods and services they could not
make themselves. But traders needed a method for keeping account of who owed how
much to whom. That was the role of currency. Many items have been used for
currency over the years, including silver, gold, copper, and cowrie shells. These
currencies have two disadvantages—they are easy to steal and difficult to carry.
Paper currency weighs less than gold or silver, but it is even easier to steal. As a
result, money had to be kept in a safe place, and banks developed to meet that
need. However, money in a vault is not very useful unless it can be readily spent.
Society needed a system for transferring paper funds easily. Commercial paper is that
system.
22-2 TYPES OF NEGOTIABLE
INSTRUMENTS
There are two kinds of commercial paper: negotiable and non-negotiable instruments.
Article 3 of the Uniform Commercial Code (UCC) covers only negotiable instruments;
non-negotiable instruments are governed by ordinary contract law. There are also two
categories of negotiable instruments: notes and drafts.
A note (also called a promissory note) is your promise that you will pay money. A
promissory note is used in virtually every loan transaction, whether the borrower is buying a
multimillion dollar company or a television set. For example, when you borrow money from
AutoLoans to buy a car, you will sign a note promising to repay the money. You are the
maker because you are the one who has made the promise. AutoLoans is the payee because
it expects to be paid.
A draft is an order directing someone else to pay money for you. A check is the most
common form of a draft—it is an order telling a bank to pay money. In a draft, three people are
involved: The drawer orders the drawee to pay money to the payee. Now before you slam the
book shut in despair, let us sort out the players. Suppose that Danica Patrick wins the Daytona
500. NASCAR writes her a check for $1,500,000.
This check is simply an order by NASCAR
(the drawer) to its bank (the drawee) to pay money
to Patrick (the payee). The terms make sense if
you remember that, when you take money out of
your account, you draw it out. Therefore, when you
write a check, you are the drawer and the bank is
the drawee. The person to whom you make out the
check is being paid, so she is called the payee.
The following table illustrates the difference
between notes and drafts. Even courts sometimes
confuse the terms drawer (the person who signs a
check) and maker (someone who signs a promissory
note). Issuer is an all-purpose term that means both
maker and drawer.
Issuer
The maker of a promissory note
or the drawer of a draft.
Note
A promise that you will pay
money. Also called a
promissory note.
Maker
The issuer of a promissory
note.
Payee
Someone who is owed money
under the terms of an
instrument.
Draft
The drawer of this instrument
orders someone else to pay
money.
Check
The most common form of a
draft, it is an order telling a
bank to pay money.
Drawer
The person who issues a draft.
Drawee
The one ordered by the drawer
to pay money to the payee. In
the case of a check, the bank is
the drawee.
In this note, Romeo is the maker and Juliet is the payee.©
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502 U N I T 3 Commercial Transactions
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Who Pays Who Plays
Note You make a promise that youwill pay. Two people are involved: maker and payee.
Draft You order someone else to pay. Three people are involved: drawer, drawee,
and payee.
22-3 THE FUNDAMENTAL “RULE” OF
COMMERCIAL PAPER
The possessor of a piece of commercial paper has an unconditional right to be paid, so long
as (1) the paper is negotiable; (2) it has been negotiated to the possessor; (3) the possessor is
a holder in due course; and (4) the issuer cannot claim a valid defense.
22-3a Negotiable
To work as a substitute for money, commercial paper must be freely transferable in the
marketplace, just as money is. In other words, it must be negotiable.
The possessor of non-negotiable commercial paper has the same rights—no more,
no less—as the person who made the original contract. With non-negotiable commercial
paper, the transferee’s rights are conditional because they depend upon the rights of the
original party to the contract. If, for some reason, the original party loses his right to be paid,
so does the transferee. The value of non-negotiable commercial paper is greatly reduced
because the transferee cannot be absolutely sure what his rights are or whether he will be
paid at all.
Suppose that Krystal buys a used car from the Trustie Car Lot for her business,
Krystal Rocks. She cannot afford to pay the full $15,000 right now, but she is willing to
sign a note promising to pay later. So long as Trustie keeps the note, Krystal’s
obligation to pay is contingent upon the validity of the underlying contract. If, for
example, the car is defective, then Krystal might not be liable to Trustie for the full
amount of the note. Trustie, however, does not want to keep the note. He needs the
cash now so that he can buy more cars to sell to other customers. Reggie’s Finance Co.
is happy to buy Krystal’s promissory note from Trustie, but the price Reggie is willing
to pay depends upon whether her note is negotiable.
If Krystal’s promissory note is non-negotiable, Reggie gets exactly the same rights that
Trustie had. As the saying goes, he steps into Trustie’s shoes. Suppose that Trustie
tampered with the odometer and, as a result, Krystal’s car is worth only $12,000. If, under
contract law, she owes Trustie only $12,000, then that is all she has to pay Reggie, even
though the note says $15,000.
The possessor of negotiable commercial paper has more rights than the person who made
the original contract. With negotiable commercial paper, the transferee’s rights are uncondi-
tional. He is entitled to be paid the full amount of the note, regardless of the relationship
between the original parties. If Krystal’s promissory note is a negotiable instrument, she
must pay the full amount to whoever has possession of it, no matter what complaints she
might have against Trustie.
Exhibit 22.1 illustrates the difference between negotiable and non-negotiable commer-
cial paper.
Negotiated
Holder in
Due Course
Checklist
No Valid
Defenses
Negotiable
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CHAPTER 22 Negotiable Instruments 503
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Because negotiable instruments are more valuable than non-negotiable ones, it is
important for buyers and sellers to be able to tell, easily and accurately, if an instrument
is indeed negotiable. To be negotiable:
1. The instrument must be in writing.
2. The instrument must be signed by the maker or drawer.
3. The instrument must contain an unconditional promise or order to pay. If Krystal’s
promissory note says, “I will pay $15,000 as long as the car is still in working order,” it
is not negotiable because it is making a conditional promise. The instrument must
also contain a promise or order to pay. It is not enough simply to say, “Krystal owes
Trustie $15,000.” She has to indicate that she owes the money and also that she
intends to pay it. “Krystal promises to pay Trustie $15,000” would work.
4. The instrument must state a definite amount of money that is clear “within its four
corners.” “I promise to pay Trustie one-third of my profits this year” would not work,
because the amount is unclear. If Krystal’s note says, “I promise to pay $15,000 worth
of diamonds,” it is not negotiable because it does not state a definite amount of money.
5. The instrument must be payable on demand or at a definite time. A demand instrument
is one that must be paid whenever the holder requests payment. If an instrument is
undated, it is treated as a demand instrument and is negotiable. An instrument can be
negotiable even if it will not be paid until sometime in the future, provided that the
payment date can be determined when the document is made. A graduate of a well-
known prep school wrote a generous check to his alma mater, but for payment date he
put, “The day the headmaster is fired.” This check is not negotiable because it is
payable neither on demand nor at a definite time.
6. The instrument must be payable to order or to bearer. Order paper must include the
words “Pay to the order of’ someone. By including the word “order,” the maker is
indicating that the instrument is not limited to only one person. “Pay to the order of
Trustie Car Lot” means that the money will be paid to Trustie or to anyone Trustie
Contract Law Applies UCC Article 3 Applies
Transferee‘s Rights
Are Conditional
Transferee‘s Rights
Are Unconditional
Non-Negotiable Negotiable
Commercial
Paper
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EXHIB IT 22.1 The Difference between Non-Negotiable and Negotiable Paper
Order paper
An instrument that includes the
words “pay to the order of” or
their equivalent.
504 U N I T 3 Commercial Transactions
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designates. If the note is made out “To bearer,” it is bearer paper and can be redeemed
by any holder in due course. “To cash” is the equivalent of “to bearer.”
The rules for checks are different from other negotiable instruments. If properly filled
out, checks are negotiable. And sometimes they are negotiable even if not completed
correctly. Most checks are preprinted with the words “Pay to the order of,” but sometimes
people inadvertently cross out “order of.” Even so, the check is still negotiable. Checks are
frequently received by consumers who, sadly, have not completed a course on business law.
The drafters of the UCC did not think it fair to penalize them when the drawer of the check
was the one who made the mistake.
EXAM Strategy
Question: Sam had a checking account at Piggy Bank. Piggy sent him special checks that
he could use to draw down a line of credit. When he used these checks, Piggy did not take
money out of his account; instead it treated the checks as loans and charged him interest.
Piggy then sold these used checks to Wolfe. Were the checks negotiable instruments?
Strategy: When faced with a question about negotiability, begin by looking at the
list of six requirements. In this case, there is no reason to doubt that the checks are in
writing, signed by the issuer, with an unconditional promise to pay to order at a
definite time. But do the checks state a definite amount of money? Can the holder
“look at the four corners of the check” and determine how much Sam owes?
Result: Sam was supposed to pay Piggy the face amount of the check plus interest.
Wolfe does not know the amount of the interest unless he reads the loan agreement.
Therefore, the checks are not negotiable.
INTERPRETATION OF AMBIGUITIES
Perhaps you have noticed that people sometimes make mistakes. Although the UCC
establishes simple and precise rules for creating negotiable instruments, people do not
always follow these rules to the letter. So the UCC has created rules that help to resolve
uncertainty and supply missing terms.
Notice anything odd about the check pictured here? Is it for $1,500 or $15,000? When
the terms in a negotiable instrument contradict each other, three rules apply:
• Words take precedence over numbers.
• Handwritten terms prevail over typed and printed
terms.
• Typed terms win over printed terms.
According to these rules, Krystal’s check is for $15,000
because, in a conflict betweenwords and numbers, words win.
In the following case, the amount of the check was not
completely clear. Was it a negotiable instrument?
Bearer paper
A note is bearer paper if it is
made out “to bearer” or “to
cash.” It can be redeemed by
any holder in due course.
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PAY TO THE
ORDER OF
DOLLARS
$
3808
20
MEMO
KRYSTAL
ROUTE 66
OKLAHOMA CITY, OK
OK BANK
OK, N.A.
January 2,
Trustie Car Lot
Fifteen Thousand and no/100
1,500.00
Krystal
12
CHAPTER 22 Negotiable Instruments 505
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22-3b Negotiated
Negotiation means that an instrument has been transferred to the holder by someone other
than the issuer. If the issuer has transferred the instrument to the holder, then it has not
been negotiated and the issuer can refuse to pay the holder if there was some flaw in
the underlying contract. Thus, if Jake gives Madison a promissory note for $2,000 in
payment for a new computer, but the computer crashes and burns the first week, Jake
has the right to refuse to pay the note. Jake was the issuer and the note was not
negotiated. But if, before the computer self-destructs, Madison indorses and transfers
the note to Kayla, then Jake is liable to Kayla for the full amount of the note, regardless
of his claims against Madison.
You Be the Judge
Facts: Christina Blasco
ran out of money. She
went to the Money Ser-
vices Center (MSC) and
borrowed $500. To repay
the loan, she gave MSC a
check for $587.50, which it
promised not to cash for
two weeks. This kind of transaction is called a “payday loan”
because it is made to someone who needs money to tide over
until the next paycheck. (Note that in this case, Blasco was
paying 17.5 percent interest for a two-week loan, which is an
annual compounded interest rate of 6,500 percent. This is the
dark side of payday loans: Interest rates are often exorbitant.)
Before MSC could cash the check, Blasco filed for
bankruptcy protection. Although MSC knew about
Blasco’s filing, it deposited the check. It is illegal for
creditors to collect debts after a bankruptcy filing, except
that creditors are entitled to payment on negotiable
instruments.
Ordinarily checks are negotiable instruments, but
only if they are for a definite amount. This check had a
wrinkle: The numerical amount of the check was $587.50
but the amount in words was written as “five eighty-seven
and 50/100 dollars.” Did the words mean “five hundred
eighty-seven” or “five thousand eighty-seven” or perhaps
“five million eighty-seven”? Was the check negotiable
despite this ambiguity?
You Be the Judge: Was this check a negotiable instrument?
Was it for a definite amount?
Argument for Blasco:
For a check to be nego-
tiable, two rules apply:
1. The check must
state a definite
amount of money,
which is clear within
its four corners.
2. If there is a contradiction between the words
and numbers, words take precedence over
numbers.
Words prevail over numbers, which means that the
check is for “five eighty-seven and 50/100 dollars.” This
amount is not definite. A holder cannot be sure of the
precise amount of the check. Therefore the check is not a
negotiable instrument, and MSC had no right to submit it
for payment.
Argument for MSC: Blasco is right about the two
rules. However, she is wrong in their interpretation. If
there is a contradiction between the words and num-
bers, words take precedence over numbers. In this
case, there was no contradiction. The words were
ambiguous but they did not contradict the numbers.
If the words had said “five thousand eighty-seven,” that
would have been a contradiction. Instead, the numbers
simply clarified the words. Even someone who was a
stranger to this transaction could safely figure out
the amount of the check. Therefore, it is negotiable.
BLASCO V. MONEY SERVICES
CENTER
2006 Bankr. LEXIS 2899
United States Bankruptcy Court
for the Northern District of Alabama, 2006
Negotiation
An instrument has been
transferred to the holder by
someone other than the issuer.
Negotiated
Holder in
Due Course
Checklist
No Valid
Defenses
Negotiable
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506 U N I T 3 Commercial Transactions
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To be negotiated, order paper must first be indorsed and then delivered to the transferee.
Bearer paper must simply be delivered to the transferee; no indorsement is required.1
An indorsement is the signature of a payee. Tess writes a rent check for $475 to her
landlord, Larnell. If Larnell signs the back of the check and delivers it to Patty, he has met
the two requirements for negotiating order paper: indorsement and delivery. (Note that, for
indorsements, a signature is sufficient. Larnell need not write, “pay to” or “pay to the order
of.”) If Larnell delivers the check to Patty but forgets to sign it, the check has not been
indorsed and therefore cannot be negotiated—it has no value to Patty.
EXAM Strategy
Question: Antoine makes a check out to cash and delivers it to Barley. He writes on
the back, “Pay to the order of Charlotte.” She signs her name. Is this check bearer
paper or order paper? Has it been negotiated?
Strategy: “To cash” is the equivalent of “to bearer,” so a check made out to cash is
bearer paper. Whenever a negotiable instrument is transferred, it is important to ask if
the instrument has been properly negotiated. To be negotiated, order paper must be
indorsed and delivered; bearer paper need only be delivered, but in both cases by
someone other than the issuer.
Result: This check changes back and forth between order and bearer paper,
depending on what the indorsement says. When Antoine makes out a check to cash, it
is bearer paper. When he gives it to Barley, it is not negotiated because he is the
issuer. When Barley writes on the back “Pay to the order of Charlotte,” it becomes
order paper. When he gives it to Charlotte, it is properly negotiated because he is not
the issuer and he has both indorsed the check and transferred it to her. When she
signs it, the check becomes bearer paper. And so on it could go forever.
22-3c Holder in Due Course
A holder in due course has an automatic right to receive payment for a negotiable instru-
ment (unless the issuer can claim a valid defense). If the possessor of an instrument is just a
holder, not a holder in due course, then his right to payment is no better than the rights of
the person from whom he obtained the instrument. If, for example, the issuer has a valid
claim against the payee, then the holder may also lose his right to be paid, because he
inherits whatever claims and defenses arise out of that contract. Clearly, then, holder in due
course status dramatically increases the value of an instrument because it enhances the
probability of being paid.
REQUIREMENTS FOR BEING A HOLDER IN DUE COURSE
A holder in due course is a holder who has given value for the instrument, in good faith, and
without notice of outstanding claims or other defects.
Negotiated
Holder in
Due Course
Checklist
No Valid
Defenses
Negotiable
Holder in due course
Someone who has given value
for an instrument, in good faith,
without notice of outstanding
claims or other defenses.
1§3-201. The UCC spells the word “indorsed.” Outside the UCC, the word is more commonly spelled
“endorsed.”
Indorsement
The signature of a payee.
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CHAPTER 22 Negotiable Instruments 507
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Holder For order paper, a holder is anyone in possession of the instrument if it is payable
to or indorsed to her. For bearer paper, a holder is anyone in possession. Tristesse gives
Felix a check payable to him. Because Felix owes his mother money, he indorses the check
and delivers it to her. This is a valid negotiation because Felix has both indorsed the check
(which is order paper) and delivered it. Therefore, Felix’s mother is a holder.
Value A holder in due course must give value for an instrument. Value means that the
holder has already done something in exchange for the instrument. Felix’s mother has
already loaned him money, so she has given value.
Good Faith There are two tests to determine if a holder acquired an instrument in good
faith. The holder must meet both these tests:
• Subjective Test. Did the holder believe the transaction was honest in fact?
• Objective Test. Did the transaction appear to be commercially reasonable?
In the following case, the plaintiff passed the subjective test, but failed the objective one.
BUCKEYE CHECK CASHING, INC. V. CAMP
159 Ohio App. 3d 784; 825 N.E.2d 644; 2005 Ohio App. LEXIS 929
Court of Appeals of Ohio, 2005
C A S E S U M M A R Y
Facts: On October 12, Shawn Sheth and James Camp
agreed that Camp would provide services to Sheth by
October 15. In payment, Sheth gave Camp a check for
$1,300 that was postdated October 15. On October 13,
Camp sold the check to Buckeye Check Cashing for
$1,261.31. On October 14, fearing that Camp would vio-
late the contract, Sheth stopped payment on the check.
That same day, Buckeye deposited the check with its
bank, believing that the check would reach Sheth’s bank
on October 15. Buckeye was unaware of the stop payment
order. Sheth’s bank refused to pay the check. Buckeye
filed suit against Sheth.
The trial court ruled that because Buckeye was a
holder in due course, the check was valid and Sheth had
to pay Buckeye. Sheth appealed.
Issues: Was Buckeye a holder in due course? Must Sheth pay
Buckeye?
Decision: Sheth is not required to pay Buckeye because
the company was not a holder in due course.
Reasoning: To be a holder in due course, Buckeye
must have acted in good faith when it bought Sheth’s
check. In determining good faith, we apply two
standards:
1. A subjective test, also called the “pure heart and
empty head doctrine.” The holder meets this test if
he subjectively believed he was negotiating an
instrument in good faith. In the absence of
obviously fraudulent behavior, an innocent party is
assumed to have acted in good faith.
2. An objective test, which requires the observance
of reasonable commercial standards of fair
dealing.
Check cashing is unlicensed and unregulated in Ohio.
Thus, there are no concrete commercial standards by
which check-cashing businesses must operate. Buckeye
argued that its own internal operating policies did not
require that it verify the availability of funds, and appar-
ently the company did not have any guidelines for the
acceptance of postdated checks.
Under the purely subjective test, it is clear that Buck-
eye accepted the check in good faith. But Buckeye fails
the objective test because it did not act in a commercially
reasonable manner. A postdated check is an obvious sign
of trouble, and Buckeye should have realized that there
was at least some possibility that the instrument was
invalid. Therefore, it should have taken reasonable steps
to verify the check before cashing it.
Value
The holder has already done
something in exchange for the
instrument.
Holder
For order paper, anyone in
possession of the instrument if
it is payable to or indorsed to
her. For bearer paper, anyone
in possession.
508 U N I T 3 Commercial Transactions
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Notice of Outstanding Claims or Other Defects In certain circumstances, a
holder is on notice that an instrument has an outstanding claim or other defect:
1. The instrument is overdue. An instrument is overdue the day after its due date. At
that point, the recipient ought to wonder why no one has bothered to collect the
money owed. A check is overdue 90 days after its date. Any other demand instrument
is overdue (1) the day after a request for payment is made or (2) a reasonable time
after the instrument was issued.
2. The instrument is dishonored. To dishonor an instrument is to refuse to pay it.
For example, once a check has been stamped “Insufficient Funds” by the bank,
it has been dishonored, and no one who obtains it afterward can be a holder in
due course.
3. The instrument is altered, forged, or incomplete. Anyone who knows that an
instrument has been altered or forged cannot be a holder in due course. Suppose
Joe wrote a check to Tony for $200. While showing the check to Liza, Tony
cackles to himself and says, “Can you believe what that goof did? Look, he left
the line blank after the words ‘two hundred.’” Taking his pen out with a
flourish, Tony changes the zeroes to nines and adds the words “ninety-nine.” He
then indorses the check over to Liza, who is definitely not a holder in due
course.
4. The holder has notice of certain claims or disputes. No one can qualify as a holder
in due course if she is on notice that (1) someone else has a claim to the
instrument or (2) there is a dispute between the original parties to the
instrument. Matt hires Sheila to put aluminum siding on his house. In payment,
he gives her a $15,000 promissory note with the due date left blank. They agree
that the note will not be due until 60 days after completion of the work. Despite
the agreement, Sheila fills in the date immediately and sells the note to Rupert
at American Finance Corp., who has bought many similar notes from Sheila.
Rupert knows that the note is not supposed to be due until after the work is
finished. Usually, before he buys a note from her, he demands a signed
document from the home owner certifying that the work is complete. Also, he
lives near Matt and can see that Matt’s house is only half finished. Rupert is not
a holder in due course because he has reason to suspect there is a dispute
between Sheila and Matt.
22-3d Defenses against a Holder in Due Course
Negotiable instruments are meant to be a close substitute for money, and, as a general rule,
holders expect to be paid.However, the issuer of a negotiable instrument is not required to pay if:
• His signature on the instrument was forged.
• After signing the instrument, his debts were discharged in bankruptcy.
• He was a minor (typically under age 18) at the time he signed the instrument.
• The amount of the instrument was altered after he signed it. (If he left the instrument
blank, however, he is liable for any amounts later filled in.)
• He signed the instrument under duress, while mentally incapacitated, or as part of an
illegal transaction.
• He was tricked into signing the instrument without knowing what it was and without
any reasonable way to find out.
Negotiated
Holder in
Due Course
Checklist
No Valid
Defenses
Negotiable
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CHAPTER 22 Negotiable Instruments 509
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22-3e Consumer Exception
The most common use for negotiable instruments is in consumer transactions. A consumer
pays for a refrigerator by giving the store a promissory note. The store promptly sells the
note to a finance company. Even if the refrigerator is defective, under Article 3 the
consumer must pay full value on the note because the finance company is a holder in due
course. However, some states require promissory notes given by a consumer to carry the
words “consumer paper.” Notes with this legend are non-negotiable.
Meanwhile, the Federal Trade Commission (FTC) has special rules for consumer credit
contracts. A consumer credit contract is one in which a consumer borrows money from a
lender to purchase goods and services from a seller who is affiliated with the lender. If Sears
loans money to Gerald to buy a high definition television at Sears, that is a consumer credit
contract. It is not a consumer credit contract if Gerald borrows money from his cousin Vinnie
to buy the television from Sears. The FTC requires all promissory notes in consumer credit
contracts to contain the following language:
NOTICE
ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL
CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE
SELLER OF GOODS OR SERVICES OBTAINED WITH THE PROCEEDS HEREOF.
No one can be a holder in due course of an instrument with this language. If the
language is omitted from a consumer note, it is possible to be a holder in due course, but the
seller is subject to a fine.
In the following case, consumers found that a home improvement contract, far from
improving their home, almost caused them to lose it.
ANTUNA V. NESCOR, INC.
2002 Conn. Super. LEXIS 1003
Superior Court of Connecticut, 2002
C A S E S U M M A R Y
Facts: NESCOR was, in theory, a home improvement
company. One of its salespeople signed a contract with
the Antunas to install vinyl siding and windows on their
house. The contract contained the required FTC lan-
guage: “Any holder of this consumer credit contract is
subject to all claims and defenses which the debtor could
assert against the Seller of the goods or services pursuant
hereto or with the proceeds hereof.” NESCOR assigned
this contract to The Money Store (TMS).
Under Connecticut law, a home improvement
contract is invalid and unenforceable if it is entered
into by a salesperson or contractor who has not regis-
tered with the state. The NESCOR salesperson was
unregistered.
Unhappy with NESCOR’s work, the Antunas stopped
making payments under the contract. TMS filed suit, seek-
ing to foreclose on their house. The Antunas moved for
summary judgment, arguing that TMS could not enforce
the contract because it was not a holder in due course.
Issue: Was TMS a holder in due course? Does it have the
right to foreclose on the Antunas’ home?
Decision: TMS had no right to foreclose because it was
not a holder in due course.
Reasoning: Because the NESCOR salesperson was not
registered, state law gave the Antunas the right to invali-
date the home improvement contract with NESCOR.
The FTC language explicitly gave the Antunas the right
to assert against TMS whatever defenses they had against
NESCOR. Accordingly, because the home improvement
contract was invalid, neither NESCOR nor TMS could
benefit from it. TMS may not enforce the consumer credit
contract by foreclosing on the Antunas’ house.
Consumer credit contract
A contract in which a consumer
borrows money from a lender
to purchase goods and
services from a seller who is
affiliated with the lender.
510 U N I T 3 Commercial Transactions
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22-4 LIABILITY FOR NEGOTIABLE
INSTRUMENTS
Thus far in this chapter, you have learned that the possessor of a piece of commercial paper has an
unconditional right to be paid, so long as (1) the paper is negotiable; (2) it has been negotiated to the
possessor; (3) the possessor is a holder in due course; and (4) the issuer cannot claim a valid defense.
The life of a negotiable instrument, however, is more complicated than this simple state-
ment indicates. Not everyone who signs a negotiable instrument is an issuer, and not everyone
who presents an instrument for payment is a holder in due course. This section focuses on the
liability of these extra players: non-issuers who sign an instrument and non-holders who receive
payment. The liability of someone who has signed an instrument is called signature liability.The
liability of someone who receives payment on an instrument is called warranty liability.
22-4a Primary versus Secondary Liability
A number of different people may be liable on the same negotiable instrument, but some
are primarily liable, others are only secondarily liable. Someone with primary liability is
unconditionally liable—he must pay unless he has a valid defense. Those with secondary
liability only pay if the person with primary liability does not. The holder of an instrument
must first ask for payment from those who are primarily liable before making demand
against anyone who is only secondarily liable.
22-5 SIGNATURE LIABILITY
Virtually everyone who signs an instrument is potentially liable for it, but the liability depends
upon the capacity in which it was signed. The maker of a note, for example, has different
liability from an indorser. Capacity can sometimes be difficult to determine if the signature is
not labeled—”maker,” “indorser,” etc. In the absence of a label, courts generally look at the
location of the signature. Someone who signs a check or a note in the lower right-hand corner
is presumed to be an issuer. If a drawee bank signs on the face of a check, it is an acceptor.
Someone who signs on the back of an instrument is considered to be an indorser.
22-5a Maker
The maker of a note is primarily liable. Hehas promised to pay, andpayhemust, unless hehas a
valid defense.2 If two makers sign a note, they are both jointly and severally liable. The holder can
demand full payment from either or partial payment from both. Suppose that Shane offers to buy
Marilyn’s bookstore in return for a $20,000 promissory note. Because Shane has no assets, Marilyn
insists that his supplier, Alexis, also sign the note as co-maker. Once Alexis signs the note, Marilyn
has the right to demand full payment from either her or Shane.
22-5b Drawer
The drawer of a check has secondary liability. He is not liable until he has received notice
that the bank has dishonored the check. Although the bank pays the check with the
drawer’s funds, the drawer is secondarily liable in the sense that he does not have to write
2For example, if the maker goes bankrupt, he does not have to pay the note because bankruptcy is a
defense even against a holder in due course.
Signature liability
The liability of someone who
signs an instrument.
Warranty liability
The liability of someone who
receives payment on an
instrument.
CHAPTER 22 Negotiable Instruments 511
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a new check or give cash to the holder unless the bank dishonors the original check.
Suppose that Shane writes a $10,000 check to pay Casey for new inventory. Casey is
nervous, and before he can get to the bank to deposit the check, he calls Shane seven
times to ask whether the check is good. He even asks Shane for
payment in cash instead of by check. Shane finally snarls at
Casey, “Just go cash the check and get off my back, will you?”
At this point, Casey has no recourse against Shane because Shane
is only secondarily liable.
Sadly, however, Casey’s fears are realized. When he presents
the check to the bank teller, she informs him that Shane’s account
is overdrawn. Casey snatches the check off the counter and
hurries over to Shane’s shop. It makes no difference that Casey
forgot to let the teller stamp “Insufficient Funds” on the check—
notice of dishonor can be made orally. Once the bank has refused
to pay, the check has been dishonored. Casey has informed
Shane, who must now pay the $10,000.
22-5c Drawee
The drawee is the bank on which a check is drawn. Since the drawer of a check is only
secondarily liable, logically you might expect the drawee bank to be primarily liable. That is
not the case, however. When a drawer signs a check, the instrument enters a kind of limbo.
The bank is not liable to the holder and owes no damages to the holder for refusing to pay
the check. The bank may be liable to the drawer for violating their checking account
agreement, but this contract does not extend to the holder of the check.
When a holder presents a check, the bank can do one of the following:
• Pay the check. In this case, the holder has no complaints.
• Dishonor the check. In this case, the holder must pursue remedies against the drawer.
What if Casey is afraid to take a check from Shane? After all, even if Shane has
enough money in his account at the moment, it may be gone by the time Casey
deposits the check and his bank presents it for payment. To protect himself, Casey
can insist that Shane give him a certified check or a cashier’s check. A certified check is
one that the issuer’s bank has signed (typically on the front), indicating its acceptance
of the check. The bank is then referred to as an acceptor and becomes primarily liable.
A cashier’s check is drawn on the bank itself and is a promise that the bank will pay out
of its own funds. In either case, Casey is sure to be paid so long as the bank stays
solvent. To protect itself once it issues either check, Shane’s bank will immediately
remove that money from his account.
These rules are precise and must be followed to the letter. In the following example, the
court pointed out that the real estate lawyer had been “bamboozled.”TheMacNabs purchased
a piece of property from Richard Harrington’s client. The couple came to the closing with an
uncertified check drawn on their Merrill Lynch cash management account for $150,000.
Harrington called Merrill Lynch and spoke with a Ms. Ruark, who told him there were
sufficient funds in the MacNabs’ account to cover the check and that she would put a hold
on the account in the amount of the check. She also sent the following fax to Harrington: “This
letter is to verify that the funds are available in the Merrill Lynch account. There is a pend on
the funds for the check that was given you.” In fact, the MacNabs’ account did not contain
sufficient cleared funds to cover the check, which bounced. After paying off the McNabs,
PAY TO THE
ORDER OF
DOLLARS
$
0912
20
MEMO
Anne Elliot
Kellynch, N.Y.
TSN Savings Bank
010110562 766 72467 3967
August 27,
Frederick Wentworth
Fifteen Thousand and no/100
15,000.00
Anne Elliot
12
real estate
Anne Elliot is only secondarily liable, but no one is primarily
liable until the bank accepts the check.
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Certified check
A check the issuer’s bank has
signed, indicating its
acceptance of the check.
Acceptor
A bank (or other drawee) that
accepts a check (or other
draft), thereby becoming
primarily liable on it.
Cashier’s check
A check drawn on the bank
itself. It is a promise that the
bank will pay out of its own
funds.
512 U N I T 3 Commercial Transactions
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Harrington sought recovery from Merrill Lynch. But Merrill Lynch was not liable because it
had not signed the check. An oral certification is invalid.3
22-5d Indorser
An indorser is anyone, other than an issuer or acceptor, who signs an instrument. Shane
gives Hannah a check to pay her for installing new shelves in his bookstore. On the back of
Shane’s check, Hannah writes, “Pay to Christian,” signs her name, and then gives the check
to Christian in payment for back rent. Underneath Hannah’s name, Christian signs his own
name and gives the check to Trustie Car Lot as a deposit on his new Prius. Hannah and
Christian are both indorsers. This is the chain of ownership:
Indorsers are secondarily liable; they must pay if the issuer does not. But indorsers are
only liable to those who come after them in the chain of ownership, not to those who held
the instrument beforehand. If Shane refuses to pay Trustie, the auto dealership can demand
payment from Christian or Hannah. If Christian pays Trustie, Christian can then demand
payment from Hannah. If, however, Hannah pays Trustie, she has no right to go after
Christian because he is not liable to a previous indorser.
There are some exceptions to this rule. Indorsers are not liable if:
1. They write the words “without recourse” next to their signature on the instrument,
2. A bank certifies the check,
3. The check is presented for payment more than 30 days after the indorsement, or
4. The check is dishonored and the indorser is not notified within 30 days.
22-5e Accommodation Party
An accommodation party is someone—other than an issuer, acceptor, or indorser—who
adds her signature to an instrument for the purpose of being liable on it. The
accommodation party typically receives no direct benefit from the instrument but is
acting for the benefit of the accommodated party. Shane wants to buy a truck from the
Trustie Car Lot. Trustie, however, will not accept a promissory note from Shane
unless his father, Walter, also signs it. Shane has no assets, but Walter is wealthy.
When Walter signs, he becomes an accommodation party to Shane, who is the
accommodated party. The accommodation party can sign for an issuer, acceptor, or
indorser. Anyone who signs an instrument is deemed to be an accommodation party
unless it is clear that he is an issuer, acceptor, or indorser.
Shane
(issuer)
Hannah
(indorser)
Christian
(indorser)
Trustie
(holder)
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3Harrington v. McNab, 163 F. Supp. 2d 583 (Fed. Dt. Ct., MD, 2001).
Indorser
Anyone, other than an issuer or
acceptor, who signs an
instrument.
Accommodation party
Someone other than an issuer,
acceptor, or indorser, who
adds her signature to an
instrument for the purpose of
being liable on it.
Accommodated party
Someone who receives a
benefit from an
accommodation party.
CHAPTER 22 Negotiable Instruments 513
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An accommodation party has the same liability to the holder as the person for whom he
signed. The holder can make a claim directly against the accommodation party without first
demanding payment from the accommodated party. Walter is liable to Trustie, whether or
not Trustie first demands payment from Shane. If forced to pay Trustie, Walter can try to
recover from Shane.
In an earlier example, Shane’s supplier, Alexis, had signed a note as co-maker. What is
the difference between a co-maker and an accommodation party? The co-maker is liable
both to the holder and to the other co-maker. The accommodation party is liable only to the
holder, not to the other maker. If Shane pays the note on which Alexis is co-maker, then
Alexis is liable to him for half the payment. But if Shane pays the note on which Walter is
the accommodation party, Walter has no liability to Shane.
22-6 WARRANTY LIABILITY
Warranty liability rules apply when someone receives payment on an instrument that has
been forged, altered, or stolen.
22-6a Basic Rules of Warranty Liability
1. The wrongdoer is always liable. If a forger signs someone else’s name to an
instrument, that signature counts as the forger’s, not as that of the person whose name
she signed. The forger is liable for the value of the instrument, plus any other
expenses or lost interest that subsequent parties may experience because of the
forgery. If Hope signs David’s name on one of his checks, Hope is liable, but not
David. Although this is a sensible rule, the problem is that forgers are difficult to catch
and, even when found, often do not have the money to pay what they owe.
2. The drawee bank is liable if it pays a check on which the drawer’s name is forged. The
bank can recover from the payee only if the payee had reason to suspect the forgery. If
a bank cashes David’s forged check, it must reimburse him whether or not it ever
recovers from Hope. Suppose that Hope forged the check to pay for a new tattoo. If
Gus, the owner of the tattoo parlor, deposits the check and the bank pays it, the bank
can only recover from Gus if he had reason to suspect the forgery. Perhaps Gus did
suspect because “David” was the name on the check and Hope does not look much
like a David.
Why hold the bank liable for something that is not its fault? In theory, the bank has
David’s signature on file and can determine that Hope’s version does not match. As the
saying goes, the drawee bank must know the drawer’s signature as a mother knows her own
child. Such a rule may have been appropriate in an era when people went to their
neighborhood bank to cash checks and a teller would indeed recognize dear Miss Plotkin’s
signature. In this day and age, most checks—especially those for small amounts—are
handled by machine, so perhaps this rule makes less sense. Nonetheless, the rule stands.
3. In any other case of wrongdoing, a person who first acquires an instrument from a
wrongdoer is ultimately liable to anyone else who pays value for it. These rules are
based on the provisions in Article 3 of the UCC that establish transfer and
presentment warranties.
514 U N I T 3 Commercial Transactions
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22-6b Transfer Warranties
When someone transfers an instrument, she warrants that:
• She is a holder of the instrument—in other words, she is a legitimate owner,
• All signatures are authentic and authorized,
• The instrument has not been altered,
• No defense can be asserted against her, and
• As far as she knows, the issuer is solvent.
When someone transfers an instrument, she promises that it is valid. The wrongdoer—
the person who created the defective instrument in the first place—is always liable, but if he
does not pay what he owes, the person who took it from him is liable in his place. She may
not be that much at fault, but she is more at fault than any of the other innocent people who
paid good value for the instrument.
Suppose that Annie writes a check for $100 to pay for a fancy dinner at Barbara’s Bistro.
Cecelia steals the check fromBarbara’s cash register, indorses Barbara’s name, and uses the check
to buy a leather jacket from Deirdre. In her turn, Deirdre takes the check home and indorses it
over to her condominium association to pay her monthly service fee. Barbara notices the check is
gone and asks Annie to stop payment on it. Once payment is stopped, the condominium
association cannot cash the check. Who is liable to whom?The chain of ownership looks like this:
Cecelia is the wrongdoer and, of course, she is liable. Unfortunately, she is currently
studying at the University of the Azores and refuses to return to the United States. The
condominium association makes a claim against Deirdre. When she transferred the check,
she warranted that all the signatures were authentic and authorized, but that was not true
because Barbara’s signature was forged. (Deirdre should have asked Cecelia for identification.)
Deirdre cannot make a claim against Annie or Barbara because neither of them violated their
transfer warranties—all the signatures at that point were authentic and authorized.
There are a few additional wrinkles to the transfer warranty rules:
• Transfer warranties flow to all subsequent holders in good faith who have indorsed
the instrument. If the condominium association indorses the check over to its
maintenance company, Deirdre is liable to the condo association when the
maintenance company makes a claim against it.
• If the instrument is bearer paper, the transfer warranties extend only to the first
transferee. If Annie had made her check out to cash, it would have been bearer paper,
and her transfer warranties would have extended only to Barbara. If Barbara transfers
the check to Hannah, Barbara’s transfer warranties extend to Hannah; Annie’s do not.
Annie Barbara Cecelia
(the culprit)
Condominium
Association
Deirdre
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• If a warranty claim is not made within 30 days of discovering the breach, damages are
reduced by the amount of harm that the delay caused. Suppose that the
condominium association waits two months to tell Deirdre the check is invalid.
Cecelia has been into Deirdre’s store several times to try on matching leather pants.
By the time Deirdre finds out the check is bad, Cecelia has again left town. Deirdre
may not be liable on the check at all because the delay has prevented her from
making a claim against Cecelia.
• Transfer warranties apply only if the instrument has been transferred for
consideration. Suppose Deirdre gives the check to an employee, Emily, as a birthday
present. When the check turns out to be worthless, Emily has no claim against
Deirdre.
The following sad case illustrates how important transfer warranties are and how easy it is,
even for a careful person, to be conned. Think about what Quimby could have done to
protect himself.
You Be the Judge
Facts: Steve Szabo, a
Venezuelan resident, had
a checking account with
the Bank of America in
Palm Beach Gardens,
Florida. Someone with
an internet address in
Nigeria hacked into Szabo’s accounts online, called custo-
mer service to change the telephone number listed on his
account, and ordered blank checks.
Someone then wrote a check on Szabo’s account
for $120,000 to pay for an investment in Freddie
Quimby’s gold mine. On February 20, Quimby pre-
sented the check for payment at the Bank of America’s
branch in Osburn, Idaho. At Quimby’s request, the
branch manager verified through Bank of America’s
records that Szabo’s account had sufficient funds to
cover the check. The branch manager also called the
telephone number in Szabo’s account records and
spoke to someone claiming to be Szabo who confirmed
that the check was valid.
Quimby endorsed the check to the bank and
received in return a cashier’s check for $120,000, which
he deposited to his account at Bank of America in
Baker City, Oregon. [You remember that a cashier’s check
is a check drawn on the bank itself.] “Szabo” then contacted
Quimby, stating that he had changed his mind about the gold
mine investment and asking Quimby to return the funds. On
February 22, Quimby wired $111,000.00 from his account
with Bank of America to an account in Hong Kong. Those
funds disappeared and Bank of America has been unable to
reclaim them.
On March 3, the real
Szabo reported to the
Bank that his signature
on the Quimby check
was a forgery. The Bank
repaid Szabo and then
filed suit against Quimby,
seeking repayment on the cashier’s check it had issued to
him, with interest. The Bank argued that Quimby had
violated his transfer warranties when he endorsed the
forged check to it.
You Be the Judge: Did Quimby violate his transfer
warranties? Is he liable to the Bank of America for $120,000?
Argument for the Bank: When Quimby endorsed the
check to the Bank, he warranted that all signatures were
authentic and authorized. That was not true—the signa-
ture was a forgery and the check was invalid. Moreover,
he only waited two days before wiring the funds. If he had
waited longer, the fraud might have been discovered in
time.
The Bank had to refund $120,000 to Szabo. Quimby
must repay the Bank.
Argument for Quimby: This whole problem is the
Bank’s fault. Let us count the ways: The Bank (1) per-
mitted a thief to hack into Szabo’s account; (2) issued
blank checks to the thief; (3) assured Quimby that there
were good funds to pay the check; (4) issued a cashier’s
check to Quimby; and (5) wired funds to Hong Kong that
it cannot trace.
In short, the Bank was repeatedly negligent and now it
seeks recovery fromQuimby, who did all he could to ensure
that the check was valid. That is unfair and preposterous.
QUIMBY V. BANK OF AMERICA
2009 U.S. Dist. LEXIS 98575
United States District Court
for the District of Oregon, 2009
516 U N I T 3 Commercial Transactions
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22-6c Comparison of Signature Liability and Transfer
Warranties
Transfer warranties fill in holes left by the signature liability rules:
• A forged signature is invalid and therefore creates no signature liability on the part of
the person whose name was signed. However, someone who receives a forged
instrument may recover under transfer warranty rules, which provide that anyone who
transfers a forged instrument is liable for it.
• The signature liability rules do not apply to the transfer of bearer paper. Bearer paper
can be negotiated simply by delivery; no indorsement is required. No signature
means no signature liability (for anyone other than the issuer—who is the only person
actually signing the instrument). Transfer warranties apply to each transfer of bearer
paper (although the transferor of bearer paper is liable only to the person to whom he
gives the instrument, not to any transferees further down the line).
22-6d Presentment Warranties
Transfer warranties impose liability on anyone who sells a negotiable instrument, such
as Deirdre. Presentment warranties apply to someone who demands payment for an
instrument from the maker, drawee, or anyone else liable on it. Thus, if the condominium
association cashes Annie’s check, it is subject to presentment warranties because it is
demanding payment from her bank, the drawee. In a sense, transfer warranties apply to
all transfers away from the issuer; presentment warranties apply when the instrument returns
to the maker or drawee for payment. As a general rule, payment on an instrument is final,
and the payer has no right to a refund, unless the presentment warranties are violated.
Anyone who presents a check for payment warrants that:
• She is a holder,
• The check has not been altered, and
• She has no reason to believe the drawer’s signature is forged.
If any of these promises is untrue, the bank has a right to demand a refund from
the presenter. Suppose that Adam writes a $500 check to pay Bruce for repairing his
motorcycle. Bruce changes the amount of the check to $1,500 and indorses it over to
Chip as payment for an oil bill. When Chip deposits the check, the bank credits his
account for $1,500 and deducts the same amount from Adam’s account. When Adam
discovers the alteration, the bank credits his account for $1,000. Chip violated his
presentment warranties when he deposited an altered check (even though he did not
know it was altered). Although Chip was not at fault, he must still reimburse the bank
for $1,000. But Chip is not without recourse—Bruce violated his transfer warranties to
Chip (by transferring an altered check). Bruce must repay the $1,000. Chip loses out
only if he cannot make Bruce pay.
The presentment warranty rules for a promissory note are different from those for a
check. Anyone who presents a promissory note for payment makes only one warranty—that
he is a holder of the instrument. Someone presenting a note does not need to warrant that the
note is unaltered or the maker’s signature is authentic because a note is presented for payment to
the issuer himself. The issuer presumably remembers the amount of the note and whether he
signed it. Suppose Adam gives a promissory note to Bruce to pay for a new motorcycle. If Bruce
increases the note from $5,000 to $10,000 before he presents it for payment in six months’ time,
Adam will almost certainly realize the note has been changed and refuse to pay it.
CHAPTER 22 Negotiable Instruments 517
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The presenter of a note warrants that she is a holder, that is, that the instrument was
payable to or indorsed to her. But if the signature was forged, subsequent owners are not
holders because the instrument was not, in fact, payable to or indorsed to her. Thus, anyone
who presents a note with a forged signature is violating the presentment warranties.
Suppose that Bruce is totally honest and does not alter the note, but Chip steals it and
forges Bruce’s indorsement before passing the note on to Donald, who presents it to Adam
for payment. Donald has violated his presentment warranties because he is not a holder. Adam
can refuse to pay him. For his part, Donald can claim repayment from Chip who violated his
transfer warranties by passing on a note with a forged signature.
EXAM Strategy
Question: Hillary owed Evan $500. She gave Evan’s roommate John a check made
out to Evan. John indorsed the check to Mike by signing Evan’s name. Mike
deposited the check in his account at the Amstel Bank. Amstel removed $500 from
Hillary’s account. Are John and Mike liable on this check?
Strategy: Whenever an instrument goes astray, begin by asking which warranties
have been violated and by whom.
Result: Transfer warranties apply to all transfers away from the issuer; presentment
warranties apply when the instrument returns to the maker or drawee for payment.
John violated transfer warranties because Evan’s signature is neither authentic nor
authorized. When Mike deposited the check, he violated presentment warranties. He
is not a holder because this check was not properly indorsed to Mike.
22-7 OTHER LIABILITY
RULES
This section contains other UCC rules that establish liability
for wrongdoing on instruments.
22-7a Conversion Liability
Conversion means that (1) someone has stolen an instru-
ment or (2) a bank has paid a check that has a forged
indorsement. The rightful owner of the instrument can
recover from either the thief or the bank.
For example, Glenn Altman was a lawyer representing Barbara Kirchoff. He settled her
case for $12,000, but when he received the check, he forged her indorsement and deposited
the check in his own account without telling her. He gave her the money four months later,
but by then she had discovered his dishonesty. What claims do the various parties have?
Kirchoff has a claim against the bank because it paid a check with a forged indorsement.
If the bank pays Kirchoff, then it can recover from Altman because he violated his present-
ment warranties. Note, however, that Kirchoff could not sue Altman for violating present-
ment warranties because he had not presented the check to her for payment. Nor could she
sue him for violating transfer warranties because he had not transferred the check to her. To
the contrary, he had transferred the check away from her.
Conversion
Means that (1) someone has
stolen an instrument or (2) a
bank has paid a check that has
a forged indorsement.
… he forged her
indorsement and
deposited the check in
his own account without
telling her.
518 U N I T 3 Commercial Transactions
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Kirchoff does have a claim against Altman for conversion because he stole the check
from her. What about the issuer of the check—can it also sue Altman for conversion? No, an
action for conversion cannot be brought by an issuer because the check technically belongs
to the payee (Kirchoff). The issuer can bring a claim only against the bank that pays the
forged check.
22-7b Impostor Rule
If someone issues an instrument to an impostor, then any indorsement in the name of the
payee is valid as long as the person (a bank, say) who pays the instrument does not know of
the fraud. A teenager knocks on your door one afternoon. He tells you he is selling magazine
subscriptions to pay for a school trip to Washington, D.C. After signing up for Career and
Popular Accounting, you make out a check to “Family Magazine Subscriptions.” Unfortu-
nately, the boy does not represent Family Magazine at all. He does cash the check,
however, by forging an indorsement for the magazine company. Is the bank liable for
cashing the fraudulent check?
No. The teenager was an impostor—he said he represented the magazine company, but
he did not. If anyone indorses the check in the name of the payee (Family Magazine
Subscriptions), you must pay the check and the bank is not liable. Does this rule seem
harsh? Maybe, but you were in the best position to determine if the teenager really worked
for the magazine company. You were more at fault than the bank, and you must pay. Of
course, the teenager would be liable to you, if you could ever find him.
22-7c Fictitious Payee Rule
If someone issues an instrument to a person who does not exist, then any indorsement in the
name of the payee is valid as long as the person (a bank, say) who pays the instrument does
not know of the fraud. The impostor rule applies if you give a check with a real name to the
wrong person. The fictitious payee rule applies if you write a check to someone who does not
exist. This type of fraud can be very difficult to prevent. Even a large law firm was stung.
Dennis Masellis, the manager of payroll for Baker & McKenzie’s New York office stole
more than $7 million from the firm by creating fictitious employees and then depositing
their salaries in his own account.
22-7d Employee Indorsement Rule
If an employee with responsibility for issuing instruments forges a check or other instru-
ment, then any indorsement in the name of the payee, or a similar name, is valid as long as
the person (a bank, say) who pays the instrument does not know of the fraud. A dishonest
employee, especially one with the authority to issue checks, has the opportunity to steal a
great deal of money. The employer cannot shift blame (and liability) onto the bank that
unknowingly cashes the forged checks because the employer was more to blame—it not
only hired the thief, it failed to supervise him carefully.
Dennis M. Hartotunian had a major gambling problem—he owed nearly $10 million.
Unfortunately, he was also the controller and accountant for the Aesar Group. Over the
course of three years, he wrote himself 154 checks worth $9.24 million. Any check for more
than $500 required the signature of Aesar’s general manager, but Hartotunian forged it.
After an internal audit revealed that millions were missing, company officers asked to talk
with Hartotunian. When he heard they were coming, he walked out and never came back.
It is always a bad sign when the company controller disappears. If an employee is
generally authorized to prepare or sign checks, then the bank is not liable on checks that the
employee forges. Hartotunian was clearly covered by this rule because he was the company
controller. If he had been a mailroom employee without authority to sign checks, the bank
would have been liable.
CHAPTER 22 Negotiable Instruments 519
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22-7e Negligence
Regardless of the impostor rule, the fictitious payee rule, and the employee indorsement
rule (the “three rules”), anyone who behaves negligently in creating or paying an unauthor-
ized instrument is liable to an innocent third party. If two people are negligent, they share
the loss according to their negligence. Here are two examples:
• Anyone who is careless in paying an unauthorized instrument is liable, despite the
three rules. Suppose that the boy selling bogus magazine subscriptions goes into the
bank and indorses the check: “Family Magazine Subscriptions, by Butch McGraw.”
The teller peers over her counter and sees a 13-year-old boy standing there with torn
jeans and a baseball cap on backwards. She may be negligent if she cashes the check
without asking for further identification.
• Anyone who is careless in allowing a forged or altered instrument to be created is also
liable, whether or not he has violated one of the three rules. The classic case
establishing this rule is more than 200 years old. In it, a businessman who was going
abroad signed five checks and gave them to his wife with instructions that they were
to be used for business expenses. A clerk in the company helpfully showed the
missus how to fill out the checks, carefully instructing her to leave a blank space in
front of the number. The clerk used this space to add a “3” in front of a “50” and
then cashed the £350 check. The court held that the drawee bank was not liable
because, “If Young, instead of leaving the check with a female, had left it with a man
of business, he would have guarded against fraud in the mode of filling it up.”4
Today, we hiss at the sexist sentiment, but it illustrates the point. Anyone who
carelessly creates a situation that facilitates the forgery or alteration of an instrument
cannot recover against a party who pays the instrument in good faith.
EXAM Strategy
Question: Jonathan is the head of payroll at Yearbook. He issues checks to his sister,
Elizabeth, who happens not to work for Yearbook. She does, however, deposit the
checks into her bank account. A teller at the bank knows that Elizabeth does not work
for Yearbook, but he deposits the checks for her without raising any questions. Is the
bank liable for the fraudulent checks?
Strategy: Whenever fraudulent checks are signed by an authorized employee, you
will naturally think first of the Employee Indorsement Rule. However, it is important
to remember that the bank’s negligence overrides the Employee Indorsement Rule.
Result: If the bank were not negligent then, under the Employee Indorsement
Rule, it would not be liable because Jonathan was authorized to sign checks.
However, because the bank was negligent in paying the checks, it must share the loss
with Yearbook. The amount each would have to pay depends upon their share of the
blame.
4Young v. Grote, 4 Bing. 253 (Common Pleas), quoted in Douglas J. Whaley, Problems and Materials on
Payment Law (Boston: Little, Brown & Co., 1995), p. 253.
520 U N I T 3 Commercial Transactions
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Chapter Conclusion
It is never wise to play an important game without understanding the rules. As you can see
from the cases in this chapter, real harm can come to those who do not know the rules of
negotiable instruments.
EXAM REVIEW
1. NEGOTIABILITY The possessor of non-negotiable commercial paper has the
same rights—no more, no less—as the person who made the original contract. The
possessor of negotiable commercial paper has more rights than the person who made
the original contract. (p. 503)
2. THE FUNDAMENTAL RULE OF COMMERCIAL PAPER The possessor of
a piece of commercial paper has an unconditional right to be paid, as long as:
• The paper is negotiable;
• It has been negotiated to the possessor;
• The possessor is a holder in due course; and
• The issuer cannot claim a valid defense. (p. 503)
3. REQUIREMENTS FOR NEGOTIABILITY Tobenegotiable, an instrumentmust:
• Be in writing;
• Be signed by the maker or drawer;
• Contain an unconditional promise or order to pay;
• State a definite amount of money which is clear “within its four corners”;
• Be payable on demand or at a definite time; and
• Be payable to order or to bearer. (pp. 503–505)
4. AMBIGUITY When the terms in a negotiable instrument contradict each other,
three rules apply:
• Words take precedence over numbers.
• Handwritten terms prevail over typed and printed terms.
• Typed terms win over printed terms. (pp. 505–506)
5. NEGOTIATION An instrument has been transferred to the holder by someone
other than the issuer. To be negotiated, order paper must first be indorsed and then
delivered to the transferee. Bearer paper must simply be delivered to the transferee;
no indorsement is required. (pp. 506–507)
CHAPTER 22 Negotiable Instruments 521
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6. HOLDER IN DUE COURSE A holder in due course has an automatic right to
receive payment for a negotiable instrument (unless the issuer can claim a valid
defense). A holder in due course is a holder who has given value for the instrument, in
good faith, without notice of outstanding claims or other defects. (p. 507)
Question: After Irene fell behind on her mortgage payments, she answered an
advertisement from Best Financial Consultants offering attractive refinancing
opportunities. During a meeting at a McDonald’s restaurant, a Best representative
told her that the company would arrange for a complete refinancing of her home,
pay off two of her creditors, and give her an additional $5,000 in spending money.
Irene would only have to pay Best $4,000. Irene signed a blank promissory note
that was filled in later by Best representatives for $14,986.61. Best did not fulfill its
promises to Irene, but within two weeks, it sold the note to Robin for just under
$14,000. Irene refused to pay the note, alleging that Robin was not a holder in due
course. Is Irene liable to Robin?
Strategy: Whenever a question asks if someone is a holder in due course, begin
by reviewing the requirements. Is this person a holder who has given value for the
instrument, in good faith, without notice of outstanding claims or other defects? (See
the “Results” at the end of this section.)
7. DEFENSES The issuer of a negotiable instrument is not required to pay if:
• His signature was forged.
• After signing the instrument, his debts were discharged in bankruptcy.
• He was a minor at the time he signed the instrument.
• The amount of the instrument was altered after he signed it.
• He signed the instrument under duress, while mentally incapacitated, or as part of
an illegal transaction.
• He was tricked into signing the instrument without knowing what it was and
without any reasonable way to find out. (p. 509)
8. CONSUMER EXCEPTION The Federal Trade Commission requires all
promissory notes in consumer credit contracts to contain language preventing any
subsequent holder from being a holder in due course. (p. 510)
Question: Gina purchased a Chrysler car with a 70,000-mile warranty. She
signed a loan contract with the dealer to pay for the car in monthly installments.
The dealer sold the contract to the Chrysler Credit Corp. Soon, the car developed
a tendency to accelerate abruptly and without warning. Two Chrysler dealers were
unable to correct the problem. Gina filed suit against Chrysler Credit Corp., but
the company refused to rescind the loan contract. The company argued that, as a
holder in due course on the note, it was entitled to be paid regardless of any
defects in the car. How would you decide this case if you were the judge?
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522 U N I T 3 Commercial Transactions
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Strategy: Whenever consumers are involved, consider the possibility that there is a
consumer credit contract. The plaintiff in this case is a consumer who borrowed money
from a lender to purchase goods from a seller who is affiliated with the lender (both seller
and lender are owned by Chrysler). Thus the contract is a consumer credit contract. (See
the “Results” at the end of this section.)
9. PRIMARY V. SECONDARY LIABILITY Someone who is primarily liable on
a negotiable instrument must pay unless he has a valid defense. Those with
secondary liability only pay if the person with primary liability does not. (p. 511)
10. PRIMARY SIGNATURE LIABILITY The maker of a note is primarily liable.
(p. 511)
11. SECONDARY SIGNATURE LIABILITY
a. The drawer of a check has secondary liability: He is not liable until he has received
notice that the bank has dishonored the check.
b. Indorsers of a note are secondarily liable; they must pay if the issuer does not. But an
indorser is only liable to those who come after him in the chain of ownership, not to
those who held the instrument before he did. (pp. 511–512)
12. SIGNATURE LIABILITY FOR AN ACCOMMODATION PARTY The
accommodation party signs an instrument to benefit the accommodated party. By
signing the instrument, an accommodation party agrees to be liable on it, whether or
not she directly benefits from it. She has the same liability as the person for whom
she signed. (pp. 513–514)
Question: Jean borrowed $6,000 from a bank. As part of the loan process,
she executed a note to the bank. Her son’s widow, Kathy, signed as an
accommodation party. The bank issued a check payable to “Kathy and Jean.”
Somehow this check was altered to read “Kathy or Jean.” Jean cashed the check
and spent the proceeds. The bank sought recovery from Kathy, who refused to
pay, arguing (1) the bank had to go after Jean first, and (2) her contract with the
bank was unenforceable because she had not received any consideration—all of
the proceeds of the loan had gone to Jean.
Strategy: An accommodation party is primarily liable; therefore the bank has no
obligation to go after Kathy first. An accommodation party is liable whether or not
she received any benefit from the loan.
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CHAPTER 22 Negotiable Instruments 523
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13. WARRANTY LIABILITY The basic rules of warranty liability are as follows:
• The wrongdoer is always liable.
• The drawee bank is responsible if it pays a check on which the drawer’s name is forged.
• In any other case of wrongdoing, a person who initially acquires an instrument
from a wrongdoer is ultimately liable to anyone else who pays value for it. (p. 514)
14. TRANSFER WARRANTIES When someone transfers an instrument, she
warrants that:
• She is a holder of the instrument,
• All signatures are authentic and authorized,
• The instrument has not been altered,
• No defense can be asserted against her, and
• As far as she knows, the issuer is solvent. (pp. 515–516)
15. PRESENTMENT WARRANTIES FOR A CHECK Anyone who presents a
check for payment warrants that:
• She is a holder,
• The check has not been altered, and
• She has no reason to believe the drawer’s signature is forged. (pp. 517–518)
16. PRESENTMENT WARRANTIES FOR A NOTE The presenter of a note
only warrants that he is a holder. (p. 517)
17. CONVERSION Conversion means that (1) someone has stolen an instrument or
(2) a bank has paid a check that has a forged indorsement. (pp. 518–519)
18. IMPOSTOR RULE If someone issues an instrument to an impostor, then any
indorsement in the name of the payee is valid as long as the person who pays the
instrument is ignorant of the fraud. (p. 519)
19. FICTITIOUS PAYEE RULE If someone issues an instrument to a person who
does not exist, then any indorsement in the name of the payee is valid as long as the
person who pays the instrument does not know of the fraud. (p. 519)
20. EMPLOYEE INDORSEMENT RULE If an employee with responsibility for
issuing instruments forges a check or other instrument, then any indorsement in the
name of the payee is valid as long as the person who pays the instrument is ignorant
of the fraud. (p. 519)
21. LIABILITY FOR NEGLIGENCE Anyone who behaves negligently in creating
or paying an unauthorized instrument is liable to an innocent third party. (p. 520)
524 U N I T 3 Commercial Transactions
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6. Result: In this case, Robin is a holder who has given value. Did she act in good
faith? We don’t know if she actually believed the transaction was honest, but the
court held that the transaction did not appear to be commercially reasonable
because Robin’s profit was so high. Thus, Robin was not a holder in due course,
and Irene was not liable to her.
8. Result: Chrysler Credit was not a holder in due course. Therefore, it is subject to any
defenses Gina might have against the dealer, including that the car was defective.
12. Result: Kathy is liable, even though she received no benefit from the loan.
MULTIPLE-CHOICE QUESTIONS
1. Which of the following statements are true?
(a) A draft is always a check.
(b) A check is always a draft.
(c) A note must involve at least three people.
(d) All of the above.
2. Which of the following standards are required for negotiability?
(a) The instrument must be signed by the payee.
(b) The instrument must be payable on demand.
(c) The instrument must be payable to order.
(d) None of the above.
3. Marla is not a holder in due course if she takes an instrument:
(a) believing that theunderlying contractwas honest, although it turned out to bedishonest.
(b) that is a consumer credit contract.
(c) that appeared commercially reasonable when made but turned out to be
dishonest.
(d) All of the above.
4. CPA QUESTION In order to negotiate bearer paper, one must:
(a) indorse the paper.
(b) indorse and deliver the paper with consideration.
(c) deliver the paper.
(d) deliver and indorse the paper.
5. What is the difference between a co-maker and an accommodation party?
(a) A co-maker is liable both to the holder and the other co-maker, while an
accommodation party is liable only to the holder.
(b) A co-maker is liable to subsequent indorsers, while an accommodation party is not.
(c) A co-maker is liable only to the other co-maker, while the accommodation party is
liable to the holder.
(d) A co-maker is not liable once a bank certifies a check, while an accommodation
party is still liable even after certification.
CHAPTER 22 Negotiable Instruments 525
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ESSAY QUESTIONS
1. Duncan Properties, Inc., agrees to buy a car from Shifty for $25,000. The company
issues a promissory note in payment. The car that Duncan bought is defective. If
Shifty still has the note, does Duncan have to pay it?
2. Shifty sells that note to Honest Abe for $22,000. Does Duncan have to pay Abe?
3. Kay signed a promissory note for $220,000 that was payable to Investments, Inc. The
company then indorsed the note over to its lawyers to pay past and future legal fees.
Were the lawyers holders in due course?
4. Shelby wrote the following check to Dana. When is it payable, and for how much?
5. Railroad issued a check to Parris which somehow came to be in Eddy’s possession.
Eddy indorsed the check “Railroad Eddy” and deposited it in his own account at
Bank. Parris sued Bank, alleging that it was liable to him for having paid the check
over an unauthorized indorsement. Is Bank liable to Parris? On what theory?
6. Sidney entered into a contract for $35,000 with MacDonald Roofing Co., Inc., to
reroof his building. Sidney made his initial payment by writing a check for $17,500
payable to “MacDonald Roofing Company, Inc., and Friendly Supply Company.”
MacDonald took the check to Friendly and requested an indorsement, which
Friendly provided. When MacDonald failed to complete the roofing work, Sidney
filed suit for damages against Friendly. Sidney argued that Friendly was liable as an
indorser. Do you agree?
7. Using her company’s check-signing machine, Doris forged $150,000 of checks on the
account of her employer, Winkie, Inc. One of Doris’s jobs at the company was to
prepare checks for the company president, Zach, to sign. He did not (1) look at the
sequence of check numbers; (2) examine the monthly account statements; or
(3) reconcile company records with bank statements. Winkie’s bank, as a matter of
policy, did not check indorsements on checks with a face value of less than $1,000. By
accident, it paid a forged check that had not even been indorsed. Is the bank liable to
Winkie for the forged checks?
Pay to the order of
DOLLARS
$
0802
July 27, 2012
320 Crest Drive
Alvin, TX 54609
August 3, 2009
Dana
Three hundred eighty-two & no/100
352.00
Shelby
Fidelity Fiduciary Bank
©
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526 U N I T 3 Commercial Transactions
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8. ETHICS When Steven was killed in an automobile accident, his wife, Debra,
received $60,000 in life insurance benefits. She decided she needed a fresh start, so
she sold her house in Bunkie and moved to Sulphur, Louisiana. Before she left,
though, she signed several blank checks and gave them to her mother-in-law, Helen,
with instructions to use them to pay off the remaining debt on Debra’s mobile home.
Instead, Helen used one of the checks to withdraw $50,000 from the account for her
own personal use, not to pay off the debt. When Debra discovered the theft, she sued
the bank for having paid an unauthorized check. How would you rule in this case?
Debra has suffered a grievous loss—her husband died tragically in an automobile
accident. She trusted her mother-in-law and counted on her help. Should the bank
show compassion? If the bank made good on the forged checks, how great would be
the injury to the bank’s shareholders compared with the harm to Debra if she loses
this entire sum?
DISCUSSION QUESTIONS
1. In the Buckeye case, the court ruled that Buckeye
was not a holder in due course and the check was
not valid because Buckeye should have checked
with Sheth’s bank before buying the check. Would
this remedy have worked? What could Buckeye
have done to protect itself?
2. In the Antuna case, the Antunas were foolish to
sign an agreement with an unlicensed contractor to
install aluminum siding. There is no evidence that
TMS was acting in bad faith. Why should it suffer
for the Antunas’ mistake? What could TMS have
done to protect itself?
3. Recall the Quimby case. This type of fraud is
increasingly common. What could Quimby have
done to protect himself?
4. Catherine suffered serious physical injuries in an
automobile accident and became acutely
depressed as a result. One morning, she received
a check for $17,400 in settlement of her claims
arising out of the accident. She indorsed the
check and placed it on the kitchen table. She
then called Robert, her longtime roommate, to
tell him the check had arrived. That afternoon,
she jumped from the roof of her apartment
building, killing herself. The police found the
check and a note from her, stating that she was
giving it to Robert. Had Catherine negotiated
the check to Robert?
5. Banks are liable for forged checks except in the
case of the three rules (Imposter Rule, Fictitious
Payee Rule, and the Employee Indorsement
Rule). Do you think this is the proper allocation of
liability? Why should banks be liable for forged
checks, in this era of automated check machines?
Alternatively, could you argue that the three rules
provide too much protection to banks?
CHAPTER 22 Negotiable Instruments 527
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CHAPTER23
SECURED
TRANSACTIONS
To: Allison@credit-help-for-all.com
From: Sam12345@yahoo.com
Hi Allison:
Look, this just doesn’t make any sense.
When I got out of school, I paid a guy $18,000
for my Jeep. I made every payment on my loan
—every one—for over two years. I paid out over
9,000 bucks for that thing. Then I got laid off
and I missed a few payments, and the bank
repossessed the car. And O.K., fair enough, I can see
why they have to do that.
So they auctioned off the Jeep and somebody else
owns it. But now the bank’s lawyer called me and said I
still owe $5,000. What is that, a joke? I owe money for a
Jeep I don’t even have anymore? That can’t be right. I
look forward to your advice.
Sam
To: Sam12345@yahoo.com
From: Allison@credit-help-for-all.com
Dear Sam,
I am sympathetic with your story, but unfortunately the bank is entitled to its money. Here
is how the law sees your plight. When you bought the Jeep, you signed two documents: a note,
in which you promised to pay the full balance owed, and a security agreement, which said that
if you stopped making payments, the bank could repossess the vehicle and sell it.
There are two problems. First, even after two years of writing checks, you might still
have owed about $10,000 (because of interest). Second, cars depreciate quickly. Your
$18,000 vehicle probably had a market value of about $8,000 thirty months later. The
security agreement allowed the bank to sell the Jeep at auction, where prices are still lower.
Your car evidently fetched about $5,000. That leaves a deficiency of $5,000—for which you
are legally responsible, regardless of who is driving the car.
I hope you have a good weekend.
Allison
I owe money for a Jeep I
don’t even have
anymore?
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

23-1 ARTICLE 9: TERMS AND SCOPE
We can sympathize with Sam, but the bank is entitled to its money. The buyer and the
bank entered into a secured transaction, meaning that one party gave credit to another,
demanding in return an assurance of repayment. Whether a used-car lot sells a car on credit
for $18,000 or a bank takes collateral for a $600 million corporate loan, the parties have
created a secured transaction.
Article 9 of the Uniform Commercial Code (UCC) governs secured transactions in
personal property. It is essential to understand the basics of this law because we live and
work in a world economy based on credit. Gravity may cause the earth to spin, but it is
secured transactions that keep the commercial world going ’round. The quantity of disputes
tells us how important this law is: About one-half of all UCC lawsuits involve Article 9.
This part of the Code employs terms not used elsewhere, so we must lead off with
some definitions.
23-1a Article 9 Vocabulary
• Fixtures are goods that have become attached to real estate. For example, heating
ducts are goods when a company manufactures them and also when it sells them to a
retailer. But when a contractor installs the ducts in a new house, they become fixtures.
• Security interest means an interest in personal property or fixtures that secures the
performance of some obligation. If an automobile dealer sells you a new car on credit
and retains a security interest in the car, it means she is keeping legal rights in your
car, including the right to drive it away if you fall behind in your payments. Usually,
your obligation is to pay money, such as the money due on the new car. Occasionally,
the obligation is to perform some other action, but in this chapter, we concentrate on
the payment of money because that is what security interests are generally designed
to ensure.
• Secured party is the person or company that holds the security interest. The
automobile dealer who sells you a car on credit is the secured party.
• Collateral is the property subject to a security interest. When a dealer sells you a new
car and keeps a security interest, the vehicle is the collateral.
• Debtor and obligor. For our purposes, debtor refers to a person who has some original
ownership interest in the collateral. Having a security interest in the collateral does
not make one a debtor. If Alice borrows money from a bank and uses her Mercedes as
collateral, she is the debtor because she owns the car. Obligor means a person who
must repay money, or perform some other task.
Throughout this chapter, the obligor and debtor will generally be the same person, but not
always. When Alice borrows money from a bank and uses her Mercedes as collateral, she is the
obligor, because she must repay the loan; as we know, Alice is also the debtor. However,
suppose that Toby borrows money from a bank and provides no collateral; Jake co-signs the
loan as a favor to Toby, using his Steinway piano as collateral. Jake is the only debtor, because
he owns the piano. Both parties are obligors, because both have agreed to repay the loan.
• Security agreement is the contract in which the debtor gives a security interest to the
secured party. This agreement protects the secured party’s rights in the collateral.
• Default occurs when the debtor fails to pay money that is due, for example, on a loan
or for a purchase made on credit. Default also includes other failures by the debtor,
such as failing to keep the collateral insured.
Debtor
A person who has original
ownership interest in the
collateral.
Fixtures
Goods that have become
attached to real estate.
Secured party
A person or company that
holds a security interest.
Collateral
Property that is subject to a
security interest.
Obligor
A person who must repay
money or perform some other
task to satisfy a debt.
Security agreement
A contract in which the debtor
gives a security interest to the
secured party.
CHAPTER 23 Secured Transactions 529
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• Repossession occurs when the secured party takes back collateral because the debtor
has defaulted. Typically, the secured party will demand that the debtor deliver the
collateral; if the debtor fails to do so, the secured party may find the collateral and take it.
• Perfection is a series of steps the secured party must take to protect its rights in the
collateral against people other than the debtor. This is important because if the
debtor cannot pay his debts, several creditors may attempt to seize the collateral, but
only one may actually obtain it. To perfect its rights in the collateral, the secured
party will typically file specific papers with a state agency.
• Financing statement is a document that the secured party files to give the general
public notice that it has a secured interest in the collateral.
• Record refers to information written on paper or stored in an electronic or other medium.
• Authenticate means to sign a document or to use any symbol or encryption method
that identifies the person and clearly indicates she is adopting the record as her own.
You authenticate a security agreement when you sign papers at an auto dealership, for
example. A corporation electronically authenticates a loan agreement by using the
Internet to transmit an encrypted signature.
AN EXAMPLE
Here is an example using the terms just discussed. Amedical equipment companymanufactures
a CAT scan machine and sells it to a clinic for $2 million, taking $500,000 cash and the clinic’s
promise to pay the rest over five years. The clinic simultaneously authenticates a security
agreement, giving the manufacturer a security interest in the CAT scanner. If the clinic fails to
make its payments, the manufacturer can repossess the machine. The manufacturer then
electronically files a financing statement with an appropriate state agency. This perfects the
manufacturer’s rights, meaning that its security interest in the CAT scanner is now valid against
all the world. If the clinic goes bankrupt and many creditors try to seize its assets, the manu-
facturer has first claim to the CAT scan machine. Exhibit 23.1 illustrates this transaction.
The clinic’s bankruptcy is of great importance.When a debtor hasmoney to pay all of its debts,
there areno concerns about security interests.Butwhat if there is not enoughmoney togo around?A
creditor insists on a security interest to protect itself in the event thedebtor cannotpay all of its debts.
The securedparty intends (1) to give itself a legal interest in specific property of the debtor and (2)
to establish a priority claim in that property, ahead of other creditors. In this chapter, we look at a
variety of issues that arise in secured transactions.
23-1b Scope of Article 9
Article 9 applies to any transaction intended to create a security interest in personal property
or fixtures.
TYPES OF COLLATERAL
The personal property used as collateral may be goods, such as cars or jewelry, but it may
also be a variety of other things:
• Instruments. Drafts, checks, certificates of deposit, and notes may all be used as
collateral, as may stocks, bonds, and other securities.
• Investment property, which refers primarily to securities and related rights.
• Documents of title. These are papers used by an owner of goods who ships or stores
them. The documents are the owner’s proof that he owns goods no longer in his
possession. For example, an owner sending goods by truck will obtain a bill of lading, a
receipt indicating where the goods will be shipped and who gets them when they
530 U N I T 3 Commercial Transactions
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arrive. Similarly, a warehouse receipt is the owner’s receipt for goods stored at a
warehouse. The owner may use these and other similar documents of title as
collateral.
• Account means a right to receive payment for goods sold or leased. This includes, for
example, accounts receivable, indicating various buyers owe a merchant money for
goods they have already received. The category now includes health-insurance
receivables.
• Deposit accounts. Article 9 now covers security interests in deposit accounts (money
placed in banks).
• Commercial tort claims. An organization that has filed a tort suit may use its claim as
collateral. Personal injuries to individuals are not covered by this article.
• General intangibles. This is a residual category, designed to include many kinds of
collateral that do not appear elsewhere on the list, such as copyrights, patents,
trademarks, goodwill, and the right to payment of some loans.
Manufacturer
Files
Sells
to
(Secured Party)
State Agency
Financing
Statement
(Debtor)
Clinic
Contra
ct
Security
Agreement
CAT Scanner
1
2
3
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EXHIB IT 23.1 A simple security agreement:
[1] The manufacturer sells a CAT scan machine to a clinic, taking $500,000 and the clinic’s
promise to pay the balance over five years.
[2] The clinic simultaneously authenticates a security agreement.
[3] The manufacturer perfects by electronically filing a financing statement.
CHAPTER 23 Secured Transactions 531
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

• Chattel paper. This is a record that indicates two things: (1) An obligor owes money and
(2) a secured party has a security interest in specific goods. Chattel paper most commonly
occurs in a consumer sale on credit. If a dealer sells an air conditioner to a customer, who
agrees in writing to make monthly payments and also agrees that the dealer has a security
interest in the air conditioner, that agreement is chattel paper. The same chattel papermay
be collateral for a second security interest. The dealer who sells the air conditioner could
use the chattel paper to obtain a loan. If the dealer gives the chattel paper to a bank as
collateral for the loan, the bank has a security interest in the chattel paper, while the dealer
continues to have a security interest in the air conditioner. Electronic chattel paper is the
same thing, except that it is an electronic record rather than a written one.
• Goods means movable things, including fixtures, crops, and manufactured homes. For
purposes of secured transactions, the Code divides goods into additional categories. In
some cases, the rights of the parties will depend upon what category the goods fall into.
These are the key categories:
• Consumer goods are those used primarily for personal, family, or household
purposes.
• Farm products are crops, livestock, or supplies used directly in farming operations
(as opposed to the business aspects of farming).
• Inventory consists of goods held by someone for sale or lease, such as all of the beds
and chairs in a furniture store.
• Equipment refers to things used in running a business, such as the desks,
telephones, and computers needed to operate a retail store.
SOFTWARE
Article 9 takes into account the increasingly important role that computer software plays in all
business. The Code distinguishes software from goods, and this becomes important when com-
peting creditors are fighting over both a computer system and the software inside it. A program
embedded in a computer counts as goods if it is customarily considered part of those goods or if,
by purchasing the goods, the owner acquires the right to use the program. A program that does not
meet those criteria is termed software, and will be treated differently for some purposes.
In sum, Article 9 applies anytime the parties intended to create a security interest in any
of the items listed above.
23-2 ATTACHMENT OF A
SECURITY INTEREST
Attachment is a vital step in a secured transaction. This means that the secured party has
taken all of the following steps to create an enforceable security interest:
• The two partiesmade a security agreement, and either the debtor has authenticated a security
agreement describing the collateral or the secured party has obtained possession or control;
• The secured party has given value to obtain the security agreement; and
• The debtor has rights in the collateral.1
1UCC §9-203.
Attachment
A three-step process that
creates an enforceable security
interest.
532 U N I T 3 Commercial Transactions
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23-2a Agreement
Without an agreement, there can be no security interest. Generally, the agreement will be in
writing and signed by the debtor or electronically recorded and authenticated by the debtor.
The agreement must reasonably identify the collateral. A description of collateral by type is
often acceptable. For example, a security agreement may properly describe the collateral as
“all equipment in the store at 123 Periwinkle Street.”2 In a security agreement for consumer
goods, however, a description by type is not sufficient, and more specificity is required.
A security agreement at a minimum might:
• State that Happy Homes, Inc., and Martha agree that Martha is buying an Arctic Co.
refrigerator and identify the exact unit by its serial number;
• Give the price, the down payment, the monthly payments, and interest rate;
• State that because Happy Homes is selling Martha the refrigerator on credit, it has a
security interest in the refrigerator; and
• Provide that if Martha defaults on her payments, Happy Homes is entitled to
repossess the refrigerator.
An actual security agreement will add many details, such as Martha’s obligation to keep
the refrigerator in good condition and to deliver it to the store if she defaults; a precise
definition of “default”; and how Happy Homes may go about repossessing if Martha
defaults and fails to return the refrigerator.
23-2b Control and Possession
In many cases, the security agreement need not be in writing if the parties have an oral
agreement and the secured party has either control or possession. For many kinds of
collateral, it is safer for the secured party actually to take the item than to rely upon a
security agreement. The rules follow.
CONTROL
For deposit accounts, electronic chattel paper and certain other collateral, the security
interest attaches if the secured party has control. The UCC specifies exactly what the
secured party must do to obtain control for each type of collateral. In a general sense, control
means that the secured party has certain exclusive rights to dispose of the collateral.
• Deposit account (in a bank). The secured party has control if it is itself the bank
holding the deposit or if the debtor has authorized the bank to dispose of funds
according to the secured party’s instructions.
• Electronic chattel paper. A secured party has control of electronic chattel paper when
it possesses the only authoritative copy of it, and the record(s) designate the secured
party as the assignee. This means that the parties have agreed on an electronic
method to verify the uniqueness of the record, so that any copies of the electronic
original are clearly recognizable as reproductions.
• Investment property and letter-of-credit rights. The Code specifies analogous
methods of controlling investment properties and letter-of-credit rights.3
2A security agreement may not use a super-generic term such as “all of Smith’s personal property.”We
will see later that, by contrast, such a super-generic description is legally adequate in a financing
statement.
3Control is described in the following sections: 9-104 (deposit accounts), 9-105 (electronic chattel
paper), 9-106 (investment property), and 9-107 (letter-of-credit rights).
CHAPTER 23 Secured Transactions 533
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POSSESSION
For most other forms of collateral, including goods, securities, and most other items, a
security interest attaches if the secured party has possession. For example, if you loan your
neighbor $175,000 and he gives you a Winslow Homer watercolor as collateral, you have an
attached security interest in the painting once it is in your possession. It would still be wise
to put the agreement in writing, to be certain both parties understand all terms and can
prove them if necessary, but the writing is not legally required.
The following case is typical of Article 9 disputes in that it was fought out in bankruptcy
court. A debtor claimed to have a security interest in property owned by a bankrupt
company. Had the parties made a security agreement?
EXAM Strategy
Question: Hector needs money to keep his business afloat. He asks his uncle for a
$1 million loan. The uncle agrees, but he insists that his nephew grant him a security
interest in Hector’s splendid gold clarinet, worth over $2 million. Hector agrees. The
uncle prepares a handwritten document summarizing the agreement and asks his
nephew to sign it. Hector hands the clarinet to his uncle and receives his money, but
he forgets to sign the document. Has a security agreement attached?
IN RE CFLC, INC.
209 B.R. 508, 1997 Bankr. LEXIS 821
United States Bankruptcy Appellate Panel of the Ninth Circuit, 1997
C A S E S U M M A R Y
Facts: Expeditors was a freight company that supervised
importing and exporting for Everex Systems, Inc. Expedi-
tors negotiated rates and services for its client and frequently
had possession of Everex’s goods. During a 17-month per-
iod, Expeditors sent over 300 invoices to Everex. Each
invoice stated that the customer either had to accept all of
the invoice’s terms or to pay cash, receiving no work on
credit. One of those terms gave Expeditors a general lien on
all of the customer’s property in its possession. In other
words, if the customer failed to pay a bill, Expeditors
claimed the right to retain the goods, auction them, and
keep enough of the proceeds to pay its overdue bills.
Everex filed for bankruptcy. Expeditors expedited its
way into the court proceedings, claiming the right to sell
Everex’s goods, worth about $81,000. The trial judge
rejected the claim, ruling that Expeditors lacked a valid
security interest. Expeditors appealed.
Issue: Did Expeditors have a security interest in Everex’s
goods?
Decision: No. Expeditors had no security interest in the
goods. Affirmed.
Reasoning: Expeditors and Everex never explicitly
agreed to create a security interest. Expeditors did send
many invoices with terms that the company wished to be
part of a general agreement. However, repetitively mailing
such documents does not make a security agreement.
Everex said nothing about the invoice terms and did
nothing to indicate that it agreed to a lien on its goods.
All Everex did was pay the invoices.
If the parties had reached an initial agreement, then
the invoices might be evidence of a continuing security
interest. Without such a clear agreement, though, there is
no security interest.
534 U N I T 3 Commercial Transactions
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Strategy: Attachment occurs if the parties made a security agreement and there was
authentication or possession; the secured party has given value; and the debtor had
rights in the collateral.
Result: Hector agreed to give his uncle a security interest in the instrument. He
never authenticated (signed) the agreement, but the uncle did take possession of the
clarinet. The uncle gave Hector $1 million, and Hector owned the instrument. Yes,
the security interest attached.
23-2c Value
For the security interest to attach, the secured party must give value. Usually, the value will
be apparent. If a bank loans $400 million to an airline, that money is the value, and the
bank, therefore, may obtain a security interest in the planes that the airline is buying. If a
store sells a living room set to a customer for a small down payment and two years of
monthly payments, the value given is the furniture.
FUTURE VALUE
The parties may also agree that some of the value will be given in the future. For example, a
finance company might extend a $5 million line of credit to a retail store, even though the
store initially takes only $1 million of the money. The remaining credit is available when-
ever the store needs it to purchase inventory. The Uniform Commercial Code considers the
entire $5 million line of credit to be value.4
23-2d Debtor Rights in the Collateral
The debtor can grant a security interest in goods only if he has some legal right to those
goods himself. Typically, the debtor owns the goods. But a debtor may also give a security
interest if he is leasing the goods or even if he is a bailee, meaning that he is lawfully
holding them for someone else. Suppose Importer receives a shipment of scallops on behalf
of Seafood Wholesaler. Wholesaler asks Importer to hold the scallops for three days as a
favor, and to keep a customer happy, Importer agrees. Importer then arranges a $150,000
loan from a bank, using the scallops as collateral. Although Importer has acted unethically, it
does have some right in the collateral—the right to hold them for three days. That is enough
to satisfy this rule.
By contrast, suppose Railroad is transporting 10 carloads of cattle on behalf of Walter,
the owner. A devious Meat Dealer uses forged documents to trick Railroad into believing
that Meat Dealer is entitled to the animals. Meat Dealer trucks the cattle away and uses
them to obtain a bank loan, giving the bank a security interest in the animals. That “security
interest” has never attached and is invalid because Dealer had no legal interest in the cattle.
When Walter, the rightful owner, locates his cattle, he may take them back. The bank can
only hope to find the deceitful Dealer, who in fact has probably disappeared.
Once the security interest has attached to the collateral, the secured party is protected
against the debtor. If the debtor fails to pay, the secured party may repossess the collateral.
23-2e Attachment to Future Property
The security agreement may specify that the security interest attaches to personal property
that the debtor does not yet possess but might obtain in the future.
4UCC §9-204(c).
CHAPTER 23 Secured Transactions 535
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

AFTER-ACQUIRED PROPERTY
After-acquired property refers to items that the debtor obtains after the parties have made
their security agreement. The parties may agree that the security interest attaches to after-
acquired property.5 Basil is starting a catering business, but owns only a beat-up car. He
borrows $55,000 from the Pesto Bank, which takes a security interest in the car. But Pesto
also insists on an after-acquired clause. When Basil purchases a commercial stove, cooking
equipment, and freezer, Pesto’s security interest attaches to each item as Basil acquires it.
PROCEEDS
Proceeds are whatever is obtained by a debtor who sells the collateral or otherwise disposes
of it. The secured party automatically obtains a security interest in the proceeds of the
collateral, unless the security agreement states otherwise.6 Suppose the Pesto Bank obtains
a security interest in Basil’s $4,000 freezer. Basil then decides he needs a larger model and
sells the original freezer to his neighbor for $3,000. The $3,000 cash is proceeds, in which
Pesto automatically obtains a security interest.
23-3 PERFECTION
23-3a Nothing Less than Perfection
Once the security interest has attached to the collateral, the secured party is protected
against the debtor, but it may not be protected against anyone else. Pesto Bank loaned money
to Basil and has a security interest in all of his property. If Basil defaults on his loan, Pesto
may insist he deliver the goods to the bank. If he fails to do that, the bank can seize the
collateral. But Pesto’s security interest is valid only against Basil; if a third person claims
some interest in the goods, the bank may never get them. For example, Basil might have
taken out another loan, from his friend Olive, and used the same property as collateral. Olive
knew nothing about the bank’s original loan. To protect itself against Olive, and all other
parties, the bank must perfect its interest.
There are several kinds of perfection:
• Perfection by filing
• Perfection by possession
• Perfection of consumer goods
• Perfection of movable collateral and fixtures
In some cases, the secured party will have a choice of which method to use; in other
cases, only one method works.
23-3b Perfection by Filing
The most common way to perfect an interest is by filing a financing statement with one or
more state agencies. A financing statement gives the names of all parties, describes the
collateral, and outlines the security interest, enabling any interested person to learn about it.
Suppose the Pesto Bank obtains a security interest in Basil’s catering equipment and then
perfects by filing with the Secretary of State. When Basil asks his friend Olive for a loan, she
5UCC §9-204(a).
6UCC §9-203(f).
After-acquired property
Items that the debtor obtains
after the parties have made
their security agreement.
Financing statement
A statement that gives the
names of all parties, describes
the collateral, and outlines the
security interest.
536 U N I T 3 Commercial Transactions
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

has the opportunity to check the records to see if anyone already has a security interest in
the catering equipment. If Olive’s search uncovers Basil’s previous security agreement, she
will realize it would be unwise to make the loan. If Basil were to default, the collateral
would go straight to Pesto Bank, leaving Olive empty-handed. See Exhibit 23.2.
Article 9 prescribes one form to be used nationwide for financing statements.7 The
financing form is available online at many websites. Remember that the filing may be done
on paper or electronically.
3
4
2
1
Contra
ct
Security
Agreement
State Agency
Loans $55,000
Buys
Stove
Considers
loaning
money to
Checks to see if
there are other
security interests in
Basil’s equipment
Docum
ent
!
Has the Pesto Bank
perfected its security
interest?
The Critical
Issue:
C id
Olive
Buys
Basil
Pesto Bank
©
C
en
g
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e
Le
ar
n
in
g
EXHIB IT 23.2 The Pesto Bank:
[1] Loans money to Basil and
[2] Takes a security interest in his equipment.
Later, when Olive:
[3] Considers loaning Basil money, she will
[4] Check to see if any other creditors already have a security interest in his goods.
7UCC §9-521.
CHAPTER 23 Secured Transactions 537
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

If the collateral is either accounts or general intangibles, filing is the only way to perfect.
Suppose Nester uses his copyright in a screenplay as collateral for a loan. The bank that
gives him the loan may perfect only by filing.
The most common problems that arise in filing cases are (1) whether the financing
statement contained enough information to put other people on notice of the security
interest and (2) whether the secured party filed the papers in the right place.
CONTENTS OF THE FINANCING STATEMENT
A financing statement is sufficient if it provides the name of the debtor, the name of the
secured party, and an indication of the collateral.8
The name of the debtor is critical because that is what an interested person will use to
search among the millions of other financing statements on file. Faulty descriptions of the
debtor’s name have led to thousands of disputes and untold years of litigation, as subse-
quent creditors have failed to locate any record of an earlier claim on the debtor’s property.
In response, the UCC is now very precise about what name must be used. If the debtor is a
“registered organization,” such as a corporation, limited partnership, or limited liability
company, the official registered name of the company is the only one acceptable. If the
debtor is a person or an unregistered organization (such as a club), then the correct name is
required. Trade names are not sufficient.
Because misnamed debtors have created so much conflict, the Code now offers a
straightforward test: A financing statement is effective if a computer search run under the
debtor’s correct name produces it. That is true even if the financing statement used the
incorrect name. If the search does not reveal the document, then the financing statement is
ineffective as a matter of law. The burden is on the secured party to file accurately, not on
the searcher to seek out erroneous filings.9
The collateral must be described reasonably so that another party contemplating a loan
to the debtor will understand which property is already secured. A financing statement
could properly state that it applies to “all inventory in the debtor’s Houston warehouse.” If
the debtor has given a security interest in everything he owns, then it is sufficient to state
simply that the financing statement covers “all assets” or “all personal property.”
The filingmust be done by the debtor’s last name. But which name is the last? The answer is
not always entirely straightforward, as the following case indicates. Did the court get it right?
CORONA FRUITS & VEGGIES, INC. V.
FROZSUN FOODS, INC.
143 Cal. App. 4th 319, 48 Cal. Rptr. 3d 868
California Court of Appeals, 2006
C A S E S U M M A R Y
Facts: Corona Fruits & Veggies (Corona) leased farmland
to a strawberry farmer named Armando Munoz Juarez. He
signed the lease, “Armando Munoz.” Corona advanced
money for payroll and farm production expenses. The
company filed a UCC-1 financing statement, claiming a
security interest in the strawberry crop. The financing
8UCC §9-502(a).
9UCC §9-506(c).
538 U N I T 3 Commercial Transactions
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Article 9—2010 Amendments In 2010, the authors of the UCC—the Uniform
Law Commission (ULC), also known as the National Conference of Commissioners on
Uniform State Laws—created a set of Amendments to Article 9. Remember that the ULC
has no power to make law. Once it creates a set of model rules, it is up to the states to decide
whether or not to enact the proposals.
At the time of this writing, all but twelve states have adopted the changes to Article 9 as
law, and it appears likely that the others will adopt the changes soon.
While most of these changes are so technical as to be beyond the scope of this chapter,
one of the Amendments addresses the issue of what name must appear on a financing
statement. Under the 2010 Amendments, states require that for individuals, the name on a
financing statement be the same as that on a person’s driver’s license. If a state also issues
official identification cards from a driver’s license office to non-drivers, then the name on
such an ID card will be acceptable. If a person has neither kind of state ID card, then her
surname and first personal name will be required to perfect by filing.
Debtor’s Signature Notice one important item that is not required on a financing
statement: the debtor’s signature. The drafters of the UCC have greatly facilitated electro-
nic filing by eliminating the old requirement that a debtor sign. Does this allow a secured
party to create any financing statement it wishes? No. The debtor must have entered into a
valid security agreement before the secured party is entitled to file any financing statement.
Of course, there is the possibility of a fraudulent filing, but the drafters reasoned that the
efficiency achieved far outweighs the danger of occasional fraud.
PLACE OF FILING
The United States is a big country, and potential creditors do not want to stagger from one
end of it to the other to learn whether particular collateral is already secured elsewhere.
Article 9 specifies where a secured party must file. These provisions may vary from state to
state, so it is essential to check local law because a misfiled record accomplishes nothing.
The general rules are as follows.
statement listed the debtor’s name as “Armando Munoz.”
Six months later, Armando Munoz Juarez contracted with
Frozsun Foods, Inc., to sell processed strawberries. Froz-
sun advanced money and filed a financing statement list-
ing the debtor’s name as “Armando Juarez.”
By the next year, the strawberry farmer owed Corona
$230,000 and Frozsun $19,600. When he was unable to
make payments on Corona’s loan, the company repos-
sessed the farmland. And, while it may sound a bit …
lame … it also repossessed the strawberries.
Both Corona and Frozsun claimed the proceeds of the
crop. The trial court awarded the money to Frozsun,
finding that Corona had filed its financing statement
under the wrong last name and therefore had failed to
perfect its security interest in the strawberry crop. Corona
appealed.
Issue: Did Corona correctly file its financing statement?
Decision: No, Corona did not correctly file. Judgment
affirmed.
Reasoning: Because UCC-1 financing statements are
indexed by last name, it is essential that a creditor use
the correct surname. This debtor’s true last name was
“Juarez,” not “Munoz.” Corona’s own business records,
receipts, and checks all refer to him as “Juarez,” as do his
green card and photo ID.
The record indicates that Frozsun’s agent conducted
a “Juarez” debtor name search and did not discover appel-
lants’ UCC-1 financing statement. The secured party, not
the debtor or uninvolved third parties, has the duty of
ensuring proper filing and indexing of the notice.
Corona contends that since the debtor is from Mexico,
we should follow the traditions of that country, where the
surname is formed by listing the father’s name, then the
mother’s. But the strawberries were planted in California,
not Mexico. This is where the debt arose and the UCC-1
was filed. The state cannot organize a filing system that will
accommodate naming practices in all foreign countries.
Corona failed to file properly, and its security interest
never perfected.
CHAPTER 23 Secured Transactions 539
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A secured party must file in the state of the debtor’s location. An individual is located at
his principal residence. If Luigi, the debtor, lives in Maryland, works in Virginia, and has a
vacation home in Florida, a secured party must file in Maryland. An organization that has
only one place of business is located in that state. If the organization has more than one
place of business, it is considered to be located at its chief executive office.10
Article 9 prescribes central filing within the state for most types of collateral. For goods,
the central location will typically be the Secretary of State’s office, although a state may
designate some other office if it wishes. For fixtures, the secured party generally has a choice
between filing in the same central office that is used for goods (which, again, is usually the
Secretary of State’s office), or filing in the local county office that would be used to file real
estate mortgages.11
DURATION OF FILING
Once a financing statement has been filed, it is effective for five years.12 After five years, the
statement will expire and leave the secured party unprotected, unless she files a continua-
tion statement within six months prior to expiration. The continuation statement is valid for
an additional five years, and if necessary, a secured party may continue to file one periodi-
cally, forever.13
23-3c Perfection by Possession or Control
For most types of collateral, in addition to filing, a secured party generally may perfect by
possession or control. So if the collateral is a diamond brooch or 1,000 shares of stock, a bank
may perfect its security interest by holding the items until the loan is paid off. When the
debtor gives collateral to the secured party, it is often called a pledge: The debtor pledges
her goods to secure her performance, and the secured party (sometimes called the pledgee)
takes the goods to perfect its interest.
POSSESSION
When may a party use possession? Whenever the collateral is goods, negotiable documents,
instruments, money, chattel paper that is tangible (as opposed to electronic), or most
securities.14
Perfection by possession has some advantages. First, notice to other parties is very
effective. No reasonable finance company assumes that it can obtain a security interest in a
Super Bowl championship ring when another creditor already holds the ring. Second, posses-
sion enables the creditor to ensure that the collateral will not be damaged during the life of
the security interest. A bank that loans money based on a rare painting may worry about the
painting’s condition, but it knows the painting is safe if it is locked up in the bank’s vault.
Third, if the debtor defaults, a secured party has no difficulties repossessing goods that it
already holds.
Of course, for some collateral, possession is impractical. If a consumer buys a new yacht
on credit, the seller can hardly expect to perfect its security interest by possession. The
buyer would become edgy sailing the boat around the dealer’s parking lot. In such a case,
the secured party must perfect by filing.
10UCC §9-307.
11UCC §9-501.
12The exception to this is for a manufactured home, where it lasts 30 years.
13UCC §9-515.
14UCC §9-313.
Pledge
A secured transaction in which
a debtor gives collateral to the
secured party.
540 U N I T 3 Commercial Transactions
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MANDATORY POSSESSION
A party must perfect a security interest in money by taking possession.15 Money is easy to
transfer, and one $100 bill is the same as another, so only possession will do. Suppose Ed’s
Real Estate claims that Jennifer, a former employee, has opened her own realty business in
violation of their noncompete agreement. Jennifer promises to move her business to another
city within 90 days, and Ed agrees not to sue. To secure Jennifer’s promise to move, Ed
takes a security interest in $50,000 cash. If she fails to move on time, he is entitled to the
money. To perfect that interest, Ed must take possession of the money and hold it until
Jennifer is out of town.
CONTROL
A security interest in investment property, deposit accounts, letter-of-credit rights, and
electronic chattel paper may be perfected by control.16 We have described control above,
in the section on attachment. In general, control means that the secured party has certain exclusive
rights to dispose of the collateral. Recall, for example, that a secured party which is a bank has
control of any deposit account located in that bank.
Mandatory Control Security interests in deposit accounts and letter-of-credit rights may
be perfected only by control.17 Once again, filing would be ineffectual with forms of collateral
so easily moved, and the UCC will grant perfection only to a secured party that has control.
CARE OF THE COLLATERAL
Possession and control give several advantages to the secured party, but also one important
duty: A secured party must use reasonable care in the custody and preservation of collateral
in her possession or control.18 If the collateral is something tangible, such as a painting, the
secured party must take reasonable steps to ensure that it is safe from harm.
What does “reasonable care” mean when the collateral is something as volatile as shares
of stock?
LAYNE V. BANK ONE
395 F.3d 271
Sixth Circuit Court of Appeals, 2005
C A S E S U M M A R Y
Facts: Charles E. Johnson was the founder and CEO of
PurchasePro.com, Inc., and Geoff Layne was its marketing
director. When their internet stock went public, both offi-
cers suddenly owned shares worth millions of dollars. To
increase his liquidity, Johnson took out a loan for $2.8
million from Bank One, and Layne borrowed $3.25 million.
Each secured the loan with shares of PurchasePro stock.
The loan agreement required a loan-to-value (LTV)
ratio of 50 percent, meaning that the value of the shares
had to be at least double the outstanding loan balance. If
the value of the shares sank below the required level, the
two men could either pay off some of the loan or offer
additional security. If the two borrowers failed to remedy
the problem, the bank was entitled (but not obligated) to
sell the shares. Johnson secured his loan with $6.9 million
worth of PurchasePro stock.
In February, internet stocks suddenly plummeted,
and both loans immediately exceeded their LTV ratio.
15UCC §9-312(b)(3).
16UCC §9-314(a).
17UCC §9-312(b)(1).
18UCC §9-207.
CHAPTER 23 Secured Transactions 541
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23-3d Perfection of Consumer Goods
The UCC gives special treatment to security interests in most consumer goods. Merchants
sell a vast amount of consumer goods on credit. They cannot file a financing statement
for every bed, television, and stereo for which a consumer owes money. Yet perfecting
by possession is also impossible since the consumer expects to take the goods home.
To understand the UCC’s treatment of these transactions, we need to know two
terms. The first is consumer goods, which as we saw earlier means goods used primarily
for personal, family, or household purposes. The second term is purchase money security
interest.
A purchase money security interest (PMSI) is one taken by the person who sells the
collateral or by the person who advances money so the debtor can buy the collateral.19
Assume the Gobroke Home Center sells Marion a $5,000 stereo system. The sales
document requires a payment of $500 down and $50 per month for the next three
centuries, and gives Gobroke a security interest in the system. Because the security
interest was “taken by the seller,” the document is a PMSI. It would also be a PMSI if
a bank had loaned Marion the money to buy the system and the document gave the
bank a security interest.
But aren’t all security interests PMSIs? No, many are not. Suppose a bank loans a retail
company $800,000 and takes a security interest in the store’s present inventory. That is not
a PMSI since the store did not use the $800,000 to purchase the collateral.
What must Gobroke Home Center do to perfect its security interest? Nothing. A PMSI
in consumer goods perfects automatically, without filing.20Marion’s new stereo is clearly
consumer goods because she will use it only in her home. Gobroke’s security interest is a
PMSI, so the interest has perfected automatically. (See Exhibit 23.3.)
Johnson and Layne spoke with the bank several times,
stating that they would offer additional collateral. During
March and April, more calls went back and forth, with the
debtors occasionally suggesting that the collateral be sold,
while at other times agreeing to provide more security.
Finally, in July, over a four-day period, the bank sold
Johnson’s PurchasePro shares for $524,757, less than 10
percent of its original worth.
Johnson and Layne both filed suit against Bank One,
claiming that it failed to exercise reasonable care of the
collateral. The trial court gave judgment for the bank, and
the plaintiffs appealed.
Issue: Did the bank exercise reasonable care of the shares?
Decision: Yes, the bank exercised reasonable care.
Judgment affirmed.
Reasoning: A secured party must take reasonable care to
preserve the value of collateral such as stock. However, the
comment to §9-207 states that the secured party is not liable
for a drop in the value of pledged instruments, including
shares, even if timely action might have prevented the
decline. It is the borrower who decides to buy stock, not
the lender. A secured party merely accepts the shares as
collateral, and it does not itself invest in the issuing firm.
The stock market is notoriously volatile. Requiring a
secured party to sell shares held as collateral to avoid losses
would shift the investment risk from borrower to lender.
If the borrower is concerned with the decline in share
value, it is his responsibility to act, using other assets to
reduce the outstanding loan, substituting different collat-
eral for the stock, or selling the pledged shares himself
and paying off the loan.
19UCC §9-103.
20UCC §9-309(1).
Purchase money security
interest (PMSI)
An interest taken by the person
who sells the collateral or
advances money so the debtor
can buy it.
542 U N I T 3 Commercial Transactions
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THE STORE
1
$2
The Store
The Store
Consumer
Consumer
PMSI
PMSI
iPod Player
iPod Player
Pays money
Loans
money
Sells
Sells
Bank
THE STORE
$
©
C
en
g
ag
e
Le
ar
n
in
g
EXHIB IT 23.3 A purchase money security interest can arise in either of two ways. In the first example, a store
sells a stereo to a consumer on credit; the consumer in turn signs a PMSI, giving the store a
security interest in the stereo. In the second example, the consumer buys the stereo with money
loaned from a bank; the consumer signs a PMSI giving the bank a security interest in the stereo.
CHAPTER 23 Secured Transactions 543
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

EXAM Strategy
Question: Winona owns a tropical fish store. To buy a spectacular new aquarium,
she borrows $25,000 from her sister, Pauline, and signs an agreement giving Pauline a
security interest in the tank. Pauline never files the security agreement. Winona’s
business goes belly up, and both Pauline and other creditors angle to repossess the
tank. Does Pauline have a perfected interest in the tank?
Strategy: Generally, a creditor obtains a perfected security interest by filing or
possession. However, a PMSI in consumer goods perfects automatically, without
filing. Was Pauline’s security agreement a PMSI? Was the fish tank a consumer good?
Result: A PMSI is one taken by the person who sells the collateral or advances
money for its purchase. Pauline advanced the money for Winona to buy the tank, so
Pauline does have a PMSI, but she has a problem, because PMSIs perfect
automatically only for consumer goods. Consumer goods are those used primarily for
personal, family, or household purposes, and so this was not a consumer purchase.
Pauline failed to perfect and is unprotected against other creditors.
23-3e Perfection of Movable Collateral and Fixtures
The rules for perfection are slightly different for security interests in movable goods, such as
cars and boats, and in fixtures. We look briefly at each.
MOVABLE GOODS GENERALLY
Goods that are easily moved create problems for creditors. Suppose a bank in Colorado loans
Dorothy money, takes a security interest in her Degas sculpture, and perfects its interest in
the proper state offices in Colorado. But then Dorothy moves to Ohio and uses the same
collateral for another loan. A lender in Ohio will never discover the security interest
perfected in Colorado. If Dorothy defaults, who gets the sculpture?
For most collateral, when the debtor moves to a new state, a security interest from the old
state remains perfected for four months; when the collateral is transferred to a new state, the
security interest remains perfected for one year.21 If the secured party reperfects in the new
state within the time limits mentioned, the security interest remains valid until it would
normally expire. If the secured party fails to re-perfect in the new state, the security interest
lapses. Suppose Dorothy takes her Degas into Ohio on February 10 and on March 5 uses it
as collateral for a new loan. The original Colorado bank still has a valid security interest in
the sculpture and may seize the art if Dorothy defaults. But if Dorothy applies for her new
loan on October 10, and the Colorado bank has failed to re-perfect, the Colorado bank has
lost its protection.
MOTOR VEHICLES AND THE LIKE
The UCC’s provisions about perfecting generally do not apply to motor vehicles, trailers,
mobile homes, boats, or farm tractors.22 Because all of these are so numerous and so mobile,
filing may be ineffective and possession is impossible. As a result, almost all states have
created special laws to deal with this problem. Anyone offering or taking a security interest
in any of these goods must consult local law.
21UCC §9-316(a).
22UCC §9-311(a)(2).
544 U N I T 3 Commercial Transactions
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State title laws generally require that a security interest in an automobile be noted
directly on the vehicle’s certificate of title. A driver needs a certificate of title to obtain
registration plates, so the law presumes that the certificate will stay with the car. By
requiring that the security interest be noted on the certificate, the law gives the best
possible notice to anyone thinking of buying the car or accepting it as collateral. Generally,
if a buyer or lender examines the certificate and finds no security interest, he may accept the
vehicle for sale, or as collateral, and take it free of any interest. In most states, the same
requirement applies to boats.
FIXTURES
Fixtures, you recall, are goods that have become attached to real estate. A security interest
may be created in goods that are fixtures and may continue in goods that become fixtures;
however, the UCC does not permit a security interest in ordinary building materials, such as
lumber and concrete, once they become part of a construction project.
The primary disputes in these cases are between a creditor holding a security interest in
a fixture, such as a furnace, and another creditor with rights in the real estate, such as a bank
holding a mortgage on the house. The issues are complex, involving local real property law,
and we cannot undertake here a thorough explanation of them. However, we can highlight
the issues that arise so that you can anticipate the potential problems. Common disputes
concern:
• The status of the personal property when the security interest was created (was it still
goods, or had it already been attached to real estate and become a fixture?);
• The status of the real estate (does the debtor also have a legal interest in the real
property?);
• The type of perfection (which was recorded first, the security interest in the fixture or
the real estate? does the secured party hold a PMSI?); and
• The physical status of the fixture (can it be removed without damaging the real
estate?).23
Any creditor who considers accepting collateral that might become a fixture must
anticipate these problems and clarify with the debtor exactly what she plans to do with
the goods. Armed with that information, the creditor should consult local law on fixtures and
make an appropriate security agreement (or just refuse to accept the fixture as collateral).
23-4 PROTECTION OF BUYERS
Generally, once a security interest is perfected, it remains effective regardless of whether the
collateral is sold, exchanged, or transferred in some other way. Bubba’s Bus Co. needs
money to meet its payroll, so it borrows $150,000 from Francine’s Finance Co., which takes
a security interest in Bubba’s 180 buses and perfects its interest. Bubba, still short of cash,
sells 30 of his buses to Antelope Transit. But even that money is not enough to keep Bubba
solvent: He defaults on his loan to Francine and goes into bankruptcy. Francine pounces on
Bubba’s buses. May she repossess the 30 that Antelope now operates? Yes. The security
interest continued in the buses even after Antelope purchased them, and Francine can
whisk them away. (Antelope has a valid claim against Bubba for the value of the buses, but
the claim may prove fruitless, since Bubba is now bankrupt.)
23UCC §9-334.
CHAPTER 23 Secured Transactions 545
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There are some exceptions to this rule. The Code gives a few kinds of buyers special
protection.
23-4a Buyers in Ordinary Course of Business
As we saw in Chapter 20, a buyer in ordinary course of business (BIOC) is someone who
buys goods in good faith from a seller who routinely deals in such goods.24 For example,
Plato’s Garden Supply purchases 500 hemlocks from Socrates’ Farm, a grower. Plato is a
BIOC: He is buying in good faith, and Socrates routinely deals in hemlocks. This is an
important status because a BIOC is generally not affected by security interests in the goods.
However, if Plato actually realized that the sale violated another party’s rights in the goods,
there would be no good faith. If Plato knew that Socrates was bankrupt and had agreed with
a creditor not to sell any of his inventory, Plato would not achieve BIOC status.
A buyer in ordinary course of business takes the goods free of a security interest created
by its seller even though the security interest is perfected.25 Suppose that, a month before
Plato made his purchase, Socrates borrowed $200,000 from the Athenian Bank. Athenian
took a security interest in all of Socrates’ trees and perfected by filing. Then Plato
purchased his 500 hemlocks. If Socrates defaults on the loan, Athenian will have no right
to repossess the 500 trees that are now at the Garden Supply. Plato took them free and clear.
(Of course, Athenian can still attempt to repossess other trees from Socrates.)
The BIOC exception is designed to encourage ordinary commerce. A buyer making
routine purchases should not be forced to perform a financing check before buying. But the
rule, efficient though it may be, creates its own problems. A creditor may extend a large sum
of money to a merchant based on collateral, such as inventory, only to discover that by the
time the merchant defaults the collateral has been sold to BIOCs.
EXAM Strategy
Question: Troy owns an art gallery specializing in Greek artifacts. To modernize the
gallery, Troy borrows $150,000 from the Sparta Bank, which takes a security interest
in his entire inventory. Sparta promptly perfects. A month later, Troy sells Helen an
Athenian warrior’s helmet for $675,000. Helen does not bother to perform a financing
check, and she is unaware of Sparta’s security interest. Troy soon goes bankrupt, and
Sparta attempts to seize all of the inventory, including the helmet. Sparta proves that
a routine financing check would have revealed its interest. Who wins the helmet?
Strategy: A creditor perfects a security interest to ensure that it is protected against
the entire world. However, exceptions leave the secured party unprotected in certain
cases, including those of consumers. Analyze this case using that exception.
Result: A BIOC takes the goods free of a security interest created by his seller.
Helen acted in good faith, buying from a dealer who routinely dealt in such goods.
And it was Troy, Helen’s seller, who created the security interest. Helen takes the
helmet free of the bank’s security interest, despite the fact that it was perfected.
24UCC §1-201(9).
25UCC §9-320(a). In fact, the buyer takes free of the security interest even if the buyer knew of it. Yet a
BIOC, by definition, must be acting in good faith. Is this a contradiction? No. Plato might know that a
third party has a security interest in Socrates’ crops yet not realize that his purchase violates the third
party’s rights. Generally, for example, a security interest will permit a retailer to sell consumer goods,
the presumption being that part of the proceeds will go to the secured party. A BIOC cannot be
expected to determine what a retailer plans to do with the money he is paid.
Buyer in ordinary course of
business (BIOC)
Someone who buys goods in
good faith from a seller who
routinely deals in such goods.
546 U N I T 3 Commercial Transactions
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Because the BIOC exception undercuts the basic protection given to a secured party,
the courts interpret it narrowly. BIOC status is available only if the seller created the security
interest. Oftentimes, a buyer will purchase goods that have a security interest created by
someone other than the seller. If that happens, the buyer is not a BIOC. However, should
that rule be strictly enforced even when the results are harsh? You make the call.
23-4b Buyers of Consumer Goods
Another exception exists to protect buyers of consumer goods who do not realize that the
item they are buying has a security interest in it. This exception tends to apply to relatively
casual purchases, such as those between friends. Typically, the pattern is that one purchaser
buys consumer goods on credit and then resells. The original purchaser is considered a
debtor-seller since she still owes money but is now selling to a second buyer. In the case of
consumer goods purchased from a debtor-seller, a buyer takes free of a security interest if he
You Be the Judge
Facts: Lila Williams pur-
chased a new Roadtrek 200
motor home from New
World R.V., Inc. She paid
about $14,000 down and
financed $63,000, giving a
security interest to New
World. The RV company assigned its security interest to
Conseco Finance, which perfected. Two years later, Williams
returned the vehicle to New World (the record does not
indicate why), and New World sold the RV to Robert and
Ann Lee for $42,800. A year later, Williams defaulted on her
payments to Conseco.
The Lees sued Conseco, claiming to be BIOCs and
asking for a court declaration that they had sole title to the
Roadtrek. Conseco counterclaimed, seeking title based on its
perfected security interest. The trial court ruled that the Lees
wereBIOCs,with full rights to thevehicle.Conseco appealed.
You Be the Judge: Were the Lees BIOCs?
Argument for Conseco: Under UCC §9-319, a buyer in
ordinary course takes free of a security interest created by
the buyer’s seller. The buyers were the Lees. The seller was
New World. New World did not create the security inter-
est—Lila Williams did. There is no security interest cre-
ated by New World. The security interest held by Con-
seco was created by someone else (Williams) and is not
affected by the Lees’ status as BIOC. The law is clear and
Conseco is entitled to the Roadtrek.
Argument for the Lees: Conseco weaves a clever
argument, but let’s look at what they are really saying.
Two honest buyers, acting in perfect good faith, can
walk into an RV dealer-
ship, spend $42,000 for
a used vehicle, and end
up with—nothing. Con-
seco claims it is entitled
to an RV that the Lees
paid for because some-
one that the Lees have never dealt with, never even
heard of, gave to this RV seller a security interest which
the seller, years earlier, passed on to a finance company.
Conseco’s argument defies common sense and the goals
of Article 9.
Rebuttal from Conseco: The best part of the Lees’
argument is the emotional appeal; the worst part is that
it does not reflect the law. Yes, $42,000 is a lot of money.
That is why a reasonable buyer is careful to do business
with conscientious, ethical sellers. New World knew that
Williams financed the RV and knew who held the security
interest, but never bothered to check on the status of the
payments. If the Lees have suffered wrongdoing, it is at
the hands of an irresponsible seller—the company they
chose to work with, the company from whom they must
seek relief.
Rebuttal from the Lees: The purpose of the UCC is to
make dealing fair and commerce work; one of its methods
is to get away from obscure, technical arguments. Con-
seco’s suggestion would demolish the used-car industry.
What buyers will ever pay serious money—any money—
for a used vehicle, knowing that thousands of dollars later,
the car might be towed out of their driveway by a finance
company they never heard of?
CONSECO FINANCE SERVICING
CORP. V. LEE
2004 WL 1243417
Court of Appeals of Texas, 2004
CHAPTER 23 Secured Transactions 547
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is not aware of the security interest, he pays value for the goods, he is buying for his own
family or household use, and the second party has not yet filed a financing statement.26
Here is how this exception works. Charles Lau used a Sears credit card to buy a
46-inch TV, a sleeper sofa, love seat, entertainment center, diamond ring, gold chain, and
microwave. He had the items delivered to the house of his girlfriend, Teresa Rierman,
because he did not want his father to know he had been using the credit card (we cannot
imagine why). Lau later sold the items to Rierman’s family and then (wait for it) defaulted
on his payments to Sears and declared bankruptcy. Sears attempted to repossess its
merchandise, but the Riermans claimed they were innocent buyers. The court ruled that
if the Riermans could show that they knew nothing about Sears’s security interest in the
goods, they could keep the goods.27
This rule may be confusing because earlier, we discussed the automatic perfection of a
security interest in consumer goods. When Sears sold the merchandise to Lau, it took a
purchase money security interest in consumer goods. That interest perfected automatically
(without filing) and was valid against almost everyone. Suppose Lau had used the furniture
as collateral to obtain a bank loan. Sears would have retained its perfected security interest
in the goods, and when Lau defaulted, Sears could have repossessed everything, leaving the
bank with no collateral and no money.
The one person that Sears’s perfect security interest could not defeat, however,
was a buyer purchasing for personal use without knowledge of the security interest—in other
words, the Riermans. Assuming the Riermans knew nothing of the security interest,
they win. If Sears considers this type of loss important, it must, in the future, protect
itself by filing a financing statement. Taking this extra step will leave Sears protected
against everyone. Then, if a buyer defaults, Sears can pull the sofa out from under any
purchaser.
23-4c Buyers of Chattel Paper, Instruments,
and Documents
We have seen that debtors often use chattel paper, instruments, or documents as collateral.
Because each of these is so easily transferred, Article 9 gives buyers special protection. A
buyer who purchases chattel paper or an instrument in the ordinary course of her business
and then takes possession generally takes free of any security interest.28
Suppose Tele-Maker sells 500 televisions to Retailer on credit, keeping a security
interest in the televisions and the proceeds. The proceeds are any money or paper that
Retailer earns from selling the sets. Retailer sells 300 of the sets to customers, most of
whom pay on credit. The customers sign chattel paper, promising to pay for the sets over
time (and giving Retailer a security interest in the sets). All of this chattel paper is
proceeds, so Tele-Maker has a perfected security interest in it. The chattel paper is worth
about $150,000 if all of the customers pay in full. But Retailer wants money now, so
Retailer sells its chattel paper to Financer, who pays $120,000 cash for it. Next, Retailer
defaults on its obligation to pay Tele-Maker for the sets. Tele-Maker cannot repossess the
televisions because each customer was a BIOC (buyer in ordinary course of business) and
took the goods free of any security interest. So Tele-Maker attempts to repossess the
chattel paper. Will it succeed? No. The buyer of chattel paper takes it free of a perfected
security interest. See Exhibit 23.4.
26UCC §9-320.
27In re Lau, 140 B.R. 172, 1992 Bankr. LEXIS 671 (N.D. Ohio 1992).
28UCC §9-330(a)(b)(d).
548 U N I T 3 Commercial Transactions
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OTHER PAPER
Similar rules apply for holders in due course of instruments and for purchasers of securities
and documents of title. Those parties obtain special rights, described in Articles 3, 7, and 8
of the UCC. The details of those rules are beyond the scope of this chapter, but once again,
the lesson for any lender is simple: A security interest is safest when the collateral is in your
vault. If you do not take possession of the paper, you may lose it to an innocent buyer.29
23-4d Liens
Law student Paul King got a costly lesson when his $28.09 check for an oil change bounced
and the repo man snatched his prized Corvette. The bill for the car’s return: $644. King was
a third-year law student, working part time in a private firm in Houston. He had just walked
in from lunch when coworkers told him his car was being towed.
$$
2
1
3
3
4
4
5
CHATTEL
All Chattel
Paper
Retailer
500
Tele-Maker
Cash
Financer
4
Chattel
Paper
Chattel
Paper
SellsSells
STORE
Consumer #1 Consumer #300
Contrac
t
Security
Agreement
for the Televisions
and Proceeds
©
C
en
g
ag
e
Le
ar
n
in
g
EXHIB IT 23.4 The buyer of chattel paper takes it free of a perfected security interest. In this case,
Tele-Maker (1) sells 500 units to Retailer on credit, keeping (2) a security interest in the
televisions and the proceeds. Retailer (3) sells the sets to customers who (4) sign chattel
paper. Retailer (5) sells the chattel paper to Financer and then defaults on its obligations
to Tele-Maker.
29UCC §9-331.
CHAPTER 23 Secured Transactions 549
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

“I thought they were joking,” King said. They were not. King saw a tow truck backing
up to his car and hurried out to speak with the workers. They advised him that Texas law
authorized them to pick up his car to satisfy a lien for work done to the car. King hurried
inside to telephone the company that had performed the oil change. Unable to make a deal
on the phone, he ran back outside and found—no car.
King phoned Harris County Repossession to see about getting his car back. That’s easy,
they told him. But you owe some fees: $28.09 for the oil change, $20 for the returned check,
$25 for the legal notice in the newspapers, $21.24 per day for storage—plus, of course, the
$550 repossession fee.30
Is that legal? Probably. The service station had a lien on the car. A lien is a security
interest created by law (rather than by agreement). State and federal law both allow parties
to assert a lien against a debtor under prescribed conditions. For example, a state may claim
a lien based on unpaid taxes; the state is giving notice to the world that it may seize the
debtor’s property and sell it. A company may claim a lien based on work performed by the
debtor.
To understand the difference between a lien and a security interest, assume that when
Paul King bought his Corvette, he made a down payment and signed a security agreement
to ensure future payments. His agreement gave the dealer a security interest in the sports car.
Later, when he paid for an oil change, his check bounced. State law gave the service station
a lien on the auto, meaning the right to hold the car if it is in the garage and to seize the auto
if it is elsewhere. Because automobile repossessions provide such a graphic view of secured
transactions, we will return to the subject later in the chapter. In this case, the oil company
had an artisan’s lien, meaning a security interest in personal property created when a worker
makes some improvement to the property. A car mechanic, a computer repairman, and a
furniture restorer all create artisan’s liens. A mechanic’s lien is similar and is created when a
worker improves real property. A carpenter who puts an addition on a kitchen and a painter
who paints the kitchen’s interior both have a mechanic’s lien on the house. The owner of an
apartment may obtain a landlord’s lien in a tenant’s personal property if the tenant fails to
pay the rent. These security interests vary from state to state, so an affected person must
consult local law. Because liens are the creation of statutes rather than agreements, Article 9
generally does not apply. The one aspect of liens that Article 9 does govern is priority
between lienholders and other secured parties, which we examine in the following section.
In Paul King’s case, the repair shop certainly had a valid lien on his car, even though the
amount in question was small. The company’s method of collecting on its lien is more
debatable. King admitted that the company had telephoned him and given him a chance
to pay for the bounced check. Some courts would hold that the repair shop had done all it
was required to do, but others might rule that it should have shown more patience and
avoided running up the bill.
23-5 PRIORITIES AMONG CREDITORS
What happens when two creditors have a security interest in the same collateral? The party
who has priority in the collateral gets it. Typically, the debtor lacks assets to pay everyone,
so all creditors struggle to be the first in line. After the first creditor has repossessed the
collateral, sold it, and taken enough of the proceeds to pay off his debt, there may be
nothing left for anyone else. Who gets priority? There are three principal rules.
30Rad Sallee and James T. Campbell, “Repo Men Hitch Up Big Fee to Car,” Houston Chronicle,
October 15, 1991, §A, p. 21. Copyright 1991 Houston Chronicle Publishing Company. Reproduced
with permission of Houston Chronicle Publishing Company via Copyright Clearance Center.
Lien
A security interest created by
law, rather than by agreement.
Artisan’s lien
A security interest in personal
property.
Mechanic’s lien
A security created when a
worker improves real property.
Landlord’s lien
A security interest created by
law to secure the payment of
rent.
550 U N I T 3 Commercial Transactions
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

The first rule is easy: A party with a perfected security interest takes priority over a party
with an unperfected interest.31 This, of course, is the whole point of perfecting: to ensure
that your security interest gets priority over everyone else’s. On August 15, Meredith’s
Market, an antique store, borrows $100,000 from the Happy Bank, which takes a security
interest in all of Meredith’s inventory. Happy Bank does not perfect. On September 15,
Meredith uses the same collateral to borrow $50,000 from the Suspicion Bank, which files a
financing statement the same day. On October 15, as if on cue, Meredith files for bank-
ruptcy and stops paying both creditors. Suspicion wins because it holds a perfected interest,
whereas the Happy Bank holds merely an unperfected interest.
The second rule: If neither secured party has perfected, the first interest to attach gets
priority.32 Suppose that Suspicion Bank and Happy Bank had both failed to perfect. In that
case, Happy Bank would have the first claim to Meredith’s inventory since Happy’s interest
attached first.
And the third rule follows logically: Between perfected security interests, the first to file
or perfect wins.33 Diminishing Perspective, a railroad, borrows $75 million from the First
Bank, which takes a security interest in Diminishing’s railroad cars and immediately perfects
by filing. Two months later, Diminishing borrows $100 million from Second Bank, which
takes a security interest in the same collateral and also files. When Diminishing arrives, on
schedule, in bankruptcy court, both banks will race to seize the rolling stock. First Bank gets
the railcars because it perfected first.
March 1: April 2: May 3: The Winner:
First Bank loans money
and perfects its security
interest by filing a
financing statement.
Second Bank loans
money and perfects its
security interest by filing
a financing statement.
Diminishing
goes bankrupt,
and both banks
attempt to take
the rolling stock.
First Bank,
because it
perfected first.
The general rules of priority are quite straightforward; however, you will not be
surprised to learn that there are some exceptions.
23-5a Filing versus Control or Possession
Recall that a secured party may use either filing or control to perfect its security interest in
deposit accounts, investment property, and letter-of-credit rights. Which method should the
secured party use? Control. For these three types of collateral, a secured party who has
control wins over a party who merely filed.34 Early Bank obtains a security interest in
Lionel’s investment property and perfects by filing. Nine months later, Late Bank obtains a
security interest in the same property and perfects by taking control. Late Bank wins.
Similarly, a secured party may perfect its interest in an instrument either by filing or
possession. Once again, possession is the better idea: Between competing secured parties,
the one who possesses wins, even over one who filed earlier.35
31UCC §9-322(a)(2).
32UCC §9-322(a)(3).
33UCC §9-322(a)(1).
34UCC §§9-327, 9-328, 9-329. If more than one creditor has control of the same collateral, the security
interests rank according to the time of obtaining control.
35UCC §9-330(d).
CHAPTER 23 Secured Transactions 551
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23-5b Priority Involving a Purchase Money
Security Interest
You may recall that a purchase money security interest (PMSI) is a security interest taken by
the seller of the collateral or by a lender whose loan enables the debtor to buy the collateral.
A PMSI can be created only in goods, fixtures, and software. On November 1, Manufacturer
sells a specially built lathe to Tool Shop for $80,000 and takes a security interest in the
lathe. The parties have created a PMSI. Parties holding a PMSI often take priority over
other perfected security interests in the same goods, even if the other security interest was
perfected first. How can the conflict arise? Suppose that on February 1, Tool Shop had
borrowed $100,000 from the Gargoyle Bank, giving Gargoyle a security interest in after-
acquired property. When the lathe arrives at the Tool Shop on November 1, Gargoyle’s
security interest attaches to it. But Manufacturer has a PMSI in the lathe, hence the conflict.
We need to examine PMSIs involving inventory and those involving noninventory. Inventory
means goods that the seller is holding for sale or lease in the ordinary course of its business. The
furniture ina furniture store is inventory; thestore’s computer, telephones, andfilingcabinetsarenot.
PMSI IN INVENTORY
A PMSI in inventory takes priority over a conflicting perfected security interest (even one
perfected earlier), if two conditions are met:
• Before filing its PMSI, the secured party must check for earlier security interests and,
if there are any, must notify the holder of that interest concerning the new PMSI; and
• The secured party must then perfect its PMSI (normally by filing) before the debtor
receives the inventory.36
If the holder of the PMSI has met both of these conditions, its PMSI takes priority over
any security interests filed earlier, as illustrated in the following chart.
1. February 1: 2. March 2: 3. March 3: 4. March 4:
Coltrane Bank loans
Monk’s Jazz Store
$90,000, taking a
security interest in all
after-acquired
property, including
inventory.
Monk offers to
buy 10
saxophones
from Webster’s
Supply for
$3,000 each.
Webster checks
the financing
records and learns
that Coltrane Bank
has a security
interest in all of
Monk’s after-
acquired property.
Webster notifies
Coltrane Bank that he
is selling 10
saxophones to Monk
for $30,000 and is
taking a PMSI in the
instruments, which
Webster carefully
describes.
5. March 4: 6. March 5: 7. September: 8. The Winner:
Webster files a
financing statement
indicating a PMSI in
the 10 saxophones.
Webster sells
the 10
saxophones to
Monk.
Monk goes
bankrupt.
Webster. His PMSI in
inventory takes
priority over
Coltrane’s earlier
interest.
PMSI IN NONINVENTORY COLLATERAL
PMSIs are often given for noninventory goods. When Tool Shop bought the lathe, in the
example above, the company gave a PMSI to the seller. The bank simultaneously obtained
a security interest in the same lathe, based on its after-acquired property interest. Who wins?
36UCC §9-324(b)(c).
Inventory
Goods that a seller is holding
for sale or lease in the ordinary
course of its business.
552 U N I T 3 Commercial Transactions
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A PMSI in collateral other than inventory takes priority over a conflicting security
interest if the PMSI is perfected at the time the debtor receives the collateral or within
20 days after he receives it.37 As long as Computer Co. perfects (by filing) within 20 days of
delivering the computer, its PMSI takes priority over the bank’s earlier security interest.
Manufacturer may repossess the machine, and the bank may never get a dime back.
Again, we must note that the PMSI exception undercuts the ability of a creditor to rely
on its perfected security interest. As a result, courts insist that a party asserting the PMSI
exception demonstrate that it has complied with every requirement. In the following case,
the creditor just got in under the wire.
23-6 DEFAULT AND TERMINATION
We have reached the end of the line. Either the debtor has defaulted or it has performed its
obligations and may terminate the security agreement.
23-6a Default
The parties define “default” in their security agreement. Generally, a debtor defaults when
he fails to make payments due or enters bankruptcy proceedings. The parties can agree that
other acts will constitute default, such as the debtor’s failure to maintain insurance on the
collateral. When a debtor defaults, the secured party has two principal options: (1) It may
IN RE ROSER
613 F.3d 1240; 2010 U.S. App. LEXIS 14817
Tenth Circuit Court of Appeals, 2010
C A S E S U M M A R Y
Facts: Robert Roser obtained a loan from Sovereign
Bank, which he promptly used to buy a car. Nineteen
days later, Sovereign filed a lien with the state of Color-
ado. The bank expected that with a perfected interest, it
would have priority over everyone else.
Unknown to Sovereign Bank, Roser had declared
bankruptcy only 12 days after he purchased the car. Later,
the bankruptcy trustee argued that he had priority over
Sovereign because the bankruptcy filing happened before
Sovereign perfected its security interest. When the court
found for the trustee, Sovereign Bank appealed.
Issue: Did Sovereign Bank, a PMSI holder, obtain priority
over the bankruptcy trustee?
Decision: Yes, the PMSI holder obtained priority.
Reasoning: On the day that Roser entered bankruptcy,
Sovereign Bank had not filed its financing statement,
which means that its security interest was not yet per-
fected. Ordinarily, a bankruptcy trustee would take prior-
ity over all security interests that are unperfected on the
day that a debtor files a bankruptcy petition. However,
there is an exception to this rule: If the creditor files a
financing statement for a PMSI within 20 days after the
debtor receives the collateral, that security interest is
deemed to have been perfected as of the date of the
debtor receives the collateral, not the day on which the
financing statement was filed. In this case, the bank filed
within that 20-day grace period, so its security interest
took priority over the bankruptcy trustee.
Reversed and remanded.
37UCC §9-324(a).
CHAPTER 23 Secured Transactions 553
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take possession of the collateral, or (2) it may file suit against the debtor for the money
owed. The secured party does not have to choose between these two remedies; it may try
one remedy, such as repossession, and if that fails, attempt the other.38
TAKING POSSESSION OF THE COLLATERAL
When the debtor defaults, the secured party may take possession of the collateral.39 How
does the secured party accomplish this? In either of two ways: The secured party may act on
its own, without any court order, and simply take the collateral, provided this can be done
without a breach of the peace. Otherwise, the secured party must file suit against the debtor and
request that the court order the debtor to deliver the collateral.
Suppose a consumer bought a refrigerator on credit and defaulted. The security agree-
ment may require the consumer to make the collateral available in a reasonable time and
manner, such as by emptying the refrigerator of all food and having it ready for a carrier to
take away. When the refrigerator is ready, the retailer can haul it away. What if the consumer
refuses to cooperate? May the retailer break into the consumer’s house to take the collateral?
No. Breaking into a house is a clear breach of the peace and violates Article 9.
Secured parties often repossess automobiles without the debtor’s cooperation. Typi-
cally, the security agreement will state that, in the event of default, the secured party has a
right to take possession of the car and drive it away. As we saw earlier, the secured party
could be the seller or it could be a mechanic with an artisan’s lien on the car.
DISPOSITION OF THE COLLATERAL
Once the secured party has obtained possession of the collateral, it has two choices. The
secured party may (1) dispose of the collateral or (2) retain the collateral as full satisfaction
of the debt.
Disposal of the Collateral A secured party may sell, lease, or otherwise dispose of the
collateral in any commercially reasonable manner.40 Typically, the secured party will sell the
collateral in either a private or a public sale. First, however, the debtor must receive
reasonable notice of the time and place of the sale so that she may bid on the collateral.
The higher the price that the secured party gets for the collateral, the lower the balance still
owed by the debtor. Giving the debtor notice of the sale and a chance to bid ensures that
the collateral will not be sold for an unreasonably low price.
Suppose Bank loans $65,000 to Farmer to purchase a tractor. While still owing $40,000,
Farmer defaults. Bank takes possession of the tractor and then notifies Farmer that it
intends to sell the tractor at an auction. Farmer has the right to attend and bid on the tractor.
When the secured party has sold the collateral, it applies the proceeds of the sale: first,
to its expenses in repossessing and selling the collateral, and second, to the debt.41 Assume
Bank sold the tractor for $35,000 and that the process of repossessing and selling the tractor
cost $5,000. Bank applies the remaining $30,000 to the debt.
Deficiency or Surplus The sale of the tractor yielded $30,000 to be applied to the
debt, which was $40,000. The disposition has left a deficiency; that is, insufficient funds to
pay off the debt. The debtor is liable for any deficiency. So the bank will sue the farmer for
the remaining $10,000. On the other hand, sometimes the sale of the collateral yields a
surplus; that is, a sum greater than the debt. In that case, the secured party must pay the
surplus to the debtor.42
38UCC §9-601(a)(b)(c).
39UCC §9-609.
40UCC §9-610.
41UCC §9-615(a).
42UCC §9-615(d).
Deficiency
Having insufficient funds to pay
off a debt.
Surplus
A sum of money greater than
the debt incurred.
554 U N I T 3 Commercial Transactions
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When a secured party disposes of collateral in a commercially unreasonable manner, then a
deficiency or surplus claim may be adjusted based on the sum that should have been
obtained.43 Suppose that Seller, who is owed $300,000, repossesses 500 bedroom sets from
a hotel and, without giving proper notice, quickly sells them for a net amount of $200,000.
Seller sues for the $100,000 deficiency. If a court determines that a properly announced sale
would have netted $250,000, Seller is only entitled to a deficiency judgment of $50,000.
Similarly, if the collateral is sold to the secured party or someone related, and the price
obtained is significantly below what would be expected, then any deficiency or surplus
must be calculated on what the sale would normally have brought. This protects the debtor
from a sale in which the secured party has followed all formalities but ended up owning the
goods for a suspiciously low price.44
Acceptance of Collateral In many cases, the secured party has the option to
satisfy the debt simply by keeping the collateral. Acceptance refers to a secured party’s
retention of the collateral as full or partial satisfaction of the debt. Partial satisfaction
means that the debtor will still owe some deficiency to the secured party. This is how
the system works.45
A secured party who wishes to accept the collateral must notify the debtor. If the debtor
agrees in an authenticated record, then the secured party may keep the collateral as full or
partial satisfaction of the debt. If the debtor does not respond within 20 days, the secured
party may still accept the collateral as full satisfaction, but not as partial satisfaction. In other
words, the debtor’s silence does not give the secured party the right to keep the goods and
still sue for more money.
Suppose the buyer of a $13 million yacht, Icarus, has defaulted, and the retailer has
repossessed the boat. The firm may decide the boat is worth more than the debt, so it
notifies the buyer that it plans to keep Icarus. If the buyer does not object, the retailer
automatically owns the boat after 20 days.
If the buyer promptly objects to acceptance, the retailer must then dispose of Icarus
as described above, typically by sale. Why would a debtor object? Because she believes
the boat is worth more than the debt. The debtor anticipates that a sale will create a
surplus.
Consumers receive additional protection. A secured party may not accept collateral that
is consumer goods if the debtor has possession of the goods or if the debtor has paid 60
percent of the purchase price. If Maud has defaulted on an oven that is in her kitchen, the
Gobroke retail store may be entitled to repossess the oven, but the company must then
dispose of the goods (sell the oven) and apply the proceeds to Maud’s debt. Similarly, if
Ernest is paying for his $10,000 television set in a “layaway” plan, with Gobroke ware-
housing the goods until the full price is paid, the store may not accept the television once
Ernest has paid $6,000. Finally, a secured party is never permitted to accept consumer
goods in partial satisfaction.46
Right of Redemption Up to the time the secured party disposes of the collateral, the
debtor has the right to redeem it, that is, to pay the full value of the debt. If the debtor
redeems, she obtains the collateral back. Sylvia borrows $25,000 from the bank and pledges
a ruby necklace as collateral. She defaults, still owing $9,000, and the bank notifies her that
it will sell the necklace. If Sylvia pays the full $9,000 before the sale occurs, plus any
expenses the bank has incurred in arranging the sale, she receives her necklace back.47
43UCC §9-626(a)(3).
44UCC §§9-615(f), 9-626(a)(5).
45UCC §9-620.
46UCC §9-620(a)(3), (e), (g).
47UCC §9-623.
Acceptance
Retention of the collateral by a
secured party as full or partial
satisfaction of a debt.
Redeem
To pay the full value of a debt to
get the collateral back.
CHAPTER 23 Secured Transactions 555
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PROCEEDING TO JUDGMENT
Occasionally, the secured party will prefer to ignore its rights in the collateral and
simply sue the debtor. A secured party may sue the debtor for the full debt.48 Why
would a creditor, having gone to so much effort to perfect its security interest, ignore
that interest and simply file a lawsuit? The collateral may have decreased in value and
be insufficient to cover the debt. Suppose a bank loaned $300,000 to a debtor to buy a
rare baseball cap worn by Babe Ruth in a World Series game. The debtor defaults,
owing $190,000. The bank discovers that the cap is now worth only $110,000. It is true
that the bank could sell the cap and sue for the deficiency. But the sale will take time,
and the outcome is uncertain. Suppose the bank knows that the debtor has recently
paid cash for a $2 million house. The bank may promptly file suit for the full $190,000.
The bank will ask the court to freeze the debtor’s bank account and legally hold the
house until the suit is resolved. The bank expects to prove the debt quickly—the loan
documents are clear, and the amount of debt is easily calculated. It will obtain its
$190,000 without ever donning the cap. Of course, the bank has the option of doing
both things simultaneously: It may slap on the cap and a lawsuit all at once.
23-6b Termination
Finally, we need to look at what happens when a debtor does not default, but pays the full
debt. (You are forgiven if you have forgotten that things sometimes work out smoothly.)
Once that happens, the secured party must complete a termination statement, a document
indicating that it no longer claims a security interest in the collateral.49
For a consumer debt, the secured party must file the termination statement in every
place that it filed a financing statement. The secured party must do this within one month
from the date the debt is fully paid, or within 20 days of a demand from the consumer,
whichever comes first. For other transactions, the secured party must, within 20 days, either
file the termination statement or send it to the secured party so that he may file it himself.
In both cases, the goal is the same: to notify all interested parties that the debt is
extinguished.
Chapter Conclusion
Secured transactions are essential to modern commerce. Billions of dollars’ worth of goods
are sold on credit annually, and creditors normally demand an assurance of payment. A
secured party that understands Article 9 and follows its provisions to the letter should be
well protected. A company that operates in ignorance of Article 9 invites disaster because
others may obtain superior rights in the goods, leaving the “secured” party with no money,
no security—and no sympathy from the courts.
EXAM REVIEW
1. ARTICLE 9 Article 9 applies to any transaction intended to create a security
interest in personal property or fixtures. (pp. 529–532)
Termination statement
A document indicating that a
secured party no longer claims
a security interest in the
collateral.
48UCC §9-601(a).
49UCC §9-513.
556 U N I T 3 Commercial Transactions
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2. ATTACHMENT Attachment means that (1) the two parties made a security
agreement and either the debtor has authenticated a security agreement describing the
collateral or the secured party has obtained possession or control; and (2) the secured
party gave value in order to get the security agreement; and (3) the debtor has rights
in the collateral. (pp. 532–536)
3. AFTER-ACQUIRED PROPERTY A security interest may attach to after-
acquired property. (p. 536)
4. PERFECTION Attachment protects against the debtor. Perfection of a security
interest protects the secured party against parties other than the debtor. (pp. 536–545)
5. FILING Filing is the most common way to perfect. For many forms of collateral, the
secured party may also perfect by obtaining either possession or control. (pp. 536–540)
6. PMSI A purchase money security interest (PMSI) is one taken by the person who
sells the collateral or advances money so the debtor can buy the collateral. (p. 542)
7. PMSI PERFECTION A PMSI in consumer goods perfects automatically, without
filing. (p. 542)
Question: John and Clara Lockovich bought a 22-foot Chaparrel Villian II boat
from Greene County Yacht Club for $32,500. They paid $6,000 cash and borrowed
the rest of the purchase price from Gallatin National Bank, which took a security
interest in the boat. Gallatin filed a financing statement in Greene County,
Pennsylvania, where the bank was located. But Pennsylvania law requires
financing statements to be filed in the county of the debtor’s residence, and the
Lockoviches lived in Allegheny County. The Lockoviches soon washed up in
bankruptcy court. Other creditors demanded that the boat be sold, claiming that
Gallatin’s security interest had been filed in the wrong place. Who wins?
Strategy: Gallatin National Bank obtained a special kind of security interest in
the boat. Identify that type of interest. What special rights does this give to the
bank? (See the “Result” at the end of this section.)
8. BIOC A buyer in ordinary course of business (BIOC) takes the goods free of a
security interest created by his seller even though the security interest is perfected.
(pp. 546–547)
9. CHATTEL PAPER A buyer who purchases chattel paper or an instrument in good
faith in the ordinary course of his business and then obtains possession or control
generally takes free of any security interest. (p. 548)
10. PRIORITY Priority among secured parties is generally as follows: (1) A party with a
perfected security interest takes priority over a party with an unperfected interest. (2)
If neither secured party has perfected, the first interest to attach gets priority. (3)
Between perfected security interests, the first to file or perfect wins. (pp. 550–553)
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Question: Barwell, Inc., sold McMann Golf Ball Co. a “preformer,” a machine
that makes golf balls, for $55,000. Barwell delivered the machine on February 20.
McMann paid $3,000 down, the remainder to be paid over several years, and
signed an agreement giving Barwell a security interest in the preformer. Barwell
did not perfect its interest. On March 1, McMann borrowed $350,000 from First of
America Bank, giving the bank a security interest in McMann’s present and after-
acquired property. First of America perfected by filing on March 2. McMann, of
course, became insolvent, and both Barwell and the bank attempted to repossess
the preformer. Who gets it?
Strategy: Two parties have a valid security interest in this machine. When that
happens, there is a three-step process to determine which party gets priority.
Apply it. (See the “Result” at the end of this section.)
11. PMSI AND PRIORITY A PMSI may take priority over a conflicting perfected
security interest (even one perfected earlier) if the holder of the PMSI meets certain
conditions. (p. 552)
12. CONTROL OR POSSESSION For deposit accounts, investment property,
letter-of-credit rights, and instruments, a secured party who obtains control or
possession takes priority over one who merely filed. (p. 551)
13. DEFAULT When the debtor defaults, the secured party may take possession of
the collateral on its own, without a court order, if it can do so without a breach of the
peace. (pp. 553–556)
14. DISPOSAL OF COLLATERAL A secured party may sell, lease, or otherwise
dispose of the collateral in any commercially reasonable way; in many cases, it may
accept the collateral in full or partial satisfaction of the debt. The secured party may
also ignore the collateral and sue the debtor for the full debt. (p. 554)
Question: Jerry Payne owed the First State Bank of Pflugerville $342,000. The
loan was secured by a 9.25-carat diamond ring. The bank claimed a default on the
loan and, without notifying Payne, sold the ring. But the proceeds did not pay off
the full debt, and the bank sued Payne for the deficiency. Is Payne liable for the
deficiency?
Strategy: A secured party may dispose of the collateral in any commercially
reasonable way. What must the secured party do to ensure commercial
reasonableness? (See the “Result” at the end of this section.)
15. TERMINATION When the debtor pays the full debt, the secured party must
complete a termination statement, notifying the public that it no longer claims a
security interest in the collateral. (p. 556)
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7. Result: Gallatin advanced the money that the Lockoviches used to buy the boat,
meaning the bank obtained a PMSI. A PMSI in consumer goods perfects auto-
matically, without filing. The boat was a consumer good. Gallatin’s security interest
perfected without any filing at all, and so the bank wins.
10. Result: This question is resolved by the first of those three steps. A party with a
perfected security interest takes priority over a party with an unperfected interest.
The bank wins because its perfected security interest takes priority over Barwell’s
unperfected interest.
14. Result: The secured party must give the debtor notice of the time and place of
the sale. This ensures that the debtor may bid on the collateral, preventing an
unreasonably low sales price. The bank failed to give such notice, and so it lost its
right to the deficiency.
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Under the UCC Secured Transactions Article, which of the
following actions will best perfect a security interest in a negotiable instrument
against any other party?
(a) Filing a security agreement
(b) Taking possession of the instrument
(c) Perfecting by attachment
(d) Obtaining a duly executed financing statement
2. CPA QUESTION Under the UCC’s Article on Secured Transactions, perfection of
a security interest by a creditor provides added protection against other parties in the
event the debtor does not pay its debts. Which of the following parties is not affected
by perfection of a security interest?
(a) Other prospective creditors of the debtor
(b) The trustee in a bankruptcy case
(c) A buyer in ordinary course of business
(d) A subsequent personal injury judgment creditor
3. CPA QUESTION Mars, Inc., manufactures and sells VCRs on credit directly to
wholesalers, retailers, and consumers. Mars can perfect its security interest in the
VCRs it sells without having to file a financing statement or take possession of the
VCRs if the sale is made to which of the following:
(a) Retailers
(b) Wholesalers that sell to distributors for resale
(c) Consumers
(d) Wholesalers that sell to buyers in ordinary course of business
CHAPTER 23 Secured Transactions 559
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4. When Michelle buys a laptop, she pays an extra fee so that the computer arrives at her
door with the latest version of Microsoft Word pre-installed. Under Article 9, the word
processing program is considered:
(a) “goods”
(b) “services”
(c) “software”
(d) none of the above
5. Alpha perfects its security interest by properly filing a financing statement on January 1, 2010.
Alpha files a continuation statement on September 1, 2014. It files another continuation
statement on September 1, 2018. When will Alpha’s financing statement expire?
(a) January 1, 2015
(b) September 1, 2019
(c) September 1, 2023
(d) Never
ESSAY QUESTIONS
1. Eugene Ables ran an excavation company. He borrowed $500,000 from the Highland Park
State Bank. Ables signed a note promising to repay the money and an agreement giving
Highland a security interest in all of his equipment, including after-acquired equipment.
Several years later, Ables agreedwith PatriciaMyers to purchase a BantamBackhoe from her
for $16,000, which hewould repay at the rate of $100 permonth, while he used themachine.
Ables later defaulted on his note to Highland, and the bank attempted to take the backhoe.
Myers and Ables contended that the bank had no right to take the backhoe. Was the
backhoe covered by Highland’s security interest? Did Ables have sufficient rights in the
backhoe for the bank’s security interest to attach?
2. The Copper King Inn, Inc., had money problems. It borrowed $62,500 from two of its
officers, Noonan and Patterson, but that did not suffice to keep the inn going. So
Noonan, on behalf of Copper King, arranged for the inn to borrow $100,000 from
Northwest Capital, an investment company that worked closely with Noonan in other
ventures. Copper King signed an agreement giving Patterson, Noonan, and
Northwest a security interest in the inn’s furniture and equipment. But the financing
statement that the parties filed made no mention of Northwest. Copper King went
bankrupt. Northwest attempted to seize assets, but other creditors objected. Is
Northwest entitled to Copper King’s furniture and equipment?
3. Sears sold a lawn tractor to Cosmo Fiscante for $1,481. Fiscante paid with his personal
credit card. Sears kept a valid security interest in the lawnmower but did not perfect.
Fiscante had the machine delivered to his business, Trackers Raceway Park, the only
place he ever used the machine. When Fiscante was unable to meet his obligations,
various creditors attempted to seize the lawnmower. Sears argued that because it had
a purchase money security interest (PMSI) in the lawnmower, its interest had
perfected automatically. Is Sears correct?
4. The state of Kentucky filed a tax lien against Panbowl Energy, claiming unpaid taxes. Six
months later,Panbowlbought apowerful drill fromWhayneSupply,making adownpayment
of $11,500 and signing a security agreement for the remaining debt of $220,000. Whayne
560 U N I T 3 Commercial Transactions
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perfected the next day. Panbowl defaulted. Whayne sold the drill for $58,000, leaving a
deficiency of just over $100,000. The state filed suit, seeking the $58,000 proceeds. The trial
court gave summary judgment to the state, andWhayne appealed. Who gets the $58,000?
5. YOU BE THE JUDGE WRITING PROBLEM Dupont Feed bought and sold
agricultural products. Dupont borrowed $300,000 from Wells Fargo Bank and gave
Wells Fargo a security interest in all inventory, including after-acquired inventory.
Wells Fargo perfected its interest by filing on June 17, 1982. Later, Dupont borrowed
$150,000 from the Rushville National Bank and used the money to buy fertilizer.
Dupont gave a PMSI to Rushville in the amount of $150,000. Rushville filed its
financing statement in February 1984 at the County Recorder’s office—the wrong
place to file a financing statement for inventory. Then Dupont took possession of the
fertilizer, and finally, in December 1984, Rushville filed correctly, with the Indiana
Secretary of State. Dupont defaulted on both loans. Rushville seized the fertilizer,
and Wells Fargo sued, claiming that it had perfected first. Rushville asserted that it
had a PMSI, which took priority over an earlier-filed security interest. Does
Rushville’s PMSI take priority over Wells Fargo? (Go slowly, the rules are very
technical.) Argument for Rushville: It is black-letter law that PMSIs take priority over
virtually everything, including interests perfected earlier. We are not fools at
Rushville: We would not loan $150,000 to buy inventory if our security interest in that
inventory was instantly inferior to someone else’s. Argument for Wells Fargo: A
PMSI in inventory gets priority only if the secured party perfects before the debtor
receives the collateral. When Dupont obtained the fertilizer, Rushville had not
perfected because it had filed in the wrong office. It only perfected long after Dupont
bought the inventory; thus, Rushville’s PMSI does not get priority.
DISCUSSION QUESTIONS
1. ETHICS The Dannemans bought a Kodak
copier worth over $40,000. Kodak arranged
financing by GECC and assigned its rights to
that company. Although the Dannemans thought
they had purchased the copier on credit, the
papers described the deal as a lease. The
Dannemans had constant problems with the
machine and stopped making payments. GECC
repossessed the machine and, without notifying
the Dannemans, sold it back to Kodak for
$12,500, leaving a deficiency of $39,927. GECC
sued the Dannemans for that amount. The
Dannemans argued that the deal was not a lease,
but a sale on credit. Why does it matter whether
the parties had a sale or a lease? Is GECC
entitled to its money? Finally, comment on the
ethics. Why did the Dannemans not understand
the papers they had signed? Who is responsible
for that? Are you satisfied with the ethical
conduct of the Dannemans? Kodak? GECC?
2. In the opening scenario, the bank demanded
$5,000 from poor Sam for his Jeep that had been
repossessed and sold to someone else. As we have
seen, Article 9 gives the bank the right to demand
this payment. But is that fair? Should Article 9
change so that a person like Sam does not have to
pay? Or is the law reasonable now?
3. After reading this chapter, will your behavior as a
consumer change? Are there any types of
transactions that you might be more inclined to
avoid?
4. After reading this chapter, will your future
behavior as a businessperson change? What
specific steps will you be most careful to take to
protect your interests?
5. A perfected security interest is far from perfect.
We examined several exceptions to normal
perfection rules involving BIOCs, consumer
goods, and so on. Are the exceptions reasonable?
Should the UCC change to give the holder of a
perfected interest absolute rights against
absolutely everyone else?
CHAPTER 23 Secured Transactions 561
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CHAPTER24
BANKRUPTCY
Three bankruptcy stories:
1. Tim’s account: “First, there was Christmas.
Was I really not going to buy my eight-
year-old the Xbox he’d been begging for?
Then my daughter’s basketball team
qualified for the nationals at Disney World.
She’s a talented player, and if she sticks
with it, maybe she’ll get a college
scholarship. The kids had never been to
Disney World. How could we say no? Then
my car died. And I didn’t get a bonus this
year. Next thing you know, we had $27,000
in credit card debt. Then we had some uninsured
medical bills. We were seriously underwater. There
was just no way we could pay all that money back.”
2. Kristen was a talented gardener and had always
loved flowers. Sometimes she did the flowers for
friends’ weddings. When the guy who owned the
local flower shop wanted to retire, it seemed a great
opportunity to buy the business. She had lots of
good ideas for improving it. First, she renovated the
space so that people could hold parties there. She
hired staff to keep the shop open longer hours. Everything went really well. Then the
recession hit, and people cut back on nonessentials like flowers. How could she pay
her loans?
3. General Motors (GM), once a symbol of American business, filed for bankruptcy in
2009. At the time, its liabilities were $90 billion more than its assets. It also had
325,000 employees and even more stakeholders: retired employees, car owners,
suppliers, investors, and communities in which it operated and its employees lived
and paid taxes. GM emerged from bankruptcy 40 days later with fewer brands,
factories, and workers, but ready to do business. The next year, the company was
profitable.
We were seriously
underwater. There was
just no way we could pay
all that money back.
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Bankruptcy law always has been and always will be controversial. Typically, in other
countries, the goal of bankruptcy law was to protect creditors and punish debtors, even
sending debtors to prison. Indeed, many of America’s first settlers fled England to escape
debtors’ prison. As if to compensate for Europe’s harsh regimes, American bankruptcy laws
were traditionally more lenient toward debtors.1
The General Motors example illustrates the good news about American bankruptcy. It is
efficient (40 days!) and effective at reviving ailing companies. Everyone—investors, employ-
ees, the country—benefits from GM’s survival. And although Kristen’s flower shop did not
survive, bankruptcy laws will protect her so that she is not afraid to try entrepreneurship again.2
New businesses fail more often than not, but they are nonetheless important engines of growth
for our country. We all benefit from the jobs they create and the taxes they pay.
Tim represents the bad news in bankruptcy laws. Unfortunately, he is often the type of
person who first comes to mind when people think about bankrupts. And people do not like
Tim very much. They think: Why should he be rewarded for his irresponsibility, when I get
stuck paying all my bills? But a more difficult bankruptcy process will probably not
discourage Tim. He is the kind of guy who cares a lot about current pleasures and little
about future pain. No matter what bankruptcy laws we have, he will not say no to Disney
World. Should the laws become too onerous, businesses will fail, entrepreneurs will be
discouraged, and the Tims of the world will continue to spend more than they should.
ButmaybeAmerica has toomuchof a good thing.This nationhas thehighest bankruptcy rate
in the world. In a recent year, there was one bankruptcy filing for every 200 Americans.3 Clearly,
bankruptcy laws play a vital role in our economy. They have the potential to resuscitate failing
companies while encouraging entrepreneurship. At the same time, it is important not to enable
irresponsible spendthrifts. Do American bankruptcy laws reach the right balance?
24-1 OVERVIEW OF THE
BANKRUPTCY CODE
The federal Bankruptcy Code (the Code) is divided into eight chapters. All chapters
except one have odd numbers. Chapters 1, 3, and 5 are administrative rules that generally
apply to all types of bankruptcy proceedings. These chapters, for example, define terms
and establish the rules of the bankruptcy court. Chapters 7, 9, 11, 12, and 13 are
substantive rules for different types of bankruptcies. All of these substantive chapters
have one of two objectives—rehabilitation or liquidation.
24-1a Rehabilitation
The objective of Chapters 11 and 13 is to rehabilitate the debtor. Many debtors can return
to financial health provided they have the time and breathing space to work out their
problems. These chapters hold creditors at bay while the debtor develops a payment plan.
In return for retaining some of their assets, debtors typically promise to pay creditors a
portion of their future earnings.
1Bankruptcy law was so important to the drafters of the Constitution that they specifically listed it as
one of the subjects that Congress had the right to regulate (Article 1, section 8).
2See, for example, Seung-Hyun Lee, Yasuhiro Yamakawa, Mike W. Peng, and Jay B. Barney, “How
do bankruptcy laws affect entrepreneurship development around the world?” in the Journal of Business
Venturing, JBV-05559, 2010.
3Some of these filings are by businesses, although that percentage is small. In the last 15 years, more
than 95 percent of all bankruptcy filings have been by consumers.
CHAPTER 24 Bankruptcy 563
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24-1b Liquidation
When debtors are unable to develop a feasible plan for rehabilitation under Chapter 11 or 13,
Chapter 7 provides for liquidation (also known as a straight bankruptcy). Most of the debtor’s
assets are distributed to creditors, but the debtor has no obligation to share future earnings.
24-1c Chapter Description
The following options are available under the Bankruptcy Code:
Number Topic Description
Chapter 7 Liquidation The bankrupt’s assets are sold to pay creditors. If the
debtor owns a business, it terminates. The creditors
have no right to the debtor’s future earnings.
Chapter 11 Reorganization This chapter is designed for businesses and wealthy
individuals. Businesses continue in operation, and
creditors receive a portion of the debtor’s current assets
and future earnings.
Chapter 13 Consumer
reorganization
Chapter 13 offers reorganization for the typical
consumer. Creditors usually receive a portion of the
individual’s current assets and future earnings.
Debtors are sometimes eligible to file under more than one chapter. No choice is
irrevocable because both debtors and creditors have the right to ask the court to convert a
case from one chapter to another at any time during the proceedings. For example, if
creditors have asked for liquidation under Chapter 7, a bankrupt consumer may request
rehabilitation under Chapter 13.
24-1d Goals
The Bankruptcy Code has three primary goals:
• To preserve as much of the debtor’s property as possible. In keeping with this goal,
the Code requires debtors to disclose all of their assets and prohibits them from
transferring assets immediately before a bankruptcy filing.
• To divide the debtor’s assets fairly between the debtor and creditors. On the one hand,
creditors are entitled to payment. On the other hand, debtors are often so deeply in
debt that full payment is virtually impossible in any reasonable period of time. The
Code tries to balance the creditors’ right to be paid with the debtors’ desire to get on
with their lives, unburdened by prior debts.
• To divide the debtor’s assets fairly among creditors. Creditors rarely receive all they are
owed, but at least they are treated fairly, according to established rules. Creditors do not
benefit from simply being the first to file or from any other gamesmanship.
24-2 CHAPTER 7 LIQUIDATION
All bankruptcy cases proceed in a roughly similar pattern, regardless of chapter. We use
Chapter 7 as a template to illustrate common features of all bankruptcy cases. Later on, the
discussions of the other chapters will indicate how they differ from Chapter 7.
Straight bankruptcy
Also known as liquidation, this
form of bankruptcy mandates
that the bankrupt’s assets be
distributed to creditors but the
debtor has no obligation to
share future earnings.
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24-2a Filing a Petition
Any individual, partnership, corporation, or other business organization that lives, conducts
business, or owns property in the United States can file under the Code. (Chapter 13,
however, is available only to individuals.) The traditional term for someone who could not
pay his debts was “bankrupt,” but the Code uses the term “debtor” instead. We use both
terms interchangeably.
A case begins with the filing of a bankruptcy petition in federal district court. The
district court typically refers bankruptcy cases to a specialized bankruptcy judge. Either
party can appeal the decision of the bankruptcy judge back to the district court and, from
there, to the federal appeals court.
Debtors may go willingly into the bankruptcy process by filing a voluntary petition, or
they may be dragged into court by creditors who file an involuntary petition. Originally, when
the goal of bankruptcy laws was to protect creditors, voluntary petitions did not exist; all
petitions were involuntary. Because the bankruptcy process is now viewed as being favorable
to debtors, the vast majority of bankruptcy filings in this country are voluntary petitions.
VOLUNTARY PETITION
Any debtor (whether a business or an individual) has the right to file for bankruptcy. It is not
necessary that the debtor’s liabilities exceed assets. Debtors sometimes file a bankruptcy
petition because cash flow is so tight they cannot pay their debts, even though they are not
technically insolvent. However, individuals must meet two requirements before filing:
• Within 180 days before the filing, an individual debtor must undergo credit
counseling with an approved agency.
• Individual debtors may only file under Chapter 7 if they earn less than the median
income in their state or they cannot afford to pay back at least $7,475 over five years.4
Generally, all other debtors must file under Chapter 11 or Chapter 13. (These
Chapters require the bankrupt to repay some debt.)
The voluntary petition must include the following documents:
Document Description
Petition Begins the case. Easy to fill out, it requires checking a few boxes and
typing in little more than name, address, and Social Security number.
List of Creditors The names and addresses of all creditors.
Schedule of Assets
and Liabilities
A list of the debtor’s assets and debts.
Claim of Exemptions A list of all assets that the debtor is entitled to keep.
Schedule of Income
and Expenditures
The debtor’s job, income, and expenses.
Statement of
Financial Affairs
A summary of the debtor’s financial history and current financial
condition. In particular, the debtor must list any recent payments to
creditors and any other property held by someone else for the debtor.
Debtor
Someone who cannot pay his
debts and files for protection
under the Bankruptcy Code.
Also known as bankrupt.
Voluntary petition
Filed by a debtor to initiate a
bankruptcy case.
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4In some circumstances, debtors with income higher than $7,475 may still be eligible to file under
Chapter 7, but the formula is highly complex and more than most readers want to know. The formula
is available at 11 USC §707(b)(2)(A). Also, you can google “bapcpa means test” and then click on the
Department of Justice website. The dollar amounts are updated every three years. You can find them
by googling “federal register bankruptcy revision of dollar amounts.”
Involuntary petition
Filed by creditors to initiate a
bankruptcy case.
CHAPTER 24 Bankruptcy 565
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INVOLUNTARY PETITION
Creditors may force a debtor into bankruptcy by filing an involuntary petition. The cred-
itors’ goal is to preserve as much of the debtor’s assets as possible and to ensure that all
creditors receive a fair share. Naturally, the Code sets strict limits—debtors cannot be forced
into bankruptcy every time they miss a credit card payment. An involuntary petition must
meet all of the following requirements:
• The debtor must owe at least $15,325 in unsecured claims to the creditors who file.5
• If the debtor has at least 12 creditors, 3 or more must sign the petition. If the debtor
has fewer than 12 creditors, any one of them may file a petition.
• The creditors must allege either that a custodian for the debtor’s property has been
appointed in the prior 120 days or that the debtor has generally not been paying debts
that are due.
What does “a custodian for the debtor’s property” mean? State laws sometimes permit
the appointment of a custodian to protect a debtor’s assets. The Code allows creditors to
pull a case out from under state law and into federal bankruptcy court by filing an
involuntary petition. In the event that a debtor objects to an involuntary petition, the
bankruptcy court must hold a trial to determine whether the creditors have met the Code’s
requirements.
Once a voluntary petition is filed or an involuntary petition approved, the bankruptcy
court issues an order for relief. This order is an official acknowledgment that the debtor is
under the jurisdiction of the court, and it is, in a sense, the start of the whole bankruptcy
process. An involuntary debtor must now make all the filings that accompany a voluntary
petition.
24-2b Trustee
The trustee is responsible for gathering the bankrupt’s assets and dividing them among
creditors. This is a critical role in a bankruptcy case. Trustees are typically lawyers or CPAs,
but any generally competent person can serve. Creditors have the right to elect the trustee,
but often they do not bother. If the creditors do not elect a trustee, then the U.S. Trustee
appoints one. Each region of the country has a U.S. Trustee selected by the U.S. attorney
general. Besides appointing trustees as necessary, this U.S. Trustee oversees the adminis-
tration of bankruptcy law in the region.
24-2c Creditors
After the court issues an order for relief, the U.S. Trustee calls a meeting of all of the
creditors. At the meeting, the bankrupt must answer (under oath) any question the creditors
pose about his financial situation. If the creditors want to elect a trustee, they do so at
this meeting.
After the meeting of creditors, unsecured creditors must submit a proof of claim. This
document is a simple form stating the name of the creditor and the amount of the claim.
The trustee and the debtor also have the right to file on behalf of a creditor. But if a claim is
Order for relief
An official acknowledgment
that a debtor is under the
jurisdiction of the bankruptcy
court.
Proof of claim
A form stating the name of an
unsecured creditor and the
amount of the claim against the
debtor.
5In Chapter 23, on secured transactions, we discuss the difference between secured and unsecured
claims at some length. A secured claim is one in which the creditor has the right to foreclose on a
specific piece of the debtor’s property (known as collateral) if the debtor fails to pay the debt when
due. For example, if Lee borrows money from GMAC Finance to buy a car, the company has the right
to repossess the car if Lee fails to repay the loan. GMAC’s loan is secured. An unsecured loan has no
collateral. If the debtor fails to repay, the creditor can make a general claim against the debtor but has
no right to foreclose on a particular item of the debtor’s property.
U.S. Trustee
Oversees the administration of
bankruptcy law in a region.
566 U N I T 3 Commercial Transactions
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not filed, the creditor loses any right to be paid. The trustee, debtor, or any creditor can
object to a claim on the grounds that the debtor does not really owe that money. The court
then holds a hearing to determine the validity of the claim.
Secured creditors do not file proofs of claim unless the claim exceeds the value of their
collateral. In this case, they are unsecured creditors for the excess amount and must file
a proof of claim for it. Suppose that Deborah borrows $750,000 from Morton in return for
a mortgage on her house. If she does not repay the debt, he can foreclose. Unfortunately,
property values plummet, and by the time Deborah files a voluntary petition in bankruptcy,
the house is worth only $500,000. Morton is a secured creditor for $500,000 and need file no
proof of claim for that amount. But he is an unsecured creditor for $250,000 and will lose his
right to this excess amount unless he files a proof of claim for it.
24-2d Automatic Stay
A fox chased by hounds has no time tomake rational long-termdecisions.What that fox needs is a
safe burrow. Similarly, it is difficult for debtors to make sound financial decisions when hounded
night and day by creditors shouting, “Pay me! Pay me!” The Code is designed to give debtors
enough breathing space to sort out their affairs sensibly. An automatic stay is a safe burrow for the
bankrupt. It goes into effect as soon as the petition is filed. An automatic stay prohibits creditors
from collecting debts that the bankrupt incurred before the petition was filed. Creditors may not
sue a bankrupt to obtain payment, normay they take other steps, outside of court, to pressure the
debtor for payment. The following case illustrates how persistent creditors can be.
JACKSON V. HOLIDAY FURNITURE
309 B.R. 33, 2004 Bankr. LEXIS 548
United States Bankruptcy Court for the Western District of Missouri, 2004
C A S E S U M M A R Y
Facts: InApril,Cora andFrank Jacksonpurchased a recliner
chair on credit from Dan Holiday Furniture. They made
payments untilNovember.Thatmonth, they filed for protec-
tion under the Bankruptcy Code. Dan Holiday received a
notice of the bankruptcy. This notice stated that the store
must stop all efforts to collect on the Jacksons’ debt.
Despite this notice, a Dan Holiday collector telephoned
the Jacksons’ house ten times between November 15 and
December 1 and left a card in their door threatening
repossession of the chair. On December 1, Frank—with-
out Cora’s knowledge—went to Dan Holiday to pay the
$230 owed for November and December. He told the
store owner about the bankruptcy filing, but allegedly
added that he and his wife wanted to continue making
payments directly to Dan Holiday.
In early January, employees at Dan Holiday learned
that Frank had died the month before. Nevertheless, after
Cora failed to make the payment for the month of January,
a collector telephoned her house twenty-six times between
January 14 and February 19. The store owner’s sister left
the following message on Cora’s answering machine:
Hello. This is Judy over at Dan Holiday Furniture. And this
is the last time I am going to call you. If you do not call me, I
will be at your house. And I expect you to call me today. If
there is a problem, I need to speak to you about it. You need
to call me. We need to get this thing going. You are a January
and February payment behind. And if you think you are
going to get away with it, you’ve got another thing coming.
When Cora returned home on February 18, she found
seven bright yellow slips of paper in her door jamb stating
that a Dan Holiday truck had stopped by to repossess her
furniture. The cards read:
OUR TRUCK was here to REPOSSESS Your furniture
[sic]. 241-6933 Dan Holiday Furn. & Appl. Co.
The threat to send a truck was merely a ruse designed
to frighten Cora. In truth, Dan Holiday did not really want
the recliner back. The owner just wanted to talk directly
with Cora about making payments.
Also on February 18, Dan Holiday sent Cora a letter
stating that she had 24 hours to bring her account current or
else “Repossession Will Be Made and Legal Action Will Be
Automatic stay
Prohibits creditors from
collecting debts that the
bankrupt incurred before the
petition was filed.
CHAPTER 24 Bankruptcy 567
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24-2e Bankruptcy Estate
The filing of the bankruptcy petition creates a new legal entity separate from the debtor—
the bankruptcy estate. All of the bankrupt’s assets pass to the estate except exempt property
and new property that the debtor acquires after the petition is filed.
EXEMPT PROPERTY
Unpaid creditors may be angry, but generally they do not want the debtor to starve to death.
The Code permits individual debtors (but not organizations) to keep some property for
themselves. This exempt property saves the debtor from destitution during the bankruptcy
process and provides the foundation for a new life once the process is over.
In this one area of bankruptcy law, the Code defers to state law. Although the Code lists
various types of exempt property, it permits states to opt out of the federal system and
define a different set of exemptions. A majority of states have indeed opted out of the Code,
and for their residents, the Code exemptions are irrelevant. Alternatively, some states allow
the debtor to choose between state or federal exemptions.
Under the federal Code, a debtor is allowed to exempt only $22,975 of the value of her
home. If the house is worth more than that, the trustee sells it and returns $22,975 of the
proceeds to the debtor. Most states exempt items such as the debtor’s home, household
goods, cars, work tools, disability and pension benefits, alimony, and health aids. Indeed,
some states set no limit on the value of exempt property. Both Florida and Texas, for
example, permit debtors to keep homes of unlimited value and a certain amount of land.
(Texas also allows debtors to hang on to two firearms; athletic and sporting equipment;
two horses, mules or donkeys and a saddle, blanket, and bridle for each; up to a total value
of $60,000 per family.) Not surprisingly, these generous exemptions sometimes lead to
abuses. Therefore, the Code provides that debtors can take advantage of state exemptions
only if they have lived in that state for two years prior to the bankruptcy. And they can
exempt only $155,675 of any house that was acquired during the 40 months before the
bankruptcy.
Taken.” That same day, Cora’s bankruptcy attorney con-
tacted Dan Holiday. Thereafter all collection activity ceased.
Issues: Did Dan Holiday violate the automatic stay
provisions of the Bankruptcy Code? What is the penalty for
a violation?
Decision: Dan Holiday was in violation of the Bank-
ruptcy Code. The court awarded the Jacksons their actual
damages, attorneys’ fees, court costs, and punitive
damages.
Reasoning: Anyone injured by a creditor who violates
the automatic stay provisions is entitled to recover
both actual damages (including court costs and attorneys’
fees) as well as punitive damages where appropriate. In
this case, the court awarded actual damages of $230,
because that is how much Dan Holiday coerced from
Frank Jackson on December 1. The Court also awarded
the Jacksons their attorneys’ fees and court costs in the
amount of $1,142.42.
In addition, the Jacksons were entitled to punitive
damages because Dan Holiday intentionally and flagrantly
violated the automatic stay provision. Dan Holiday’s conduct
was remarkably bad—employees called the Jackson house-
hold no fewer than twenty-six times in January and February.
It was not clear how much the punitive damages
should be because there was no evidence presented at
trial about how much Dan Holiday could afford. The
court was only aware that Dan Holiday was a family-
owned business that had been in existence for fifty-two
years. It seemed likely that it was a relatively small
business. Therefore, the Court assessed a penalty of
$100 for each illegal contact with the Jacksons after
December 1, when it was crystal clear that Dan Holiday
knew about the Jacksons’ bankruptcy filing. Under this
calculation, punitive damages totaled $2,800. The court
believed that this penalty would be enough to sting the
pocketbook of Dan Holiday and impress upon the company,
its owners, and employees the importance of complying with
the provisions of the Bankruptcy Code.
Bankruptcy estate
The new legal entity created
when a debtor files a
bankruptcy petition. The
debtor’s existing assets pass
into the estate.
568 U N I T 3 Commercial Transactions
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VOIDABLE PREFERENCES
A major goal of the bankruptcy system is to divide the debtor’s assets fairly among creditors.
It would not be fair, or in keeping with this goal, if debtors were permitted to pay off some
of their creditors immediately before filing a bankruptcy petition. These transfers are called
preferences because they give unfair preferential treatment to some creditors. The trustee
has the right to void such preferences.
Preferences can take two forms: payments and liens. A payment simply means that
the debtor gives a creditor cash that would otherwise end up in the bankruptcy estate.
A lien means a security interest in the debtor’s property. In bankruptcy proceedings,
secured creditors are more likely to be paid than unsecured creditors. If the debtor
grants a security interest in specific property, he vaults that creditor out of the great
unwashed mass of unsecured creditors and into the elite company of secured creditors.
If it happens immediately before the petition is filed, it is unfair to other unsecured
creditors.
The trustee can void any transfer (whether payment or lien) that meets all of the following
requirements:
• The transfer was to a creditor of the bankrupt.
• It was to pay an existing debt.
• The creditor received more from the transfer than she would have received during
the bankruptcy process.
• The debtor’s liabilities exceeded assets at the time of the transfer.
• The transfer took place in the 90-day period before the filing of the petition.
In addition, the trustee can void a transfer to an insider that occurs in the year preceding
the filing of the petition. Insiders are family members of an individual, officers and directors
of a corporation, or partners of a partnership.
FRAUDULENT TRANSFERS
Suppose that a debtor sees bankruptcy approaching across the horizon like a tornado.
He knows that, once the storm hits and he files a petition, everything he owns except a
few items of exempt property will become part of the bankruptcy estate. Before that
happens, he may be tempted to give some of his property to friends or family to shelter
it from the tornado. If he succumbs to temptation, however, he is committing a
fraudulent transfer.
A transfer is fraudulent if it is made within the year
before a petition is filed and its purpose is to hinder, delay,
or defraud creditors. The trustee can void any fraudulent
transfer. The debtor has committed a crime and may be
prosecuted.
Not all payments by a debtor prior to filing are
considered voidable preferences or fraudulent transfers. A
trustee cannot void pre-petition payments made in the
ordinary course. In a business context, that means a trustee
cannot void payments from, say, a grocery store to its
regular cookie supplier. For consumers, the trustee cannot void payments below $650 or
other routine payments, say, to the electric or water company. In these situations, the
bankrupt is clearly not trying to cheat creditors. Even the insolvent are allowed to shower
with the lights on.
Even the insolvent are
allowed to shower with
the lights on.
Preferences
When a debtor unfairly pays
creditors immediately before
filing a bankruptcy petition.
Insider
Family members of an individual
debtor, officers and directors
of a corporation, or partners of
a partnership.
CHAPTER 24 Bankruptcy 569
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EXAM Strategy
Question: Eddie and Lola appeared to be happily married. But then Eddie’s
business failed, and he owed millions. Suddenly, Lola announced that she wanted a
divorce. Eddie immediately agreed to transfer all of the couple’s remaining assets to
her as part of the divorce settlement. Are you suspicious? Is there a problem?
Strategy: Was this a voidable preference or a fraudulent transfer? What difference
does it make?
Result: In a voidable preference, the debtor makes an unfair transfer to a creditor. In
a fraudulent transfer, the bankrupt’s goal is to hold on to assets himself. In a case
similar to this one, the court ruled that the transfer was fraudulent because Eddie
intended to shield his assets from all creditors.
24-2f Payment of Claims
Imagine a crowded delicatessen on a Saturday evening. People are pushing and shoving
because they know there is not enough food for everyone; some customers will go home
hungry. The delicatessen could simply serve whoever pushes to the front of the line, or it
could establish a number system to ensure that the most deserving customers are served
first—longtime patrons or those who called ahead. The Code has, in essence, adopted a
number system to prevent a free-for-all fight over the bankrupt’s assets. Indeed, one of the
Code’s primary goals is to ensure that creditors are paid in the proper order, not according to
who pushes to the front of the line.
All claims are placed in one of three classes: (1) secured claims, (2) priority claims, and
(3) unsecured claims. The second class—priority claims—has seven subcategories; the third
class—unsecured claims—has three. The trustee pays the bankruptcy estate to the various
classes of claims in order of rank. A higher class is paid in full before the next class receives any
payment at all. In the case of priority claims, each subcategory is paid in order, with the higher
subcategory receiving full payment before the next subcategory receives anything. If there are
not enough funds to pay an entire subcategory, all claimants in that group receive a pro rata
share. The rule is different for unsecured claims. All categories of unsecured claims are treated
the same, and if there are not enough funds to pay the entire class, everyone in the class shares
pro rata. If, for example, there is only enough money to pay 10 percent of the claims owing to
unsecured creditors, then each creditor receives 10 percent of her claim. In bankruptcy
parlance, this is referred to as “getting 10 cents on the dollar.” The debtor is entitled to any
funds remaining after all claims have been paid. The payment order is shown in Exhibit 24.1.
Debtor
Secured
Claims
Priority
Claims
Unsecured
Claims
Debtor’s
Estate
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EXHIB IT 24.1 Payment Order
570 U N I T 3 Commercial Transactions
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SECURED CLAIMS
Creditors whose loans are secured by specific collateral are paid first. Secured claims are
fundamentally different from all other claims because they are paid by selling a specific
asset, not out of the general funds of the estate. Sometimes, however, collateral is not
valuable enough to pay off the entire secured debt. In this case, the creditor must wait
in line with the unsecured creditors for the balance. Deborah (whom we met earlier
in the section entitled “Creditors”) borrowed $750,000 from Morton, secured by
a mortgage on her house. By the time she files a voluntary petition, the house is
worth only $500,000. Morton is a secured creditor for $500,000 and is paid that amount
as soon as the trustee sells the house. But Morton is an unsecured creditor for $250,000
and will only receive this amount if the estate has enough funds to pay the unsecured
creditors.
PRIORITY CLAIMS
There are seven subcategories of priority claims. Each category is paid in order, with the
first group receiving full payment before the next group receives anything.
• Alimony and child support. The trustee must first pay any claims for alimony and child
support. However, if the trustee is administering assets that could pay these support
claims, then the trustee’s fees are paid first.
• Administrative expenses. These include fees to the trustee, lawyers, and accountants.
• Gap expenses. If creditors file an involuntary petition, the debtor will continue to
operate her business until the order for relief. Any expenses she incurs in the ordinary
course of her business during this so-called gap period are paid now.
• Payments to employees. The trustee now pays back wages to the debtor’s employees for
work performed during the 180 days prior to the date of the petition. The trustee,
however, can pay no more than $12,475 to each employee. Any other wages become
unsecured claims.
• Employee benefit plans. The trustee pays what the debtor owes to employee
pension, health, or life insurance plans for work performed during the 180 days
prior to the date of the petition. The total payment for wages and benefits under
this and the prior paragraph cannot exceed $12,475 times the number of
employees.
• Consumer deposits. Any individual who has put down a deposit with the bankrupt for
consumer goods is entitled to a refund of up to $2,775. If Stewart puts down a $3,000
deposit on a Miata sports car, he is entitled to a refund of $2,775 when the Trustie Car
Lot goes bankrupt.
• Taxes. The trustee pays the debtor’s income taxes for the three years prior to filing
and property taxes for one prior year.
• Intoxication injuries. The trustee next pays the claims of anyone injured by a bankrupt
who was driving a vehicle while drunk or on drugs.
UNSECURED CLAIMS
Last, and frequently very much least, the trustee pays unsecured claims. All three of these
unsecured subcategories have an equal claim and must be paid together.
• Secured claims that exceed the value of the available collateral. If funds permit, the trustee
pays Morton the $250,000 that his collateral did not cover.
Gap period
The period between the time
that a creditor files an
involuntary petition and the
court issues the order for
relief.
CHAPTER 24 Bankruptcy 571
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• Priority claims that exceed the priority limits. The trustee now pays employees, Stewart,
and the tax authorities who were not paid in full the first time around because their
claims exceeded the priority limits.
• All other unsecured claims. Unsecured creditors have now reached the delicatessen
counter. They can only hope that some food remains.
24-2g Discharge
Filing a bankruptcy petition is embarrassing, time-consuming, and disruptive. It can affect the
debtor’s credit rating for years, making the simplest car loan a challenge. To encourage
debtors to file for bankruptcy despite the pain involved, the Code offers a powerful incentive:
the fresh start. Once a bankruptcy estate has been distributed to creditors, they cannot make
a claim against the debtor for money owed before the filing, whether or not they actually received
any payment. These pre-petition debts are discharged. All is forgiven, if not forgotten.
Discharge is an essential part of bankruptcy law. Without it, debtors would have little
incentive to take part. To avoid abuses, however, the Code limits both the type of debts
that can be discharged and the circumstances under which discharge can take place. In
addition, an individual debtor must complete an approved course on financial management
before receiving a discharge.
DEBTS THAT CANNOT BE DISCHARGED
The following debts are never discharged, and the debtor remains liable in full until they are paid:
• Income taxes for the three years prior to filing and property taxes for the prior year.
• Money obtained fraudulently. Kenneth Smith ran a home repair business that fleeced
senior citizens by making unnecessary repairs. Three months after he was found
liable for fraud, he filed a voluntary petition in bankruptcy. The court held that his
liability on the fraud claim could not be discharged.6
• Any loan of more than $650 that a consumer uses to purchase luxury goods within
90 days before the order for relief is granted.
• Cash advances on a credit card totaling more than $925 that an individual debtor takes
out within 70 days before the order for relief.
• Debts omitted from the Schedule of Assets and Liabilities that the debtor filed with
the petition, if the creditor did not know about the bankruptcy and therefore did not
file a proof of claim.
• Money that the debtor stole or obtained through a violation of fiduciary duty.
• Money owed for alimony or child support.
• Debts stemming from intentional and malicious injury.
• Fines and penalties owed to the government.
• Liability for injuries caused by the debtor while operating a vehicle under the
influence of drugs or alcohol. (Yet another reason why friends don’t let friends drive
drunk.)
• Liability for breach of duty to a bank. During the 1980s, a record number of
savings and loans failed because their officers had made too many risky loans
Fresh start
After the termination of a
bankruptcy case, creditors
cannot make a claim against
the debtor for money owed
before the initial bankruptcy
petition was filed.
Discharged
The debtor no longer has an
obligation to pay a debt.
6In re Smith, 848 F.2d 813, 1988 U.S. App. LEXIS 8037 (7th Cir. 1988).
572 U N I T 3 Commercial Transactions
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(in some cases to friends and family). This provision, added to the Code in 1990,
was designed to prevent these officers from declaring bankruptcy to avoid their
liability to bank shareholders.
• Debts stemming from a violation of securities laws.
• Student loans can be discharged only if repayment would cause undue hardship. As
the following case illustrates, proving undue hardship is difficult.
IN RE STERN
288 B.R. 36; 2002 Bankr. LEXIS 1609
United States Bankruptcy Court for the Northern District of New York, 2002
C A S E S U M M A R Y
Facts: James Stern took out student loans to attend Bates
College and Syracuse College of Law. Afterwards, he had
difficulty finding a job as a lawyer, so he opened his own
practice. His annual income averaged $17,000, while his
wife’s earnings averaged $18,000.
Stern was sued for malpractice. Although he won the
case, his malpractice premiums increased so much that he
could no longer afford the insurance. Believing that his debt
and default on his student loans made him unemployable as
a lawyer, he moved with his wife to her native country,
France. Unfortunately, he did not speak French and, there-
fore, could not obtain a job, even as a street sweeper. His
wife’s total income over six months in France was $2,200.
Even more unfortunately, their expenses in France were
higher than in the United States.
After paying back $27,000, Stern still owed $147,000
in student loans: $56,000 in principal and $91,000 in
interest. Stern calculated that paying his debt would cost
$1,167 per month over 30 years. He asked the court to
discharge these student loans on grounds of undue hard-
ship. As he put it, “I’m never going to be able to get a
house, I’m never going to be able to have a car, and I
won’t you know, I want to have kids. I want to be respon-
sible, and I can’t—I can’t possibly pay this amount and
have a life, not with what I expect I’ll be able to earn.”
Issue: Is Stern entitled to a discharge of his student loans?
Decision: The court did not allow the discharge of these
loans.
Reasoning: Educational loans are different from most
business loans because they are made without security
or cosigners. The lender must rely for repayment solely
on the debtor’s income (which presumably will increase as
a result of the education). These loans are, in a sense, a
mortgage on the student’s future.
Although Stern has a J.D., he is not required
to practice law. However, he must use his education to
earn an income that will permit repayment of his loans.
Stern has not only failed to maximize his income, he
has also failed to minimize his expenses. He moved to
France where his expenses are higher, but he cannot
even get a job as a street sweeper because he does not
speak French.
Instead of repaying his loans, Stern would like to
be able to buy a house or raise children. These desires,
while understandable, do not constitute an undue hard-
ship that warrants even a partial discharge. To obtain a
discharge, Stern must prove more than his present
inability to pay his student loans. He must also show
that his current financial hardship is likely to be
long term.
While Stern and his wife have experienced some
bumps in the road, their future is under their control.
They are young and healthy and have a good educa-
tion. Indeed, the student loans permitted Stern to
obtain an education that opens job opportunities not
available to others who could not afford such an
education.
CHAPTER 24 Bankruptcy 573
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CIRCUMSTANCES THAT PREVENT DEBTS FROM BEING DISCHARGED
Apart from identifying the kinds of debts that cannot be discharged, the Code also prohibits
the discharge of debts under the following circumstances:
• Business organizations. Under Chapter 7 (but not the other Chapters), only the
debts of individuals can be discharged, not those of business organizations. Once
its assets have been distributed, the organization must cease operation. If it
continues in business, it is responsible for all pre-petition debts. Shortly after
E. G. Sprinkler Corp. entered into an agreement with its union employees, it
filed for bankruptcy under Chapter 7. Its debts were discharged, and the company
began operation again. A court ordered it to pay its obligations to the employees
because, once the company resumed business, it was responsible for all of its pre-
filing debts.7
• Revocation. A court can revoke a discharge within one year if it discovers the debtor
engaged in fraud or concealment.
• Dishonesty or bad faith behavior. The court may deny discharge altogether if the
debtor has, for example, made fraudulent transfers, hidden assets, falsified records,
disobeyed court orders, refused to testify, or otherwise acted in bad faith. For
instance, a court denied discharge under Chapter 7 to a couple who failed to list
15 pounds of marijuana on their Schedule of Assets and Liabilities. The court was
unsympathetic to their arguments that a listing of this asset might have caused larger
problems than merely being in debt.8
• Repeated filings for bankruptcy. Congress feared that some debtors, attracted by the
lure of a fresh start, would make a habit of bankruptcy. Therefore, a debtor who has
received a discharge under Chapter 7 or 11 cannot receive another discharge under
Chapter 7 for at least eight years after the prior filing. And a debtor who received a
prior discharge under Chapter 13 cannot in most cases receive one under Chapter 7
for at least six years.
Ethics Banks and credit card companies lobbied Congress hard for the prohibition
against repeated bankruptcy filings. They argued that irresponsible
consumers run up debt and then blithely walk away. You might think that, if this were true,
lenders would avoid customers with a history of bankruptcy. Research indicates, though,
that lenders actually target those consumers, repeatedly sending them offers to borrow
money. The reason is simple: These consumers are much more likely to take cash
advances, which carry very high interest rates. And this is one audience that must repay its
loans for the simple reason that these borrowers cannot obtain a discharge again anytime
soon.9 Is this strategy ethical?
7In re Goodman, 873 F.2d 598, 1989 U.S. App. LEXIS 5472 (2d Cir. 1989).
8In re Tripp, 224 B.R. 95, 1998 Bankr. LEXIS 1108 (1998).
9See Katherine M. Porter, “Bankrupt Profits: The Credit Industry’s Business Model for Postbankruptcy
Lending,” University of Iowa Legal Studies Research Paper No. 07–26, Iowa Law Review, Vol. 94, 2008.
This paper is available by googling “ssrn katherine porter bankrupt profits.”
574 U N I T 3 Commercial Transactions
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EXAM Strategy
Question: Someone stole a truck full of cigarettes. Zeke found the vehicle
abandoned at a truck stop. Not being a thoughtful fellow, he took the truck and sold it
with its cargo. Although Tobacco Company never found out who stole the truck
originally, it did discover Zeke’s role. A court ordered Zeke to pay Tobacco $50,000.
He also owed his wife $25,000 in child support. Unfortunately, he only had $20,000 in
assets. After he files for bankruptcy, who will get paid what?
Strategy: There are two issues: the order in which the debts are paid and whether
they will be discharged.
Result: Child support is a priority claim, so that will be paid first. In a similar case, the
court refused to discharge the claim over the theft of the truck, ruling that that was an
intentional and malicious injury. Nor will a court discharge the child support claim. So
Zeke will be on the hook for both debts, but the child support must be paid first.
REAFFIRMATION
Sometimes debtors are willing to reaffirm a debt, meaning they promise to pay even after
discharge. They may want to reaffirm a secured debt to avoid losing the collateral. For example,
a debtor who has taken out a loan secured by a car may reaffirm that debt so that the finance
company will not repossess it. Sometimes debtors reaffirm because they feel guilty or want to
maintain a good relationshipwith the creditor.Theymayhaveborrowed froma familymember or
an important supplier. Because discharge is a fundamental pillar of the bankruptcy process,
creditors are not permitted to unfairly pressure the bankrupt. To be valid, the reaffirmationmust:
• Not violate common law standards for fraud, duress, or unconscionability. If creditors
force a bankrupt into reaffirming a debt, the reaffirmation is invalid.
• Have been filed in court before the discharge is granted.
• Include the detailed disclosure statement required by the statute (§524).
• Be approved by the court if the debtor is not represented by an attorney or if, as a
result of the reaffirmed debt, the bankrupt’s expenses exceed his income.
In the following case, the debtor sought to reaffirm the loan on his truck. He may have
been afraid that if he did not, the lender would repossess it, leaving him stranded. It is hard
to get around Dallas without a car. Should the court permit the reaffirmation?
IN RE GRISHAM
436 B.R. 896; 2010 Bankr. LEXIS 2907
United States Bankruptcy Court for the Northern District of Texas, 2010
C A S E S U M M A R Y
Facts: William Grisham owned a Dodge truck. When he
filed for bankruptcy, the vehicle was worth $16,000, but
he owed $17,500 on it. The monthly payments were $400.
In addition, Grisham owed $200,000 in non-dischargeable
debt and $70,000 in unsecured loans.
Grisham sought to reaffirm the truck loan. Should the
court allow him to do so?
Issue: Would reaffirmation of this debt create an undue
hardship for the debtor?
Reaffirm
To promise to pay a debt even
after it is discharged.
CHAPTER 24 Bankruptcy 575
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24-3 CHAPTER 11 REORGANIZATION
For a business, the goal of a Chapter 7 bankruptcy is euthanasia—putting it out of its misery
by shutting it down and distributing its assets to creditors. Chapter 11 has a much more
complicated and ambitious goal—resuscitating a business so that it can ultimately emerge as
a viable economic concern, as General Motors did. Keeping a business in operation benefits
virtually all company stakeholders: employees, customers, creditors, shareholders, and the
community.
Both individuals and businesses can use Chapter 11. Businesses usually prefer
Chapter 11 over Chapter 7 because Chapter 11 does not require them to dissolve at the
end, as Chapter 7 does. The threat of death creates a powerful incentive to try rehabilitation
under Chapter 11. Individuals, however, tend to prefer Chapter 13 because it is easier and
cheaper for them.
A Chapter 11 proceeding follows many of the same steps as Chapter 7: a petition (either
voluntary or involuntary), order for relief, meeting of creditors, proofs of claim, and an
automatic stay. There are, however, some significant differences.
24-3a Debtor in Possession
Chapter 11 does not require a trustee. The bankrupt is called the debtor in possession and,
in essence, acts as trustee. The debtor in possession has two jobs: to operate the business
and to develop a plan of reorganization. A trustee is chosen only if the debtor is incompetent
or uncooperative. In that case, the creditors can elect the trustee, but if they do not choose
to do so, the U.S. Trustee appoints one.
24-3b Creditors’ Committee
In a Chapter 11 case, the creditors’ committee is important because typically there is no
neutral trustee to watch over their interests. The committee generally protects the interests
of its constituency and may play a role in developing the plan of reorganization. Moreover,
the Code requires the committee to communicate diligently with all creditors. The U.S.
Trustee typically appoints the seven largest unsecured creditors to the committee. How-
ever, the court may require the U.S. Trustee to appoint some small-business creditors as
well. Secured creditors do not serve because their interests require less protection. If the
debtor is a corporation, the U.S. Trustee may also appoint a committee of shareholders. The
Code refers to the claims of creditors and the interests of shareholders.
Decision: The court did not approve the reaffirmation.
Reasoning: The debtor’s expenses are $1,100 a month
higher than his income. He owns no real estate and is
living rent-free with a relative. The truck is worth less
than he owes on it. The debtor also has enormous non-
dischargeable debts. While the monthly payments on the
vehicle are not eye-popping, they are nonetheless unduly
burdensome for him.
The whole point of a bankruptcy filing is to obtain a
fresh start. It is about belt-tightening and shedding past
bad habits. Too often, bankrupts do not understand this
principle and instead want to go forward in a manner that
will impair their fresh start and perpetuate bad habits from
the past.
The court presumes that the debtor wants to reaffirm
the debt to prevent the lender from repossessing the
truck. But the debtor never explained why he especially
needed this vehicle. The time has come simply to say
“good riddance” to it.
The court will not stamp its seal of approval on the
debtor’s reaffirmation of the debt. To do so would create a
hardship on this debtor and does not otherwise seem
justified.
Debtor in possession
The debtor acts as trustee in a
Chapter 11 bankruptcy.
576 U N I T 3 Commercial Transactions
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24-3c Plan of Reorganization
Once the bankruptcy petition is filed, an automatic stay goes into effect to provide the
debtor with temporary relief from creditors. The next stage is to develop a plan of
reorganization that provides for the payment of debts and the continuation of the business.
For the first 120 days (which the court can extend up to 18 months), the debtor has the
exclusive right to propose a plan. If the debtor fails to file a plan, or if the court rejects it,
then creditors and shareholders can develop their own plan.
24-3d Confirmation of the Plan
Anyone who proposes a plan of reorganization must also prepare a disclosure statement to
be mailed out with the plan. The purpose of this statement is to provide creditors and
shareholders with enough information to make an informed judgment. The statement
describes the company’s business, explains the plan, calculates the company’s liquidation
value, and assesses the likelihood that the debtor can be rehabilitated. The court must
approve a disclosure statement before it is sent to creditors and shareholders.
All the creditors and shareholders have the right to vote on the plan of reorganization. In
preparation for the vote, each creditor and shareholder is assigned to a class. Everyone in a
class has similar claims or interests. Chapter 11 classifies claims in the same way as Chapter 7:
(1) secured claims, (2) priority claims, and (3) unsecured claims. Each secured claim is
usually in its own class because each one is secured by different collateral. Shareholders are
also divided into classes depending upon their interests. For example, holders of preferred
stock are in a different class from common shareholders.
Creditors and shareholders receive a ballot with their disclosure statement to vote for or
against the plan of reorganization. After the vote, the bankruptcy court holds a confirmation
hearing to determine whether it should accept the plan. The court will approve a plan if a
majority of each class votes in favor of it and if the “yes” votes hold at least two-thirds of the
total debt in that class.
Even if some classes vote against the plan, the court can still confirm it under what is
called a cramdown (as in “the plan is crammed down the creditors’ throats”). The court will
not impose a cramdown unless, in its view, the plan is feasible and fair. If the court rejects
the plan of reorganization, the creditors must develop a new one. In the following case, the
court did impose a cramdown.
IN RE FOX
2000 Bankr. LEXIS 1713
United States Bankruptcy Court, District of Kansas, 2000
C A S E S U M M A R Y
Facts: Donald Fox founded Midland Fumigant, Inc., a
company in the business of fumigating stored wheat, corn,
and other grain. In a prior case, a competitor, United
Phosphorus, Ltd., obtained a verdict of $2 million against
Midland and Fox for fraud.
Unable to pay the judgment, Fox filed a voluntary
petition under Chapter 11 of the Bankruptcy Code. His
plan of reorganization envisioned that he would use
revenues from Midland to pay off his creditors in full over
five years, with interest. To ensure that the plan of
reorganization was feasible, Fox hired CPA KirkW.Wiesner
to analyze Midland’s financial statements and prepare
projections of its income and expenses. Wiesner also
reviewed Midland’s operations, business, products, and
the industry. He concluded that the plan’s projections
were conservative and could easily be met.
Midland had six classes of creditors. All of the
classes accepted the plan, except the two classes in
which United was a member. The bankruptcy judge
noted that United had an incentive to oppose Midland’s
Cramdown
The bankruptcy court confirms
a plan of reorganization despite
a negative vote from one or
more classes of creditors
and/or shareholders.
CHAPTER 24 Bankruptcy 577
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24-3e Discharge
A confirmed plan of reorganization is binding on the debtor, creditors, and shareholders. The
debtor now owns the assets in the bankruptcy estate, free of all obligations except those listed in
the plan.Under a typical plan of reorganization, the debtor gives some current assets to creditors
and also promises to pay them a portion of future earnings. In contrast, the Chapter 7 debtor
typically relinquishes all assets (except exempt property) to creditors but then has no obligation
to turn over future income. Exhibit 24.2 illustrates the steps in a Chapter 11 bankruptcy.
reorganization because this industry was highly compe-
titive and, if Midland were to cease operations, United
would be able to raise its prices substantially.
Issue: Was Fox’s plan of reorganization feasible and fair?
Should the court impose a cramdown?
Decision: Fox’s plan of reorganization was feasible and
fair. The court did impose a cramdown.
Reasoning: Fox proposed a Plan that paid all creditors in
full, with interest. United, the only creditor to object, was
to be paid in full within sixteen months.
Fox’s goal under the Plan—to keep his business in
operation—is consistent with the purposes of the Code.
But the Code’s objective is also to prevent visionary plans
that promise creditors and shareholders more than the debtor
can possibly achieve. United contends that Fox’s Plan is not
feasible because its financial projections are unrealistic.
United’s fears, however, are not supported by the evidence.
An expert witness, Kirk Wiesner, analyzed Midland’s
financial statements and determined that Midland would
have sufficient income and cash flow to comply with the
Plan. The court finds Wiesner a reliable witness because
his projections in the past have been conservative.
The Plan has a reasonable chance of success and
is not likely to result in liquidation or further financial
reorganization. Moreover, the U.S. Trustee has filed
a statement in support of confirmation. Therefore,
debtor’s Plan is confirmed over the objection of United
and over the dissenting votes of two classes of creditors.
VotingPlan Discharge
Rejection
Cramdown
Acceptance
Voluntary
Petition
Involuntary
Petition
Disclosure Confirmation
©
C
en
g
ag
e
Le
ar
n
in
g
EXHIB IT 24.2 The Steps in a Chapter 11 Bankruptcy
578 U N I T 3 Commercial Transactions
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24-3f Small-Business Bankruptcy
Out of concern that the lengthy procedure in Chapter 11 was harming the creditors of
small businesses, in 2005 Congress included provisions designed to speed up the
process for businesses with less than $2 million in debt. After the order for relief, the
bankrupt has the exclusive right to file a plan for 180 days. Both a plan and a disclosure
statement must be filed within 300 days. The court must confirm or reject the plan
within 45 days after its filing. If these deadlines are not met, the case can be converted
to Chapter 7 or dismissed.
24-4 CHAPTER 13 CONSUMER
REORGANIZATIONS
The purpose of Chapter 13 is to rehabilitate an individual debtor. It is not available at all to
businesses or to individuals with more than $383,175 in unsecured debts or $1,149,525 in
secured debts. Under Chapter 13, the bankrupt consumer typically keeps most of her assets
in exchange for a promise to repay some of her debts using future income. Therefore, to be
eligible, the debtor must have a regular source of income. Individuals usually choose this
chapter because it is easier and cheaper than Chapters 7 and 11. Consequently, more money
is retained for both creditors and debtor.
As you read at the beginning of the chapter, debtors can convert from one chapter
to another as they wish. In the following case, the trustees objected to a conversion.
The case went all the way to the Supreme Court, which split 5–4. How would you have
voted?
You Be the Judge
Facts: WhenRobertMar-
rama filed a voluntary peti-
tion under Chapter 7, he
lied.Althoughhe disclosed
that he was the sole bene-
ficiary of a trust that owned
a house in Maine, he listed
its value as zero. Marrama also denied that he had transferred
any property during the prior year. Neither statement was
true: The Maine property was valuable (how many houses
are worth zero?), and he had given it for free to the trust seven
months prior to filing for bankruptcy protection.Marrama also
lied when he claimed that he was not entitled to a tax refund.
In fact, he knew that a check for $8,700 from the Internal
Revenue Service was in the mail.
Once Marrama found out that the bankruptcy trustees
were going after the Maine property, he filed a notice to
convert his Chapter 7 bankruptcy to Chapter 13. The trustee
and creditors objected.
They contended that
because Marrama had
acted in bad faith when he
tried to conceal the Maine
property from his creditors,
he should not be permitted
to convert. The bankruptcy court and the appeals court
agreed. The Supreme Court granted certiorari.
You Be The Judge: Can a bankruptcy court refuse to allow a
debtor to convert from Chapter 7 to Chapter 13?
Argument for Marrama: Under the Bankruptcy Code, a
Chapter7debtormayconvert a case,withonly tworestrictions.
First, the bankrupt can convert only once. Second, the debtor
must meet the conditions that would have been required for
him to file under the new chapter in the first place.Nothing in
the Code suggests that a bankruptcy judge has the right to
prohibit a conversion because of the debtor’s bad faith.
MARRAMA V. CITIZENS BANK
OF MASSACHUSETTS
549 U.S. 365; 127 S. Ct. 1105; 2007 U.S. LEXIS 2651
Supreme Court of the United States, 2007
CHAPTER 24 Bankruptcy 579
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EXAM Strategy
Question: Why did Marrama first file under Chapter 7 and then try to switch to
Chapter 13 after he was caught lying?
Strategy: This question is a good test of your understanding of the advantages and
disadvantages of the different chapters. For help in answering this question, you
might want to look at the chart at the end of the chapter. Remember that Chapter 7 is
a liquidation provision—it takes more of the bankrupt’s money upfront but then
discharges his debts and gives him a fresh start for the future. Chapter 13 does not
take as many assets during the bankruptcy process but may attach all the debtor’s
disposable income for the next five years.
Result: Marrama filed under Chapter 7 in the hope that he could hold on to his
house while all his debts were discharged. Once that plan failed, he tried to switch to
Chapter 13 in the hope that he could keep the house and give up his disposable
income instead. This case illustrates the different emphases of Chapters 7 and 13.
A bankruptcy under Chapter 13 generally follows the same course as Chapter 11:
The debtor files a petition, creditors submit proofs of claim, the court imposes an
automatic stay, the debtor files a plan, and the court confirms the plan. But there are
some differences.
24-4a Beginning a Chapter 13 Case
To initiate a Chapter 13 case, the debtor must file a voluntary petition. Creditors cannot
use an involuntary petition to force a debtor into Chapter 13. In all Chapter 13 cases, the
U.S. Trustee appoints a trustee to supervise the debtor, although the debtor remains in
possession of the bankruptcy estate. The trustee also serves as a central clearinghouse
for the debtor’s payments to creditors. The debtor pays the trustee who, in turn,
transmits these funds to creditors. For this service, the trustee is allowed up to 10
percent of the payments.
24-4b Plan of Payment
The debtor must file a plan of payment within 15 days after filing the voluntary petition.
Only the debtor can file a plan; the creditors have no right to file their own version. Under
the plan, the debtor must (1) commit some future earnings to pay off debts, (2) promise to
If a debtor acts in bad faith, the court has other reme-
dies: It can convert the case back to a Chapter 7 liquidation;
it can refuse to approve the plan of payment; or it can charge
the debtor with perjury. That is the law, whether the trustee
and creditors like it or not.
Argument for the Bankruptcy Trustee: A bankruptcy
court has the unquestioned right to dismiss a Chapter 13
petition if the debtor demonstrates bad faith. There
seems no logical reason why a court would have the right
to dismiss a case for bad faith but not the right to prohibit
a filing under Chapter 13 to begin with. In both cases,
the court is simply saying that the individual does
not qualify as a debtor under Chapter 13. That individual
is not a member of the class of honest but unfortunate
debtors whom the bankruptcy laws were enacted to
protect.
580 U N I T 3 Commercial Transactions
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pay all secured and priority claims in full, and (3) treat all remaining classes equally. If the
plan does not provide for the debtor to pay off creditors in full, then all of the debtor’s
disposable income for the next five years must go to creditors.
Within 30 days after filing the plan of payment, the debtor must begin making
payments to the trustee under the plan. The trustee holds these payments until the plan
is confirmed and then transmits them to creditors. The debtor continues to make payments
to the trustee until the plan has been fully implemented. If the plan is rejected, the trustee
returns the payments to the debtor.
Only the bankruptcy court has the authority to confirm or reject a plan of payment.
Creditors have no right to vote on it. However, to confirm a plan, the court must ensure that:
• The creditors have the opportunity to voice their objections at a hearing;
• All of the unsecured creditors receive at least as much as they would have if the
bankruptcy estate had been liquidated under Chapter 7;
• The plan is feasible and the bankrupt will be able to make the promised
payments;
• The plan does not extend beyond three years without good reason and in no event
lasts longer than five years; and
• The debtor is acting in good faith, making a reasonable effort to pay obligations.
24-4c Discharge
Once confirmed, a plan is binding on all creditors whether they like it or not. The debtor is
washed clean of all pre-petition debts except those provided for in the plan, but, unlike
Chapter 7 , the debts are not permanently discharged. If the debtor violates the plan, all of
the debts are revived, and the court may either dismiss the case or convert it to a liquidation
proceeding under Chapter 7. The debts become permanently discharged only when the
bankrupt fully complies with the plan.
Note, however, that any debtor who has received a discharge under Chapter 7 or 11
within the prior four years, or under Chapter 13 within the prior two years, is not eligible
under Chapter 13.
If the debtor’s circumstances change, the debtor, the trustee, or unsecured creditors can
ask the court to modify the plan. Most such requests come from debtors whose income has
declined. However, if the debtor’s income rises, the creditors or the trustee can ask that
payments increase, too.
Chapter Conclusion
Whenever an individual or organization incurs more debts than it can pay in a timely
fashion, everyone loses. The debtor loses control of his assets and the creditors lose money.
Bankruptcy laws cannot create assets where there are none (or not enough), but they can
ensure that the debtor’s assets, however limited, are fairly divided between the debtor and
creditors. Any bankruptcy system that accomplishes this goal must be deemed a success. Is
the U.S. Bankruptcy Code fair?
CHAPTER 24 Bankruptcy 581
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EXAM REVIEW
This chart sets out the important elements of each bankruptcy chapter.
Chapter 7 Chapter 11 Chapter 13
Objective Liquidation Reorganization Consumer
reorganization
Who May Use It Individual or
organization
Individual or
organization
Individual
Type of Petition Voluntary or
involuntary
Voluntary or
involuntary
Only voluntary
Administration of
Bankruptcy Estate
Trustee Debtor in possession
(trustee selected only if
debtor is unable to
serve)
Trustee
Selection of Trustee Creditors have right
to elect trustee;
otherwise, U.S.
Trustee makes
appointment
Usually no trustee Appointed by U.S.
Trustee
Participation in
Formulation of Plan
No plan is filed Both creditors and
debtor can propose
plans
Only debtor can
propose a plan
Creditor Approval of
Plan
Creditors do not vote Creditors vote on plan,
but court may approve
plan without the
creditors’ support
Creditors do not vote
on plan
Impact on Debtor’s
Post-petition Income
Not affected; debtor
keeps all future
earnings
Must contribute
toward payment of
pre-petition debts
Must contribute
toward payment of
pre-petition debts
1. Question: Mark Milbank’s custom furniture business was unsuccessful, so he
repeatedly borrowed money from his wife and her father. He promised that the
loans would enable him to spend more time with his family. Instead, he spent
more time in bed with his next-door neighbor. After the divorce, his ex-wife and
her father demanded repayment of the loans. Milbank filed for protection under
Chapter 13. What could his ex-wife and her father do to help their chances of
being repaid?
Strategy: First ask yourself what kind of creditor they are: secured or unsecured.
Then think about what creditors can do to get special treatment. (See the
“Result” at the end of this section.)E
X
A
M
S
tr
a
te
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582 U N I T 3 Commercial Transactions
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2. After a jury ordered actor Kim Basinger to pay $8 million for violating a movie
contract, she filed for bankruptcy protection, claiming $5 million in assets and
$11 million in liabilities. Under which Chapter should she file? Why?
Strategy: Look at the requirements for each Chapter. Was Basinger eligible for
Chapter 13? What would be the advantages and disadvantages of Chapters 7 and 11?
(See the “Result” at the end of this section.)
1. Result: The father and the ex-wife were unsecured creditors who, as a class,
come last on the priority list. The court granted their request not to discharge their
loans on the grounds that Milbank had acted in bad faith.
2. Result: Basinger was not eligible to file under Chapter 13 because she had debts
of $11 million. She first filed under Chapter 11 in an effort to retain some of her
assets, but then her creditors would not approve her plan of reorganization, so she
converted to liquidation under Chapter 7.
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION A voluntary petition filed under the liquidation provisions of
Chapter 7 of the federal Bankruptcy Code:
(a) is not available to a corporation unless it has previously filed a petition under the
reorganization provisions of Chapter 11 of the Code.
(b) automatically stays collection actions against the debtor except by secured
creditors.
(c) will be dismissed unless the debtor has 12 or more unsecured creditors whose
claims total at least $5,000.
(d) does not require the debtor to show that the debtor’s liabilities exceed the fair
market value of assets.
2. CPA QUESTION Decal Corp. incurred substantial operating losses for the past
three years. Unable to meet its current obligations, Decal filed a petition of
reorganization under Chapter 11 of the federal Bankruptcy Code. Which of the
following statements is correct?
(a) A creditors’ committee, if appointed, will consist of unsecured creditors.
(b) The court must appoint a trustee to manage Decal’s affairs.
(c) Decal may continue in business only with the approval of a trustee.
(d) The creditors’ committee must select a trustee to manage Decal’s affairs.
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CHAPTER 24 Bankruptcy 583
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3. CPA QUESTION Unger owes a total of $150,000 to eight unsecured creditors and
one fully secured creditor. Quincy is one of the unsecured creditors and is owed
$32,000. Quincy has filed a petition against Unger under the liquidation provisions of
Chapter 7 of the federal Bankruptcy Code. Unger has been unable to pay debts as
they become due. Unger’s liabilities exceed Unger’s assets. Unger has filed papers
opposing the bankruptcy petition. Which of the following statements regarding
Quincy’s petition is correct?
(a) It will be dismissed because the secured creditor failed to join in the filing of the
petition.
(b) It will be dismissed because three unsecured creditors must join in the filing of
the petition.
(c) It will be granted because Unger’s liabilities exceed Unger’s assets.
(d) It will be granted becauseUnger is unable to payUnger’s debts as they become due.
4. Dale is in bankruptcy proceedings under Chapter 13. Which of the following
statements is true?
(a) His debtors must have filed an involuntary petition.
(b) His unsecured creditors will be worse off than if he had filed under Chapter 7.
(c) All of his debts are discharged as soon as the court approves his plan.
(d) His creditors have an opportunity to voice objections to his plan.
5. Grass Co. is in bankruptcy proceedings under Chapter 11. serves as
trustee. In the case of the court can approve a plan of reorganization
over the objections of the creditors.
(a) The debtor in possession; a cramdown
(b) A person appointed by the U.S. Trustee; fraud
(c) The head of the creditors’ committee; reaffirmation
(d) The U.S. Trustee; voidable preference
ESSAY QUESTIONS
1. James, the owner of an auto parts store, told his employee, Rickey, to clean and paint
some tires in the basement. Highly flammable gasoline fumes accumulated in the
poorly ventilated space. James threw a firecracker into the basement as a joke,
intending only to startle Rickey. Sparks from the firecracker caused an explosion and
fire that severely burned him. Rickey filed a personal injury suit against James for
$1 million. Is this debt dischargeable under Chapter 7?
2. Mary Price went for a consultation about a surgical procedure to remove abdominal fat.
When Robert Britton met with her, he wore a name tag that identified him as a doctor,
and was addressed as “doctor” by the nurse. Britton then examined Price, touching her
stomach and showing her where the incision would be made. But Britton was the office
manager, not a doctor. Although a doctor actually performed the surgery on Price, Britton
was present. It turned out that the doctor left a tube in Price’s body at the site of the
incision. The area became infected, requiring corrective surgery. A jury awarded Price
$275,000 in damages in a suit against Britton. He subsequently filed a Chapter 7
bankruptcy petition. Is this judgment dischargeable in bankruptcy court?
584 U N I T 3 Commercial Transactions
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3. YOU BE THE JUDGE WRITING PROBLEM Lydia D’Ettore received a
degree in computer programming at the DeVry Institute of Technology, with a
grade point average of 2.51. To finance her education, she borrowed $20,516.52
from a federal student loan program. After graduation, she could not find a job in
her field, so she went to work as a clerk at an annual salary of $12,500. D’Ettore
and her daughter lived with her parents free of charge. After setting aside $50 a
month in savings and paying bills that included $233 for a new car (a Suzuki
Samurai) and $50 for jewelry from Zales, her disposable income was $125 per
month. D’Ettore asked the bankruptcy court to discharge the debts she owed
DeVry for her education. Did the debts to the DeVry Institute impose an undue
hardship on D’Ettore? Argument for D’Ettore: Lydia D’Ettore lives at home with
her parents. Even so, her disposable income is a meager $125 a month. She would
have to spend every single penny of her disposable income for nearly 15 years to
pay back her $20,500 debt to DeVry. That would be an undue hardship.
Argument for the Creditors: The U.S. government guaranteed D’Ettore’s loan.
Therefore, if the court discharges it, the American taxpayer will have to pay the
bill. Why should taxpayers subsidize an irresponsible student? D’Ettore must also
stop buying new cars and jewelry. And why should the government pay her debts
while she saves money every month?
4. Dr. Ibrahim Khan caused an automobile accident in which a fellow physician,
Dolly Yusufji, became a quadriplegic. Khan signed a contract for the lifetime support
of Yusufji. When he refused to make payments under the contract, she sued him and
obtained a judgment for $1,205,400. Khan filed a Chapter 11 petition. At the time of the
bankruptcy hearing, five years after the accident, Khan had not paid Yusufji anything.
She was dependent on a motorized wheelchair; he drove a Rolls-Royce. Is Khan’s debt
dischargeable under Chapter 11?
5. After filing for bankruptcy, Yvonne Brown sought permission of the court to reaffirm a
$6,000 debt to her credit union. The debt was unsecured, and she was under no
obligation to pay it. The credit union had published the following notice in its
newsletter:
If you are thinking about filing bankruptcy, THINK about the long-term implications. This
action, filing bankruptcy, closes the door on TOMORROW. Having no credit means no
ability to purchase cars, houses, credit cards. Look into the future—no loans for the
education of your children.
Should the court approve Brown’s reaffirmation?
DISCUSSION QUESTIONS
1. ETHICS On November 5, Hawes, Inc., a small
subcontractor, opened an account with Basic Corp.,
a supplier of construction materials. Hawes
promised to pay its bills within 30 days of purchase.
Although Hawes purchased a substantial quantity of
goods on credit from Basic, it made few payments
on the accounts until the following March,when it
paid Basic over $21,000. On May 14, Hawes filed a
voluntary petition under Chapter 7. Does the
bankruptcy trustee have a right to recover this
payment? Is it fair to Hawes’s other creditors if
Basic is allowed to keep the $21,000 payment?
CHAPTER 24 Bankruptcy 585
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2. Look on the web for your state’s rules on exempt
property. Compared with other states and the
federal government, is your state generous or
stingy with exemptions? In considering a new
bankruptcy statute, Congress struggled mightily
over whether or not to permit state exemptions at
all. Is it fair for exemptions to vary by state? Why
should someone in one state fare better than his or
her neighbor across the state line?
3. Some states permit debtors an unlimited
exemption on their homes. Is it fair for bankrupts
to be allowed to keep multimillion dollar homes
while their creditors remain unpaid? But other
states allow as little as $5,000. Should bankrupts be
thrown out on the street? What amount is fair?
4. What about the rules regarding repeated bankruptcy
filings? Debtors cannot obtain a discharge under
Chapter 7 within eight years of a prior filing. Under
Chapter 13, no discharge is available within four
years of a prior Chapter 7 or 11 filing and within two
years of a prior Chapter 13 filing. Are these rules too
onerous, too lenient, or just right?
5. A bankrupt who owns a house has the option of
either paying the mortgage or losing his home. The
only advantage of bankruptcy is that his debt to the
bank is discharged. The U.S. House of
Representatives passed a bill permitting a
bankruptcy judge to adjust the terms of mortgages to
aid debtors in holding onto their houses. Proponents
argued that this change in the law would reduce
foreclosures and stabilize the national housing
market. Opponents said that it was not fair to reward
homeowners for being irresponsible. How would
you vote if you were in the Senate?
6. In the Grisham case, the debtor had virtually no
income but owed about $200,000 in debts that
could not be discharged. What kind of fresh
start is that? Should limits be placed on the total
debt that cannot be discharged? Is the list of
non-dischargeable debts appropriate?
586 U N I T 3 Commercial Transactions
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CHAPTER25
AGENCY LAW
The good news is that Mac’s parents gave him a
car when he went off to college. (An SUV, which
he called “the Tank.”) The bad news is that his
friends were constantly borrowing it. And you
know how these things go.
One night, James borrowed the Tank to
drive a friend to the airport. On the way home,
he rear-ended a Mini Cooper at a stoplight.
Although there was no damage to the Tank, the
Mini was totaled. Then Peter borrowed the
Tank to drive to work. While at work, he and
Teddy went out to buy pizza for the office.
When Peter hit a curb, the airbag deployed and broke Teddy’s nose. So Mac had to take
the Tank to the repair shop. While the car was there overnight, one of the repair people got
drunk, took the SUV out for a joy ride, and banged it up.
Who is liable for all this damage?
The Mini Cooper: Mac is liable only if James was
acting as his agent. But in this case, James was not doing
Mac any favors, so he was not his agent. If, on the other
hand, James had agreed to pick up some food for Mac,
then Mac would be liable for the accident.
Teddy’s nose: Mac is clearly not liable because Peter
was not his agent. What about Peter’s employer? If Peter
was acting within the scope of his employment, his
employer would be liable. Was buying pizza for the
office within this scope? Probably.
The joy ride: The repair shop owner is liable even
though the drunk worker was clearly violating company policy. He was on duty at the time,
and it is the garage owner’s fault for hiring such an unreliable worker.
The good news is that
Mac’s parents gave him a
car when he went off to
college. The bad news is
that his friends were
constantly borrowing it.
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Thus far, this book has primarily dealt with issues of individual responsibility: What
happens if you knock someone down or you sign an agreement? Agency law, on the other
hand, is concerned with your responsibility for the actions of others. What happens if your
agent assaults someone or signs a contract in your name? Agency law presents a significant
trade-off: If you do everything yourself, you have control over the result. But the size and
scope of your business (and your life) will be severely limited. Once you hire other people,
you can accomplish a great deal more, but your risks increase immensely. Your agents may
violate your instructions, and still you could be liable for what they have done. Although it
might be safer to do everything yourself, that is not a practical decision for most business
owners (or most people). The alternative is to hire carefully and to limit the risks as much as
possible by understanding the law of agency.
25-1 CREATING AN AGENCY
RELATIONSHIP
Let us begin with two important definitions:
• Principal: A person who has someone else acting for him.
• Agent: A person who acts for someone else.
Principals have substantial liability for the actions of their agents.1 Therefore, disputes
about whether an agency relationship exists are not mere legal quibbles but important issues
with potentially profound financial consequences.
In an agency relationship, someone (the agent) agrees to perform a task for, and under
the control of, someone else (the principal). To create an agency relationship, there must be:
• a principal and
• an agent
• who mutually consent that the agent will act on behalf of the principal and
• be subject to the principal’s control,
• thereby creating a fiduciary relationship.
25-1a Consent
To establish consent, the principal must ask the agent to do something, and the agent must agree.
In the most straightforward example, you ask a neighbor to walk your dog, and she agrees. Matters
were more complicated, however, when Steven James met some friends one evening at a
restaurant. During the two hours he was there, he drank four to six beers. (It is probably a bad
sign that he cannot remember howmany.) From then on, onemisfortune piled upon another. After
leaving the restaurant at about 7:00 p.m., James sped down a highway and crashed into a car that
had stalled on the road, thereby killing the driver. James told the police at the scene that he had not
seen the parked car (another bad sign). Evidently, James’s lawyer was not as perceptive as the
police in recognizing drunkenness. In a misguided attempt to help his client, James’s lawyer took
him to the local hospital for a blood test. Unfortunately, the test confirmed that James had indeed
been drunk at the time of the accident.
1The word “principal” is always used when referring to a person. It is not to be confused with the
word “principle,” which refers to a fundamental idea.
Principal
In an agency relationship, the
person for whom an agent is
acting.
Agent
In an agency relationship, the
person who is acting on behalf
of a principal.
588 U N I T 3 Commercial Transactions
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The attorney knew that if this evidence was admitted at trial, his client would soon be
receiving free room and board from the Massachusetts Department of Corrections. So at
trial, the lawyer argued that the blood test was protected by the client-attorney privilege
because the hospital had been his agent and therefore a member of the defense team. The
court disagreed, however, holding that the hospital employees were not agents for the
lawyer because they had not consented to act in that role.
The court upheld James’s conviction of murder in the first degree by reason of extreme
atrocity or cruelty.2
25-1b Control
Principals are liable for the acts of their agents because they exercise control over the agents.
If principals direct their agents to commit an act, it seems fair to hold the principal liable
when that act causes harm. How would you apply that rule to the following situation?
William Stanford was an employee of the Agency for International Development. While
on his way home to Pakistan to spend the holidays with his family, his plane was hijacked
and taken to Iran, where he was killed. Stanford had originally purchased a ticket on
Northwest Airlines but had traded it for a seat on Kuwait Airways (KA). The airlines had
an agreement permitting passengers to exchange tickets from one to the other. Stanford’s
widow sued Northwest on the theory that KA was Northwest’s agent. The court found,
however, that no agency relationship existed because Northwest had no control over KA.3
Northwest did not tell KA how to fly planes or handle terrorists; therefore, it should not be
liable when KA made fatal errors. Not only must an agent and principal consent to an
agency relationship, but the principal also must have control over the agent.
25-1c Fiduciary Relationship
In a fiduciary relationship, a trustee acts for the benefit of the beneficiary, always putting the
interests of the beneficiary before his own. A fiduciary relationship is a special relationship with
high standards. The beneficiary places special confidence in the fiduciary who, in turn, is obligated
to act in good faith and candor, putting his own needs second. The purpose of a fiduciary
relationship is for one person to benefit another. Agents have a fiduciary duty to their principals.
All three elements—consent, control, and a fiduciary duty—are necessary to create an
agency relationship. In some relationships, for example, there might be a fiduciary duty but
no control. A trustee of a trust must act for the benefit of the beneficiaries, but the
beneficiaries have no right to control the trustee. Therefore, a trustee is not an agent of
the beneficiaries. Consent is present in every contractual relationship, but that does not
necessarily mean that the two parties are agent and principal. If Horace sells his car to Lily,
they both expect to benefit under the contract, but neither has a fiduciary duty to the other
and neither controls the other, so there is no agency relationship.
25-1d Elements Not Required for an Agency
Relationship
Consent, control, and a fiduciary relationship are necessary to establish an agency relation-
ship. The following elements are not required:
• A Written Agreement. In most cases, an agency agreement does not have to be in
writing. An oral understanding is valid, except in one circumstance—the equal
dignities rule. According to this rule, if an agent is empowered to enter into a contract
2Commonwealth v. James, 427 Mass. 312, 693 N.E.2nd 148, 1998 Mass. LEXIS 175. (S.J.C. MA, 1998).
3Stanford v. Kuwait Airways Corp., 648 F. Supp. 1158, 1986 U.S. Dist. LEXIS 18880 (S.D.N.Y. 1986).
Fiduciary relationship
A trustee acts for the benefit of
the beneficiary, always putting
the interests of the beneficiary
before his own.
Equal dignities rule
If an agent is empowered to
enter into a contract that must
be in writing, then the
appointment of the agent must
also be written.
CHAPTER 25 Agency Law 589
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that must be in writing, then the appointment of the agent must also be written. For
example, under the statute of frauds, a contract for the sale of land is unenforceable
unless in writing, so the agency agreement to sell land must also be in writing.
• A Formal Agreement. The principal and agent need not agree formally that they have
an agency relationship. They do not even have to think the word “agent.” So long as
they act like an agent and a principal, the law will treat them as such.
• Compensation. An agency relationship need not meet all the standards of contract
law. For example, a contract is not valid without consideration, but an agency
agreement is valid even if the agent is not paid.
25-2 DUTIES OF AGENTS TO PRINCIPALS
Agents owe a fiduciary duty to their principals. There are four elements to this duty.
25-2a Duty of Loyalty
An agent has a fiduciary duty to act loyally for the principal’s benefit in all matters connected
with the agency relationship.4 The agent has an obligation to put the principal first, to strive
to accomplish the principal’s goals. As the following case illustrates, this duty applies to all
employees, no matter how lowly.
The various components of the duty of loyalty follow.
OTSUKA V. POLO RALPH LAUREN CORPORATION
2007 U.S. DIST. LEXIS 86523
United States District Court for the Northern District of California, 2007
C A S E S U M M A R Y
Facts: Justin Kiser and Germania worked together at a
Ralph Lauren Polo store in San Francisco. After she left
the job, he let her buy clothing using merchandise credits
made out to nonexistent people. He also let her use his
employee discount. Not surprisingly, both of these activ-
ities were against store policies. Polo sued Kiser, alleging
that he had violated his duty of loyalty.
Kiser filed a motion to dismiss on the grounds that he
was such a low-level employee that he did not owe a duty
of loyalty to Polo.
Issue: Do all employees owe a duty of loyalty to their
employer?
Decision: Yes, all employees owe a duty of loyalty.
Reasoning: The cases cited by Polo to support its claim
involved higher-level employees than Kiser, who was
simply a clerk in a Polo store. No matter—the Restate-
ment (Third) of Agency clearly states that all employees
are agents and owe a duty of loyalty to their employers.
All employees must put their employer’s interests first.
4Restatement (Third) of Agency §8.01.
590 U N I T 3 Commercial Transactions
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OUTSIDE BENEFITS
An agent may not receive profits unless the principal knows and approves. Suppose that
Hope is an employee of the agency Big Egos and Talents, Inc. (BEAT). She has been
representing Will Smith in his latest movie negotiations.5 Smith often drives her to meetings
in his new Maybach. He is so thrilled that she has arranged for him to star in the new movie
Little Men that he buys her a Maybach. Can Hope keep this generous gift? Only with
BEAT’s permission. She must tell BEAT about the Maybach; the company may then take
the vehicle itself or allow her to keep it.
CONFIDENTIAL INFORMATION
The ability to keep secrets is important in any relationship, but especially a fiduciary
relationship. Agents can neither disclose nor use for their own benefit any confidential
information they acquire during their agency. As the following case shows, this duty
continues even after the agency relationship ends.
To listen to the two songs involved in this case, google “benedict copyright.”
ABKCO MUSIC, INC. V. HARRISONGS MUSIC, LTD.
722 F.2d 988, 1983 U.S. App. LEXIS 15562
United States Court of Appeals for the Second Circuit, 1983
C A S E S U M M A R Y
Facts: Bright Tunes Music Corp. (Bright Tunes) owned
the copyright to the song “He’s So Fine.” The company
sued George Harrison, a Beatle, alleging that the Harrison
composition “My Sweet Lord” copied “He’s So Fine.” At
the time the suit was filed, Allen B. Klein handled the
business affairs of the Beatles.
Klein (representing Harrison) met with the president of
Bright Tunes to discuss possible settlement of the copyright
lawsuit. Klein suggested that Harrison might be interested in
purchasing the copyright to “He’s So Fine.” Shortly there-
after, Klein’s management contract with the Beatles expired.
Without telling Harrison, Klein began negotiating with
Bright Tunes to purchase the copyright to “He’s So Fine”
for himself. To advance these negotiations, Klein gave Bright
Tunes information about royalty income for “My Sweet
Lord”—information that he had gained as Harrison’s agent.
The trial judge in the copyright case ultimately found that
Harrison had infringed the copyright on “He’s So Fine” and
assesseddamagesof$1,599,987.After the trial,Kleinpurchased
the “He’s So Fine” copyright from Bright Tunes and with it,
the right to recover fromHarrison for the breach of copyright.
Issue: Did Klein violate his fiduciary duty to Harrison by
using confidential information after the agency relationship
terminated?
Decision: Klein did violate his fiduciary duty to
Harrison.
Reasoning: While serving as Harrison’s agent, Klein
learned confidential information about royalty income
for “My Sweet Lord.” An agent has a duty not to use
confidential information to compete against his princi-
pal. This duty continues even after the agency relation-
ship ends. A former agent does have the right to com-
pete against his principal using general business
knowledge or publicly available information. However,
the information that Klein passed on to Bright Tunes
was not publicly available.
Although some years separated Klein’s attempt to
buy the copyright for Harrison and his later purchase for
himself, Klein was still under a duty to Harrison. Klein’s
conduct did not meet the standard required of him as a
former fiduciary.
5Do not be confused by the fact that Hope works as an agent for movie stars. As an employee of
BEAT, her duty is to the company. She is an agent of BEAT, and BEAT works for the celebrities.
CHAPTER 25 Agency Law 591
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Ethics Klein was angry that the Beatles had failed to renew his management
contract. Was it reasonable for him to think that he owed no duty to the
principal who had fired him? Why kind of world would it be if everyone acted like Klein? Why
would George Harrison prefer to owe money to Bright Tunes rather than to Klein?
COMPETITION WITH THE PRINCIPAL
Agents are not allowed to compete with their principal in any matter within the scope of the agency
business. If Allen Klein had purchased the “He’s So Fine” copyright while he was George
Harrison’s agent, he would have committed an additional sin against the agency relation-
ship. Owning song rights was clearly part of the agency business, so Klein could not make
such purchases without Harrison’s consent. Once the agency relationship ends, however, so
does the rule against competition. Klein was entitled to buy the “He’s So Fine” copyright
after the agency relationship ended (so long as he did not use confidential information).
CONFLICT OF INTEREST BETWEEN TWO PRINCIPALS
Unless otherwise agreed, an agent may not act for two principals whose interests conflict.
Suppose Travis represents both director Steven Spielberg and actor Amy Adams. Spielberg
is casting the title role in his new movie, Nancy Drew: Girl Detective, a role that Adams covets.
Travis cannot represent these two clients when they are negotiating with each other unless
they both know about the conflict and agree to ignore it. The following example illustrates
the dangers of acting for two principals at once.
EXAM Strategy
Question: The Sisters of Charity was an order of nuns in New Jersey. Faced with
growing health care and retirement costs, they decided to sell off a piece of property.
The nuns soon found, however, that the world is not always a charitable place. They
agreed to sell the land to Linpro for nearly $10 million. But before the deal closed,
Linpro signed a contract to resell the property to Sammis for $34 million. So, you say,
the sisters made a bad deal. There is no law against that. But it turned out that the
nuns’ law firm also represented Linpro. Their lawyer at the firm, Peter Berkley, never
told the sisters about the deal between Linpro and Sammis. Was that the charitable—
or legal—thing to do?
Strategy: Always begin by asking if there is an agency relationship. Was there
consent, control, and a fiduciary relationship? Consent: Berkley had agreed to work for
the nuns. Control: They told him what he was to do—sell the land. The purpose of a
fiduciary relationship is for one person to benefit another. The point of the nuns’
relationship with Berkley is for him to help them. Once you know there is an agency
relationship, then ask if the agent has violated his duty of loyalty.
Result: You know that an agent is not permitted to act for two principals whose
interests conflict. Here, Berkley is working for the nuns, who want the highest
possible price for their land, and Linpro, who wants the lowest price. Berkley has
violated his duty of loyalty.
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SECRETLY DEALING WITH THE PRINCIPAL
If a principal hires an agent to arrange a transaction, the agent may not become a party to
the transaction without the principal’s permission. Matt Damon became an overnight
sensation after starring in the movie Good Will Hunting. Suppose that he hired Trang to
read scripts for him. Unbeknownst to Damon, Trang has written her own script, which she
thinks would be ideal for him. She may not sell it to him without revealing that she wrote it
herself. Damon may be perfectly happy to buy Trang’s script, but he has the right, as her
principal, to know that she is the person selling it.
APPROPRIATE BEHAVIOR
An agent may not engage in inappropriate behavior that reflects badly on the principal. This
rule applies even to off-duty conduct. For example, a coed trio of flight attendants went wild
at a hotel bar in London. They kissed and caressed each other, showed off their underwear,
and poured alcohol down their trousers. The airline fired two of the employees and gave a
warning letter to the third.
25-2b Other Duties of an Agent
Before Taylor left for a five-week trip to England, he hired Angie to rent his vacation house.
Angie never got around to listing his house on the Multiple Listing Service used by all the
area brokers, nor did she post it on the web herself, but when the Fords contacted her
looking for rental housing, she did show them Taylor’s place. They offered to rent it for
$750 per month.
Angie called Taylor in England to tell him. He responded that he would not accept less
than $850 a month, which Angie thought the Fords would be willing to pay. He told Angie
to call back if there was any problem. The Fords decided that they would go no higher than
$800 a month. Although Taylor had told Angie that he could not receive text messages in
England, she texted him the Fords’ counteroffer. Taylor never received it, so he never
responded. When the Fords pressed Angie for an answer, she said she could not get in touch
with Taylor. Not until Taylor returned home did he learn that the Fords had rented another
house. Did Angie violate any of the duties that agents owe to their principals?
DUTY TO OBEY INSTRUCTIONS
An agent must obey her principal’s instructions unless the principal directs her to behave
illegally or unethically. Taylor instructed Angie to call him if the Fords rejected the offer.
When Angie failed to do so, she violated her duty to obey instructions. If, however, Taylor
had asked her to say that the house’s basement was dry when in fact it looked like a swamp
every spring, Angie would be under no obligation to follow those illegal instructions.
DUTY OF CARE
An agent has a duty to act with reasonable care. In other words, an agent must act as a
reasonable person would, under the circumstances. A reasonable person would not have
texted Taylor while he was in England.
Under some circumstances, an agent is held to a higher—or lower—standard than usual.
An agent with special skills is held to a higher standard because she is expected to use those
skills. A trained real estate agent should know enough to post all listings on the web.
But suppose Taylor had asked his neighbor, Jed, to help him sell the house. Jed is not a
trained real estate agent, and he is not being paid, which makes him a gratuitous agent. A
gratuitous agent is held to a lower standard because he is doing his principal a favor and, as
the old saying goes, you get what you pay for—up to a point. Gratuitous agents are liable if
they commit gross negligence, but not ordinary negligence. If Jed, as a gratuitous agent,
texted Taylor an important message because he forgot that Taylor could not receive these
Gratuitous agent
An agent who is not paid by the
principal.
CHAPTER 25 Agency Law 593
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messages in England, he would not be liable for that ordinary negligence. But if Taylor had,
just that day, sent Jed an email complaining that he could not get any text messages, Jed
would be liable for gross negligence and a violation of his duty.
DUTY TO PROVIDE INFORMATION
An agent has a duty to provide the principal with all information in her possession that she
has reason to believe the principal wants to know. She also has a duty to provide accurate
information. Angie knew that the Fords had counteroffered for $800 a month. She had a
duty to pass this information on to Taylor.
EXAM Strategy
Question: Jonah tells his friend Derek that he would like to go parasailing. Derek is
very enthusiastic and suggests that they try an outfit called Wind Beneath Your Wings
because he has heard good things about it. Derek offers to arrange everything. He
makes a reservation, puts the $600 fee on his credit card, and picks Jonah up to drive him
to the Wings location. What a friend! But the day does not turn out as Jonah had
hoped. While he is soaring up in the air over the Pacific Ocean, his sail springs a leak, he
goes plummeting into the sea and breaks both legs. During his recuperation in the
hospital, he learns that Wings is unlicensed. He also sees an ad for Wings offering
parasailing for only $350. AndDerek is listed in the ad as one of the company’s owners. Is
Derek an agent for Jonah? Has he violated his fiduciary responsibility?
Strategy: There are three issues to consider in answering this question: (1) Was
there an agency relationship? This requires consent, control, and a fiduciary
relationship. (2) Is anything missing—does it matter if the agent is unpaid or the
contract is not in writing? (3) Has the agent fulfilled his duties?
Result: There is an agency relationship: Derek had agreed to help Jonah; it was
Jonah who set the goal for the relationship (parasailing); the purpose of this
relationship is for one person to benefit another. It does not matter if Derek was not
paid or the agreement not written. Derek has violated his duty to exercise due care.
He should not have taken Jonah to an unlicensed company. He has also violated his
duty to provide information: He should have told Jonah the true cost for the lessons
and also revealed that he was a principal of the company. And he violated his duty of
loyalty when he worked for two principals whose interests were in conflict.
25-2c Principal’s Remedies When the Agent
Breaches a Duty
A principal has three potential remedies when an agent breaches her duty:
• The principal can recover from the agent any damages the breach has caused. Thus,
if Taylor can rent his house for only $600 a month instead of the $800 the Fords
offered, Angie would be liable for $2,400—$200 a month for one year.
• If an agent breaches the duty of loyalty, he must turn over to the principal any profits
he has earned as a result of his wrongdoing. Thus, after Klein violated his duty of
loyalty to Harrison, he forfeited profits he would have earned from the copyright of
“He’s So Fine.”
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• If the agent has violated her duty of loyalty, the principal may rescind the transaction.When
Trang sold a script to her principal, Matt Damon, without telling him that she was the
author, she violated her duty of loyalty. Damon could rescind the contract to buy the script.6
25-3 DUTIES OF PRINCIPALS TO AGENTS
In a typical agency relationship, the agent agrees to perform tasks for the principal, and the
principal agrees to pay the agent. The range of tasks undertaken by an agent is limited only
by the imagination of the principal. Because the agent’s job can be so varied, the law needs
to define an agent’s duties carefully. The role of the principal, on the other hand, is typically
less complicated—often little more than paying the agent as required by the agreement.
Thus, the law enumerates fewer duties for the principal. Primarily, the principal must
reimburse the agent for reasonable expenses and cooperate with the agent in performing
agency tasks. The respective duties of agents and principals can be summarized as follows:
Duties of Agents to Principals Duty of Principals to Agents
Duty of loyalty Duty to compensate as provided by the agreement
Duty to obey instructions Duty to reimburse for reasonable expenses
Duty of care Duty to cooperate
Duty to provide information
As a general rule, the principal must indemnify (i.e., reimburse) the agent for any expenses
she has reasonably incurred. These reimbursable expenses fall into three categories:
• A principal must indemnify an agent for any expenses or damages reasonably incurred
in carrying out his agency responsibilities. For example, Peace Baptist Church of
Birmingham, Alabama, asked its pastor to buy land for a new church. He paid part of
the purchase price out of his own pocket, but the church refused to reimburse him.
Although the pastor lost in church, he won in court.7
• A principal must indemnify an agent for tort claims brought by a third party if the principal
authorized the agent’ s behavior and the agentdidnot realizehewas committinga tort.Marisa
owns all the apartment buildings on Elm Street, except one. She hires Rajiv tomanage the
units and tells him that, under the terms of the leases, she has the right to ask guests to
leave if a party becomes too rowdy. But she forgets to tell Rajiv that she does not own one
of the buildings, which happens to house a college sorority. One night, when the sorority is
having a rambunctious party, Rajiv hustles over and starts ejecting the noisy guests. The
sorority is furious and sues Rajiv for trespass. If the sorority wins its suit against Rajiv,
Marisa would have to pay the judgment, plus Rajiv’s attorney’s fees, because she had told
him to quell noisy parties and he did not realize he was trespassing.
6A principal can rescind his contract with an agent who has violated her duty, but, as we shall see later
in the chapter, the principal might not be able to rescind a contract with a third party when the agent
misbehaves.
7Lauderdale v. Peace Baptist Church of Birmingham, 246 Ala. 178, 19 So. 2d 538, 1944 Ala. LEXIS 508
(S. Ct. AL, 1944).
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CHAPTER 25 Agency Law 595
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• The principal must indemnify the agent for any liability she incurs from third parties as a
result of entering into a contract on the principal’s behalf, including attorney’s fees and
reasonable settlements. An agent signed a contract to buy cucumbers for Vlasic Food
Products Co. to use in making pickles. When the first shipment of cucumbers arrived,
Vlasic inspectors found them unsuitable and directed the agent to refuse the
shipment. The agent found himself in a pickle when the cucumber farmer sued. The
agent notified Vlasic, but the company refused to defend him. He settled the claim
himself and, in turn, sued Vlasic. The court ordered Vlasic to reimburse the agent
because he had notified them of the suit and had acted reasonably and in good faith.8
25-3a Duty to Cooperate
Principals have a duty to cooperate with their agent:
• The principal must furnish the agent with the opportunity to work. If Lewis agrees to
serve as Ida’s real estate agent in selling her house, Ida must allow Lewis access to
the house. It is unlikely that Lewis will be able to sell the house without taking
anyone inside.
• The principal cannot unreasonably interfere with the agent’s ability to accomplish his
task. Ida allows Lewis to show the house, but she refuses to clean it and then makes
disparaging comments to prospective purchasers. “I really get tired of living in such a
dark, dreary house,” she says. “And the neighborhood children are vicious thugs.”
This behavior would constitute unreasonable interference with an agent.
• The principal must perform her part of the contract. Once the agent has successfully
completed the task, the principal must pay him, even if the principal has changed her
mind and no longer wants the agent to perform. Ida is a 78-year-old widow who has
lived alone for many years in a house that she loves. Her asking price is outrageously
high. But lo and behold, Lewis finds a couple happy to pay Ida’s price. There is only
one problem. Ida does not really want to sell. She put her house on the market
because she enjoys showing it to all the folks who move to town. She rejects the offer.
Now there is a second problem. The contract provided that Lewis would find a
willing buyer at the asking price. Because he has done so, Ida must pay his real estate
commission even if she does not want to sell her house.
25-4 TERMINATING AN AGENCY
RELATIONSHIP
Either the agent or the principal can terminate the agency relationship at any time. In addition,
the relationship terminates automatically if the principal or agent no longer can perform their
required duties or a change in circumstances renders the agency relationship pointless.
25-4a Termination by Agent or Principal
The two parties—principal and agent—have three choices in terminating their relationship:
• Term Agreement. If the principal and agent agree in advance how long their
relationship will last, they have a term agreement. For example:
8Long v. Vlasic Food Products Co., 439 F.2d 229, 1971 U.S. App. LEXIS 11455 (4th Cir. 1971).
596 U N I T 3 Commercial Transactions
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• Time. Alexandra hires Boris to help her add to her collection of guitars previously
owned by rock stars. If they agree that the relationship will last two years, they have a
term agreement.
• Achieving a Purpose. The principal and agent can agree that the agency relationship
will terminate when the principal’s goals have been achieved. Alexandra and Boris
might agree that their relationship will end when Alexandra has purchased 10 guitars.
• Mutual Agreement. No matter what the principal and agent agree at the start, they
can always change their minds later on, so long as the change is mutual. If Boris and
Alexandra originally agree to a two-year term, but Boris decides he wants to go back
to business school and Alexandra runs out of money after only one year, they can
decide together to terminate the agency.
• Agency at Will. If they make no agreement in advance about the term of the
agreement, either principal or agent can terminate at any time.
• Wrongful Termination. An agency relationship is a personal relationship. Hiring an
agent is not like buying a book. You might not care which copy of the book you buy, but
you do care which agent you hire. If an agency relationship is not working out, the courts
will not force the agent and principal to stay together. Either party always has the power
to walk out. They may not, however, have the right. If one party’s departure from the
agency relationship violates the agreement and causes harm to the other party, the
wrongful party must pay damages. Nonetheless, he will be permitted to leave. If Boris
has agreed to work for Alexandra for two years but he wants to leave after one, he can
leave, provided he pays Alexandra the cost of hiring and training a replacement.
If the agent is a gratuitous agent (i.e., is not being paid), he has both the power and the right
to quit any time he wants, regardless of the agency agreement. If Boris is doing this job for
Alexandra as a favor, he will not owe her damages when he stops work.
25-4b Principal or Agent Can No Longer Perform
Required Duties
If the principal or the agent is unable to perform the duties required under the agency
agreement, the agreement terminates.
• If either the agent or the principal fails to obtain (or keep) a license necessary to
perform duties under the agency agreement, the agreement ends. Caleb hires Allegra to
represent him in a lawsuit. If she is disbarred, their agency agreement terminates because
the agent is no longer allowed in court. Alternatively, if Emil hires Bess to work in his gun
shop, their agency relationship terminates when he loses his license to sell firearms.
• The bankruptcy of the agent or the principal terminates an agency relationship only if
it affects their ability to perform. Bankruptcy rarely interferes with an agent’s
responsibilities. After all, there is generally no reason why an agent cannot continue to
act for the principal whether the agent is rich or poor. If Lewis, the real estate agent,
becomes bankrupt, he can continue to represent Ida or anyone else who wants to sell
a house. The bankruptcy of a principal is different, however, because after filing for
bankruptcy, the principal loses control of his assets. A bankrupt principal may be
unable to pay the agent or honor contracts that the agent enters into on his behalf.
Therefore, the bankruptcy of a principal is more likely to terminate an agency
relationship.
• An agency relationship terminates upon the death or incapacity of either the principal
or the agent. Agency is a personal relationship, and when the principal dies, the agent
CHAPTER 25 Agency Law 597
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cannot act on behalf of a nonexistent person.9 Of course, a nonexistent person cannot
act either, so the relationship also terminates when the agent dies. Incapacity has the
same legal effect because either the principal or the agent is at least temporarily
unable to act.
• If the agent violates her duty of loyalty, the agency agreement automatically
terminates. Agents are appointed to represent the principal’s interest; if they fail
to do so, there is no point to the relationship. Louisa is negotiating a military
procurement contract on behalf of her employer, Missiles R Us, Inc. In the midst
of these negotiations, she becomes very friendly with Sam, the government
negotiator. One night over drinks, she tells Sam what Missiles’ real costs are on
the project and the lowest bid it could possibly make. By passing on this
confidential information, Louisa has violated her duty of loyalty, and her agency
relationship terminates.
25-4c Change in Circumstances
After the agency agreement is negotiated, circumstances may change. If these changes
are significant enough to undermine the purpose of the agreement, the relationship
ends automatically. Andrew hires Melissa to sell his country farm for $100,000. Shortly
thereafter, the largest oil reserve in North America is discovered nearby. The farm is
now worth 10 times Andrew’s asking price. Melissa’s authority terminates automatically.
Other changes in circumstance that affect an agency agreement are:
• Change of Law. If the agent’s responsibilities become illegal, the agency agreement
terminates. Oscar has hired Marta to ship him succulent avocados from California’s
Imperial Valley. Before she sends the shipment, Mediterranean fruit flies are
discovered, and all fruits and vegetables in California are quarantined. The agency
agreement terminates because it is now illegal to ship the California avocados.
• Loss or Destruction of Subject Matter. Andrew hired Damian to sell his Palm Beach
condominium, but before Damian could even measure the living room, Andrew’s
creditors attached the condo. Damian is no longer authorized to sell the real estate
because Andrew has “lost” the subject matter of his agency agreement with Damian.
25-4d Effect of Termination
Once an agency relationship ends, the agent no longer has the authority to act for the
principal. If she continues to act, she is liable to the principal for any damages he incurs as a
result. The Mediterranean fruit fly quarantine ended Marta’s agency. If she sends Oscar the
avocados anyway and he is fined for possession of a fruit fly, Marta must pay the fine.
The agent loses her authority to act, but some of the duties of both the principal and
agent continue even after the relationship ends:
• Principal’s Duty to Indemnify Agent. Oscar must reimburse Marta for expenses she
incurred before the agency ended. If Marta accumulated mileage on her car during
her search for the perfect avocado, Oscar must pay her for gasoline and depreciation.
But he owes her nothing for her expenses after the agency relationship ends.
• Confidential Information. Remember the “He’s So Fine” case earlier in the chapter?
George Harrison’s agent used confidential information to negotiate on his own behalf
the purchase of the “He’s So Fine” copyright. An agent is not entitled to use
confidential information even after the agency relationship terminates.
9Restatement (Third) of Agency §§3.05, 3.06, 3.07, and 3.08.
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25-5 LIABILITY
Thus far, this chapter has dealt with the relationship between principals and agents. Although
an agent can dramatically increase his principal’s ability to accomplish her goals, an agency
relationship also dramatically increases the risk of legal liability to third parties. A principal may
be liable in tort for any harm the agent causes and also liable in contract for agreements that the
agent signs. Indeed, once a principal hires an agent, she may be liable to third parties for his
acts, even if he disobeys instructions. Agents may also find themselves liable to third parties.
25-6 PRINCIPAL’S LIABILITY
FOR CONTRACTS
Many agents are hired for the primary purpose of entering into contracts on behalf of their
principals. Salespeople, for example, may do little other than sign on the dotted line. Most
of the time, the principal wants to be liable on these contracts. But even if the principal is
unhappy (because, say, the agent has disobeyed orders), the principal generally cannot
rescind contracts entered into by the agent. After all, if someone is going to be penalized, it
should be the principal who hired the disobedient agent, not the innocent third party.
The principal is liable for the acts of an agent if (1) the agent had authority, or (2) the
principal ratifies the acts of the agent.
To say that the principal is “liable for the acts” of the agent means that the principal is
as responsible as if he had performed the acts himself. It also means that the principal is
liable for statements the agent makes to a third party. Thus, when a lawyer lied on an
application for malpractice insurance, the insurance company was allowed to void the policy
for the entire law firm. It was as if the firm had lied. In addition, the principal is deemed to
know any information that the agent knows or should know.
25-6a Authority
A principal is bound by the acts of an agent if the agent has authority. There are three types
of authority: express, implied, and apparent. Express and implied authority are categories of
actual authority because the agent is truly authorized to act for the principal. In apparent
authority, the principal is liable for the agent’s actions even though the agent was not authorized.
EXPRESS AUTHORITY
The principal grants express authority by words or conduct that, reasonably interpreted,
cause the agent to believe the principal desires her to act on the principal’s account.10 In
other words, the principal asks the agent to do something and the agent does it. Craig calls
his stockbroker, Alice, and asks her to buy 100 shares of Banshee Corp. for his account. She
has express authority to carry out this transaction.
IMPLIED AUTHORITY
Unless otherwise agreed, authority to conduct a transaction includes authority to do acts that
are reasonably necessary to accomplish it.11 The principal does not have to micromanage the
agent. David has recently inherited a house from his grandmother. He hires Nell to auction
10Restatement (Third) of Agency §2.01.
11Restatement (Third) of Agency §2.02.
CHAPTER 25 Agency Law 599
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off the house and its contents. She hires an auctioneer, advertises the event, rents a tent,
and generally does everything necessary to conduct a successful auction. After withholding
her expenses, she sends the tidy balance to David. Totally outraged, he calls her on the
phone, “How dare you hire an auctioneer and rent a tent? I never gave you permission! I
absolutely refuse to pay these expenses!”
David is wrong. A principal almost never gives an agent absolutely complete instruc-
tions. Unless some authority is implied, David would have had to say, “Open the car door,
get in, put the key in the ignition, drive to the store, buy stickers, mark an auction number
on each sticker …” and so forth. To solve this problem, the law assumes that the agent has
authority to do anything that is reasonably necessary to accomplish her task.
APPARENT AUTHORITY
A principal can be liable for the acts of an agent who is not, in fact, acting with authority if
the principal’s conduct causes a third party reasonably to believe that the agent is author-
ized.12 In the case of express and implied authority, the principal has authorized the agent to
act. Apparent authority is different: The principal has not authorized the agent, but has done
something to make an innocent third party believe the agent is authorized. As a result, the
principal is every bit as liable to the third party as if the agent did have authority.
For example, Zbigniew Lambo and Scott Kennedy were brokers at Paulson Investment
Co., a stock brokerage firm in Oregon. The two men violated securities laws by selling
unregistered stock, which ultimately proved to be worthless. Kennedy and Lambo were
liable, but they were unable to repay the money. Either Paulson or its customers would end
up bearing the loss. What is the fair result? The law takes the view that the principal is
liable, not the third party, because the principal, by word or deed, allowed the third party to
believe that the agent was acting on the principal’s behalf. The principal could have
prevented the third party from losing money.
Although the two brokers did not have express or implied authority to sell the stock
(Paulson had not authorized them to break the law), the company was nonetheless liable on
the grounds that the brokers had apparent authority. Paulson had sent letters to its customers
notifying them when it hired Kennedy. The two brokers made sales presentations at
Paulson’s offices. The company had never told customers that the two men were not
authorized to sell this worthless stock.13 Thus the agents appeared to have authority, even
though they did not. Of course, Paulson had the right to recover from Kennedy and Lambo,
if it could ever compel them to pay.
Remember that the issue in apparent authority is always what the principal has done to
make the third party believe that the agent has authority. Suppose that Kennedy and Lambo
never worked for Paulson but, on their own, printed up Paulson stationery. The company
would not be liable for the stock the two men sold because it had never done or said
anything that would reasonably make a third party believe that the men were its agents.
25-6b Ratification
If a person accepts the benefit of an unauthorized transaction or fails to repudiate it, then he
is as bound by the act as if he had originally authorized it. He has ratified the act.14 Many of
the cases in agency law involve instances in which one person acts without authority for
another. To avoid liability, the alleged principal shows that he had not authorized the task at
issue. But sometimes after the fact, the principal decides that he approves of what the agent
has done even though it was not authorized at the time. The law would be perverse if it did
not permit the principal, under those circumstances, to agree to the deal the agent has made.
12Restatement (Third) of Agency §2.03.
13Badger v. Paulson Investment Co., 311 Ore. 14, 803 P.2d 1178, 1991 Ore. LEXIS 7 (S. Ct. OR, 1991).
14Restatement (Third) of Agency §4.01.
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The law is not perverse, but it is careful. Even if an agent acts without authority, the
principal can decide later to be bound by her actions so long as these requirements are met:
• The “agent” indicates to the third party that she is acting for a principal.
• The “principal” knows all the material facts of the transaction.
• The “principal” accepts the benefit of the whole transaction, not just part.
• The third party does not withdraw from the contract before ratification.
A night clerk at the St. Regis Hotel in Detroit, Michigan, was brutally murdered in the
course of a robbery. A few days later, the Detroit News reported that the St. Regis manage-
ment had offered a $1,000 reward for any information leading to the arrest and conviction of
the killer. Two days after the article appeared, Robert Jackson turned in the man who was
subsequently convicted of the crime. But then it was Jackson’s turn to be robbed—the hotel
refused to pay the reward on the grounds that the manager who had made the offer had no
authority. Jackson still had one weapon left: He convinced the court that the hotel had
ratified the offer. One of the hotel’s owners admitted he read the Detroit News. The court
concluded that if someone reads a newspaper, he is sure to read any articles about a business
he owns; therefore, the owner must have been aware of the offer. He accepted the benefit
of the offer by failing to revoke it publicly by, say, announcing to the press that the reward
was invalid. This failure to revoke constituted a ratification, and the hotel was liable.15
25-6c Subagents
Many of the examples in this chapter involve a single agent acting for a principal. Real life is
often more complex. Daniel, the owner of a restaurant, hires Michaela to manage it. She in
turn hires chefs, waiters, and dishwashers. Daniel has never even met the restaurant help,
yet they are also his agents, albeit a special category called subagent. Michaela is called an
intermediary agent—someone who hires subagents for the principal.
As a general rule, an agent has no authority to delegate her tasks to another unless the
principal authorizes her to do so. But when an agent is authorized to hire a subagent, the
principal is as liable for the acts of the subagent as he is for the acts of a regular agent. Daniel
authorizes Michaela to hire a restaurant staff, so she hires Lydia to serve as produce buyer.
When Lydia buys food for the restaurant, Daniel must pay the bill.
25-7 AGENT’S LIABILITY FOR CONTRACTS
The agent’s liability on a contract depends upon how much the third party knows about the
principal. Disclosure is the agent’s best protection against liability.
25-7a Fully Disclosed Principal
An agent is not liable for any contracts she makes on behalf of a fully disclosed principal. A
principal is fully disclosed if the third party knows of his existence and his identity. Augusta
acts as agent for Parker when he buys Tracey’s prize-winning show horse. Augusta and
Tracey both grew up in posh Grosse Pointe, Michigan, where they attended the same elite
schools. Tracey does not know Parker, but she figures any friend of Augusta’s must be OK.
She figures wrong—Parker is a charming deadbeat. He injures Tracey’s horse, fails to pay
the full contract price, and promptly disappears. Tracey angrily demands that Augusta make
15Jackson v. Goodman, 69 Mich. App. 225, 244 N.W.2d 423, 1976 Mich. App., LEXIS 741 (Mich. Ct.
App., 1976).
CHAPTER 25 Agency Law 601
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good on Parker’s debt. Unfortunately for Tracey, Parker was a fully disclosed principal—
Tracey knew of his existence and his identity. Although Tracey partly relied on Augusta’s good
character when contracting with Parker, Augusta is not liable because Tracey knew who the
principal was and could have (should have) investigated him. Augusta did not promise anything
herself, and Tracey’s only recourse is against the principal, Parker (wherever he may be).
To avoid liability when signing a contract on behalf of a principal, an agent must clearly state
that she is an agent and also must identify the principal. Augusta should sign a contract on behalf
of her principal, Parker, as follows: “Augusta, as agent for Parker” or “Parker, by Augusta, Agent.”
25-7b Unidentified Principal
In the case of an unidentified principal, the third party can recover from either the agent or
the principal. (An unidentified principal is also sometimes called a “partially disclosed princi-
pal.”) A principal is unidentified if the third party knew of his existence but not his identity.
Suppose that, when approaching Tracey about the horse, Augusta simply says, “I have a friend
who is interested in buying your champion.” Any friend of Augusta’s is a friend of Tracey’s—or
so Tracey thinks. Parker is an unidentified principal because Tracey knows only that he exists,
not who he is. She cannot investigate his creditworthiness because she does not know his
name. Tracey relies solely on what she is able to learn from the agent, Augusta. Both Augusta
and Parker are liable to Tracey. (They are jointly and severally liable, which means that Tracey
can recover from either or both of them. However, she cannot recover more than the total she is
owed: If her damages are $100,000, she can recover that amount from either Augusta or Parker,
or partial amounts from both, but in no event more than $100,000.)
25-7c Undisclosed Principal
In the case of an undisclosed principal, the third party can recover from either the agent or the
principal. A principal is undisclosed if the third party did not know of his existence. Suppose
that Augusta simply asks to buy the horse herself, without mentioning that she is purchasing
it for Parker. In this case, Parker is an undisclosed principal because Tracey does not know
that Augusta is acting for someone else. Both Parker and Augusta are jointly and severally
liable. As Exhibit 25.1 illustrates, the principal is always liable, but the agent is not unless
the principal’s identity is a mystery.
Unidentified
Principal
Fully
Disclosed
Principal
Undisclosed
Principal
Agent
Is Not
Liable on
Contract
Agent
Is Liable
on
Contract
Principal
Is Liable
on
Contract
©
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EXHIB IT 25.1 Liability of Principal and Agent
602 U N I T 3 Commercial Transactions
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In some ways, the concept of an undisclosed principal violates principles of contract
law. If Tracey does not even know that Parker exists, how can they have an agreement or a
meeting of the minds? Is such an arrangement fair to Tracey? No matter—a contract with an
undisclosed principal is binding. The following incident illustrates why.
William Zeckendorf was a man with a plan. For years, he had been eyeing a six-block
tract of land along New York’s East River. It was a wasteland of slums and slaughterhouses,
but he could see its potential. The meat packers had refused to sell to him, however,
because they knew they would never be permitted to build slaughterhouses in Manhattan
again. Finally, he got the phone call he had been waiting for. The companies were willing to
sell—at more than three times the market price of surrounding land. Undeterred, Zeck-
endorf immediately put down a $1 million deposit. But to make his investment worthwhile,
he needed to buy the neighboring property—once the slaughterhouses were gone, the other
land would be much more valuable. Zeckendorf was well
known as a wealthy developer; he had begun his business
career managing the Astor family’s real estate holdings. If
he personally tried to negotiate the purchase of the sur-
rounding land, word would soon get out that he wanted to
put together a large parcel. Prices would skyrocket, and the
project would become too costly. So he hired agents to
purchase the land for him. To conceal his involvement
further, he went to South America for a month. When he
returned, his agents had completed 75 different purchases,
and he owned 18 acres of land.
Shortly afterwards, the United Nations (UN) began
seeking a site for its headquarters. President Truman favored
Boston, Philadelphia, or a location in the Midwest. The UN committee suggested Greenwich or
Stamford, Connecticut. But John D. Rockefeller settled the question once and for all. He
purchased Zeckendorf’s land and donated it to the UN (netting Zeckendorf a 25 percent profit).
Without the cooperation of agency law, the UN headquarters would not be in New York today.
Because of concerns about fair play, there are some exceptions to the rule on undisclosed
principals. A third party is not bound to the contract with an undisclosed principal if (1) the
contract specifically provides that the third party is not bound to anyone other than the agent, or
(2) the agent lies about the principal because she knows the third party would refuse to contract
with him. Suppose that a large university is buying up land in an impoverished area near its
campus. An owner of a house there wants to make sure that if he sells to the university, he gets
a higher price than if he sells to an individual with more limited resources. A cagey property
owner, when approached by one of the university’s agents, could ask for a clause in the contract
providing that the agent was not representing someone else. If the agent told the truth, the
owner could demand a higher price. If the agent lied, then the owner could rescind the contract
when the truth emerged.
25-7d Unauthorized Agent
Thus far in this section, we have been discussing an agent’s liability to a third party for a
transaction that was authorized by the principal. Sometimes, however, agents act without
the authority of a principal. If the agent has no authority (express, implied, or apparent), the
principal is not liable to the third party, and the agent is. Suppose that Augusta agrees to sell
Parker’s horse to Tracey. Unfortunately, Parker has never met Augusta and has certainly not
authorized this transaction. Augusta is hoping that she can persuade him to sell, but Parker
refuses. Augusta, but not Parker, is liable to Tracey for breach of contract.
Without the cooperation
of agency law, the UN
headquarters would not
be in New York today.
CHAPTER 25 Agency Law 603
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25-8 PRINCIPAL’S LIABILITY FOR TORTS
An employer is liable for a tort committed by its employee acting within the scope of
employment or acting with authority.16 This principle of liability is called respondeat superior,
which is a Latin phrase that means “let the master answer.” Under the theory of respondeat
superior, the employer (i.e., the principal) is liable for misbehavior by the employee (i.e., the
agent) whether or not the employer was at fault. Indeed, the employer is liable even if he forbade
or tried to prevent the employee from misbehaving. Thus, a company could be liable for the
damage a worker causes while driving and talking on her cell phone, even if she is violating
company policy at the time. This sounds like a harsh rule. The logic is that, because the principal
controls the agent, he should be able to prevent misbehavior. If he cannot prevent it, at least he
can insure against the risks. Furthermore, the principal may have deeper pockets than the agent
or the injured third party and thus be better able to afford the cost of the agent’s misbehavior.
To apply the principle of respondeat superior, it is important to understand each part of the rule.
25-8a Employee
There are two kinds of agents: (1) employees and (2) independent contractors. A principal may
be liable for the torts of an employee but generally is not liable for the torts of an
independent contractor. Because of this rule, the distinction between an employee and an
independent contractor is important.
EMPLOYEE OR INDEPENDENT CONTRACTOR?
The more control the principal has over an agent, the more likely that the agent will be
considered an employee. Therefore, when determining if agents are employees or inde-
pendent contractors, courts consider whether:
• The principal supervises details of the work.
• The principal supplies the tools and place of work.
• The agents work full time for the principal.
• The agents receive a salary or hourly wages, not a fixed price for the job.
• The work is part of the regular business of the principal.
• The principal and agents believe they have an employer-employee relationship.
• The principal is in business.17
Suppose, for example, that Mutt and Jeff work 40 hours a week at Swansong Media
preparing food for the company’s onsite dining room. They earn a weekly salary. Swansong
provides food, utensils, and kitchen. This year, however, Swansong decides to go all out for
its holiday party, so it hires FiFi LaBelle to prepare special food. She buys the food,
prepares it in her own kitchen, and delivers it to the company in time for the party. She
is an independent contractor, while Mutt and Jeff are employees.
NEGLIGENT HIRING
Principals prefer agents to be considered independent contractors, not employees, because,
as a general rule, principals are not liable for the torts of an independent contractor. There
is, however, one exception to this rule: The principal is liable for the torts of an independent
16Restatement (Third) of Agency §7.07.
17Ibid.
604 U N I T 3 Commercial Transactions
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contractor if the principal has been negligent in hiring or supervising her. Remember that,
under respondeat superior, the principal is liable without fault for the torts of employees. The
case of independent contractors is different: The principal is liable only if he was at fault by
being careless in his hiring or supervising.
Exhibit 25.2 illustrates the difference in liability between an employee and an inde-
pendent contractor.
25-8b Scope of Employment
Principals are liable only for torts that an employee commits within the scope of employment.
If an employee leaves a pool of water on the floor of a store and a customer slips and falls,
the employer is liable. But if the same employee leaves water on his own kitchen floor and a
friend falls, the employer is not liable because the employee is not acting within the scope
of employment. An employee is acting within the scope of employment if the act:
• Is one that employees are generally responsible for
• Takes place during hours that the employee is generally employed
• Is part of the principal’s business
• Is similar to the one the principal authorized
• Is one for which the principal supplied the tools; and
• Is not seriously criminal.
Scope of employment cases raise two major issues: authorization and abandonment.
Principal
Principal may be
liable for Employee’s
torts, even if Principal
was not negligent
Principal is not liable
for torts of an
Independent Contractor
unless Principal was
negligent in hiring
or supervising
Does not control
agent
Con
tro
ls a
gen
t
Employee
Independent
Contractor
©
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EXHIB IT 25.2 Liability of Principal
CHAPTER 25 Agency Law 605
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AUTHORIZATION
In authorization cases, the agent is clearly working for the principal but commits an act that
the principal has not authorized. Although Jane has often told the driver of her delivery van
not to speed, Hank ignores her instructions and plows into Bernadette. At the time of the
accident, he is working for Jane, delivering flowers for her shop, but his act is not authorized.
An act is within the scope of employment, even if expressly forbidden, if it is of the same
general nature as that authorized or if it is incidental to the conduct authorized. Hank was
authorized to drive the van, but not to speed. However, his speeding was of the same
general nature as the authorized act, so Jane is liable to Bernadette.
ABANDONMENT
The second major issue in a scope of employment case involves abandonment. The principal is
liable for the actions of the employee that occur while the employee is at work, but not for
actions that occur after the employee has abandoned the principal’s business. Although the
rule sounds straightforward, the difficulty lies in determining whether the employee has in
fact abandoned the principal’s business. The employer is liable if the employee is simply on
a detour from company business, but the employer is not liable if the employee is off on a
frolic of his own. Suppose that Hank, the delivery van driver, speeds during his afternoon
commute home. An employee is generally not acting within the scope of his employment
when he commutes to and from work, so his principal, Jane, is not liable. Or suppose that,
while on the way to a delivery, he stops to view his favorite movie classic, Dead on Arrival.
Unable to see in the darkened theater, he knocks Anna down, causing grave harm. Jane is
not liable because Hank’s visit to the movies is outside the scope of his employ-
ment. On the other hand, if Hank stops at the Burger Box drive-in window en route
to making a delivery, Jane is liable when he crashes into Anna on the way out of the
parking lot because this time, he is simply making a detour.
Was the employee in the following case acting within the scope of his employment
while driving to work? You be the judge.
You Be the Judge
Facts: Staff Sergeant
William E. Dreyer was a
recruiter for the United
States Marine Corps.
Driving to work one
morning at 6:40 a.m., in
a government-owned car,
he struck and killed
12-year-old Justin Zankel. The child’s parents sued the
federal government, claiming that it was liable for
Dreyer’s actions because he had been acting within the
scope of his employment at the time of the accident.
The Marine Corps had provided Dreyer with a car to
drive while on government business, but he was not per-
mitted to use this car while commuting to and from home
unless he had specific authorization from his boss, Major
Michael Sherman. However, Sherman was flexible in giving
authorization and even permitted his soldiers simply to
leave a message on his
voicemail. Indeed, he
had denied only about a
dozen such requests over
a three-year period.
Each month, Dreyer
was expected to meet
specific quotas for the
number of contracts signed and recruits shipped to basic
training. However, despite working 16 to 18 hours every
day of the week, Dreyer had not met his recruiting quotas
for months. Sherman had formally reprimanded him and
increased his target for the following month.
On the day before the accident, Dreyer left home
at 6:30 a.m., driving his own car. At the office, he switched
to a government car and worked until 10:45 p.m. He then
discovered that his personal car would not start. He did
not want to call Sherman that late, so he drove his
ZANKEL V. UNITED STATES OF
AMERICA
2008 U.S. Dist. LEXIS 23655
United States District Court for the Western District of
Pennsylvania, 2008
606 U N I T 3 Commercial Transactions
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25-8c Intentional Torts
A principal is not liable for the intentional torts of an employee unless (1) the employee
intended to serve some purpose of the employer; or (2) the employer was negligent in hiring
or supervising this employee. During an NBA basketball game, Kobe pushes LeBron into
some chairs under the basket to prevent him from scoring a breakaway layup. Kobe’s team
is liable for his actions because he was motivated, at least in part, by a desire to help his
team. But if Kobe hits LeBron in the parking lot after the playoffs are over, Kobe’s team is
not liable because he is no longer motivated by a desire to help the team. His motivation
now is personal revenge or frustration.
In the following case, a priest did wrong. Was he serving some purpose of the Church?
Was the Church liable for his criminal acts?
government car home without permission. He believed
that, had he called, Sherman would have said it was OK.
Dreyer arrived home at midnight. He was under
orders to attend an early-morning training session the
next day. So he awoke early and left home at 6:35 a.m.
At 6:40 a.m., his car hit Justin Zankel.
You Be the Judge: Was Dreyer within the scope of
employment when he killed Zankel?
Argument for the Zankels: At the time of the accident,
Dreyer was driving a government vehicle. Although he
had not requested permission to drive the car, if he had
done so, permission certainly would have been granted.
Moreover, even if Dreyer was not authorized to
drive the Marine Corps car, the government is still
liable because his activity was of the same general
nature as that authorized and it was incidental to the
conduct authorized. Driving the car was part of
Dreyer’s work. Indeed, he could not perform his job
without it. In addition, Dreyer was on the road early so
that he could attend a required training session. He
was exhausted from trying to reach impossible goals.
The Marine Corps must bear responsibility for this
tragic accident.
Argument for United States: The government had a
clear policy stating that recruiters were not authorized to
drive a government car without first requesting permis-
sion. Dreyer had not done so. Therefore, he was not
authorized to drive the government car at the time of
the accident.
Moreover, it is well established that an employee
commuting to and from work is not within the scope of
employment. If Dreyer had been driving from one
recruiting event to another, that would be a different
story. But on the day of the accident, he had not yet
started work for the Marine Corps, and therefore the
government is not liable.
DOE V. LIBERATORE
478 F. Supp. 2d 742; 2007 U.S. Dist. LEXIS 19067
United States District Court for the Middle District of Pennsylvania, 2007
C A S E S U M M A R Y
Facts: A number of priests wrote to James Timlin, the
Bishop of Scranton, warning him that Father Albert Lib-
eratore was engaging in a sexual relationship with one of
his male students. Bishop Timlin transferred Liberatore
from the school to a parish church.
Fourteen year-old John Doe was a member of Libera-
tore’s parish. Liberatore befriended Doe, taking him on
outings and giving him expensive gifts. Doe routinely slept
in Liberatore’s bed. A number of priests told Bishop Timlin
that they feared Liberatore was sexually abusing Doe. One
witness reported that she had seen Doe put his hand down
Liberatore’s pants. Eventually, Doe himself told a priest
that he was being sexually abused. The priest instructed
Doe to forgive Liberatore and not to tell other people
because it would ruin Doe’s life and the lives of others.
Only after Liberatore pleaded guilty to multiple counts
of sexual abuse did the Church dismiss him from the priest-
hood. Doe filed suit against the Church and Bishop Timlin,
CHAPTER 25 Agency Law 607
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25-8d Physical or Nonphysical Harm
In the case of physical torts, a principal is liable for the negligent conduct of a
employee that occurs within the scope of employment. The rule for nonphysical torts
(i.e., torts that harm only reputation, feelings, or wallet) is different. Nonphysical torts
are treated more like a contract claim, and the principal is liable if the employee acted
with express, implied, or apparent authority.18 For example, suppose that Dwayne
buys a house insurance policy from Andy, who is an agent of the Balls of Fire
Insurance Company. Andy throws away Dwayne’s policy and pockets his premiums.
When Dwayne’s house burns down, Balls of Fire is liable because Andy was acting
with apparent authority.
EXAM Strategy
Question: Daisy was the founder of an Internet start-up company. Jay was her
driver. One day, after he had dropped her at a board meeting, he went to the car
wash. There, he told an attractive woman that he worked for a money
management firm. She gave him money to invest. On the way out of the car wash,
he was so excited that he hit another customer’s expensive car. Who is liable for
Jay’s misdeeds?
Strategy: In determining a principal’s liability, begin by figuring out whether the
agent has committed a physical or nonphysical tort. Remember that the principal
is liable for physical torts within the scope of employment, but for nonphysical
torts, she is liable only if the employee acted with authority.
Result: In this case, Daisy is liable for the damage to the car because that was a
physical tort within the scope of employment. But she is not liable for the investment
money because Jay did not have authority (express, implied, or apparent) to take
those funds.
alleging that they were liable for the torts committed by
Liberatore. The defendants filed a motion to dismiss.
Issues: Was Liberatore acting within the scope of his
employment? Were the defendants liable for his criminal acts?
Decision: The priest’s sexual misconduct was not within
the scope of his employment. Nevertheless, the defend-
ants could be liable on the grounds of negligent super-
vision.
Reasoning: Liberatore’s sexual abuse of a child was not
within the scope of his employment as a priest. In no way
did it serve the purposes of the Church or Bishop Timlin.
Therefore, the Court granted summary judgment for the
defendants on this issue.
However, an employer owes a duty to exercise
reasonable care in hiring and supervising employees.
The defendants are not negligent for hiring the priest
at the beginning because at that point, there was no
evidence he would sexually abuse children, but a jury
could certainly conclude that both the Church and
the Bishop had been negligent in supervising
Liberatore.
18Restatement (Third) of Agency §7.08.
608 U N I T 3 Commercial Transactions
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25-9 AGENT’S LIABILITY FOR TORTS
The focus of the prior section was on the principal’s liability for the agent’s torts. But it is
important to remember that agents are always liable for their own torts. Agents who commit
torts are personally responsible, whether or not their principal is also liable. Even if the tort
was committed to benefit the principal, the agent is still liable. So the sailor who got into a
fistfight while rousting a shipmate from bed is liable even though he thought he was acting
for the benefit of his principal.
This rule makes obvious sense. If the agent were not liable, he would have little
incentive to be careful. Imagine Hank driving his delivery van for Jane. If he were not
personally liable for his own torts, he might think, “If I drive fast enough, I can make it
through that light even though it just turned red. And if I don’t, what the heck, it’ll be
Jane’s problem, not mine.” Agents, as a rule, may have fewer assets than their principal, but
it is important that their personal assets be at risk in the event of their negligent behavior.
If the agent and principal are both liable, which does the injured third party sue? The
principal and the agent are jointly and severally liable, which means, as we have seen, that the
injured third party can sue either one or both, as she chooses. If she recovers from the
principal, he can sue the agent.
Chapter Conclusion
When students enroll in a business law course, they fully expect to learn about torts and
contracts, corporations and partnerships. They probably do not think much about agency
law; many of them have not even heard the term before. Yet it is an area of the law that
affects us all because each of us has been and will continue to be both an agent and a
principal many times in our lives.
EXAM REVIEW
1. CREATING AN AGENCY RELATIONSHIP A principal and an agent
mutually consent that the agent will act on behalf of the principal and be subject to
the principal’s control, thereby creating a fiduciary relationship. (pp. 588–590)
2. ELEMENTS NOT REQUIRED An agency relationship can exist without either
a written agreement, a formal agreement, or compensation. (pp. 589–590)
3. AN AGENT’S DUTIES TO THE PRINCIPAL An agent owes these duties to
the principal: duty of loyalty, duty to obey instructions, duty of care, and duty to
provide information. (pp. 590–595)
4. THE PRINCIPAL’S REMEDIES IN THE EVENT OF A BREACH The
principal has three potential remedies when the agent breaches her duty: recovery of
damages the breach has caused, recovery of any profits earned by the agent from the
breach, and rescission of any transaction with the agent. (pp. 594–595)
CHAPTER 25 Agency Law 609
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5. THE PRINCIPAL’S DUTIES TO THE AGENT The principal has three duties
to the agent: to compensate as provided by the agreement, to reimburse legitimate
expenses, and to cooperate with the agent. (pp. 595–596)
6. POWER AND RIGHT TO TERMINATE Both the agent and the principal
have the power to terminate an agency relationship, but they may not have the right.
If the termination violates the agency agreement and causes harm to the other party,
the wrongful party must pay damages. (pp. 596–598)
7. AUTOMATIC TERMINATION An agency relationship automatically
terminates if the principal or agent no longer can perform the required duties or if a
change in circumstances renders the agency relationship pointless. (p. 596)
8. A PRINCIPAL’S LIABILITY FOR CONTRACTS A principal is liable for the
contracts of the agent if the agent has express, implied, or apparent authority.
(pp. 599–601)
9. EXPRESS AUTHORITY The principal grants express authority by words or
conduct that, reasonably interpreted, cause the agent to believe that the principal
desires her to act on the principal’s account. (p. 599)
10. IMPLIED AUTHORITY Implied authority includes authority to do acts that are
incidental to a transaction, usually accompany it, or are reasonably necessary to
accomplish it. (pp. 599–600)
11. APPARENT AUTHORITY Apparent authority means that a principal is liable for
the acts of an agent who is not, in fact, acting with authority if the principal’s conduct
causes a third party reasonably to believe that the agent is authorized. (p. 600)
Question: Dr. James Leonard wrote Dr. Edward Jacobson to offer him the
position of chief of audiology at Jefferson Medical College in Philadelphia. In the
letter, Leonard stated that this appointment would have to be approved by the
promotion and appointment committee. Jacobson believed that the appointment
committee acted only as a “rubber stamp,” affirming whatever recommendation
Leonard made. Jacobson accepted Leonard’s offer and proceeded to sell his house
and quit his job in Colorado. You can guess what happened next. Two weeks
later, Leonard sent Jacobson another letter, rescinding his offer because of
opposition from the appointment committee. Did Leonard have apparent
authority?
Strategy: In cases of apparent authority, begin by asking what the principal did to
make the third party believe that the agent was authorized. What did the Medical
College do? (See the “Result” at the end of this section.)
12. AN AGENT’S LIABILITY FOR A CONTRACT An agent is not liable for any
contract she makes on behalf of a fully disclosed principal. The principal is liable. In
the case of a unidentified or undisclosed principal, both the agent and the principal
are liable on the contract. (pp. 601–603)
E
X
A
M
S
tr
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610 U N I T 3 Commercial Transactions
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13. A PRINCIPAL’S LIABILITY FOR TORTS An employer is liable for a tort
committed by its employee acting within the scope of employment or acting with
authority. (pp. 604–608)
Question: While drunk, the driver of a subway car plows into the back of the car
ahead of him, killing a passenger. It was against the rules for the driver to be
drunk. Is the subway authority liable for the negligence of its employee?
Strategy: With a tort case, always determine first if the agents are employees or
independent contractors. This worker was an employee. Then ask if the employee
was acting within the scope of employment. Yes, he was driving a subway car, which
is what he was hired to do. Does it matter than he had violated subway rules? No,
his violation of the rules does not eliminate his principal’s liability. (See the
“Results” at the end of this section.)
14. INDEPENDENT CONTRACTOR The principal is liable for the physical torts
of an independent contractor only if the principal has been negligent in hiring or
supervising him. (p. 604)
15. INTENTIONAL TORTS A principal is not liable for the intentional torts of an
employee unless (1) the employee intended to serve some purpose of the employer; or
(2) the employer was negligent in hiring or supervising the employee. (pp. 607–608)
Question: What if the subway driver mentioned above had stabbed a passenger?
Strategy: In the case of an intentional tort, the principal is liable only if the agent
was intending to serve some purpose of the employer or the employer was
negligent in hiring or supervising him. (See the “Results” at the end of this
section.)
16. NONPHYSICAL TORTS A principal is liable only for the nonphysical torts of
an employee who is acting with express, implied, or apparent authority. (p. 608)
17. AGENT’S LIABILITY FOR TORTS Agents are always liable for their own torts.
(p. 609)
11. Result: No. Indeed, Leonard had told Jacobson that he did not have authority.
If Jacobson chose to believe otherwise, that was his problem.
13. Result: The subway authority is liable.
15. Result: When he stabbed a passenger, the driver was not serving the purpose of
the employer, so the subway authority would not be liable. There was no evidence
that the subway authority had been negligent in its hiring or supervising of employees.
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MULTIPLE-CHOICE QUESTIONS
1. At Business University, semester enrollment begins at midnight on April 1. Jasper
asked his roommate, Alonso, to register him for an important required course as a
favor. Alonso agreed to do so but then overslept. As a result, Jasper could not enroll in
the required course he needed to graduate and had to stay in school for an additional
semester. Is Alonso liable to Jasper?
(a) No, because an agency agreement is invalid unless the agent receives payment.
(b) No, because Alonso was not grossly negligent.
(c) No, because the cost of the extra semester is unreasonably high.
(d) Yes, because Alonso disobeyed his instructions.
2. Finn learns that, despite his stellar record, he is being paid less than other salespeople
at Barry Co., so he decides to start his own company. During his last month on the
Barry payroll, he tells all of his clients about his new business. He also tells them that
Barry is a great company, but his fees will be lower. After he opens the doors of his
new business, most of his former clients move with him. Is Finn liable to Barry?
(a) No, because he has not been disloyal to Barry—he praised the company.
(b) No, because Barry was underpaying him.
(c) No, because his clients have the right to hire whichever company they choose.
(d) Yes, Finn has violated his duty of loyalty to Barry.
3. Kurt asked his car mechanic, Quinn, for help in buying a used car. Quinn
recommends a Ford Focus that she has been taking care of its whole life. Quinn was
working for the seller. Which of the following statements is true?
(a) Quinn must pay Kurt the amount of money she received from the Ford’s prior
owner.
(b) After buying the car, Kurt finds out that it needs $1,000 in repairs. He can recover
that amount from Quinn, but only if Quinn knew about the needed repairs before
Kurt bought the car.
(c) Kurt cannot recover anything because Quinn had no obligation to reveal her
relationship with the car’s seller.
(d) Kurt cannot recover anything because he had not paid Quinn for her help.
4. Figgins is the dean of a college. He appointed Sue as acting dean while he was out of
the country and posted an announcement on the college website announcing that she
was authorized to act in his place. He also told Sue privately that she did not have the
right to make admissions decisions. While Figgins was gone, Sue overruled the
admissions committee to admit the child of a wealthy alumnus. Does the child have
the right to attend this college?
(a) No, because Sue was not authorized to admit him.
(b) No, because Figgins did not ratify Sue’s decision.
(c) Yes, because Figgins was a fully disclosed principal.
(d) Yes, because Sue had apparent authority.
612 U N I T 3 Commercial Transactions
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5. CPA QUESTION A principal will not be liable to a third party for a tort committed
by an agent:
(a) unless the principal instructed the agent to commit the tort.
(b) unless the tort was committed within the scope of the agency relationship.
(c) if the agency agreement limits the principal’s liability for the agent’s tort.
(d) if the tort is also regarded as a criminal act.
6. CPA QUESTION Cox engaged Datz as her agent. It was mutually agreed that Datz
would not disclose that he was acting as Cox’s agent. Instead, he was to deal with
prospective customers as if he were a principal acting on his own behalf. This he did
and made several contracts for Cox. Assuming Cox, Datz, or the customer seeks to
avoid liability on one of the contracts involved, which of the following statements is
correct?
(a) Cox must ratify the Datz contracts to be held liable.
(b) Datz has no liability once he discloses that Cox was the real principal.
(c) The third party can avoid liability because he believed he was dealing with Datz
as a principal.
(d) The third party may choose to hold either Datz or Cox liable.
ESSAY QUESTIONS
1. An elementary school custodian hit a child who wrote graffiti on the wall. Is the school
district liable for this intentional tort by its employee?
2. What if the custodian hit one of the schoolchildren for calling him a name? Is the
school district liable?
3. A soldier was drinking at a training seminar. Although he was told to leave his car
at the seminar, he disobeyed orders and drove to a military club. On the way to
the club, he was involved in an accident. Is the military liable for the damage
he caused?
4. One afternoon while visiting friends, tennis star Vitas Gerulaitis fell asleep in their
pool house. A mechanic had improperly installed the swimming pool heater,
which leaked carbon monoxide fumes into the house where he slept, killing him.
His mother filed suit against the owners of the estate. On what theory would they
be liable?
5. YOU BE THE JUDGE WRITING PROBLEM Sarah went to an auction at
Christie’s to bid on a tapestry for her employer, Fine Arts Gallery. The good news is
that she purchased a Dufy tapestry for $77,000. The bad news is that it was not the
one her employer had told her to buy. In the excitement of the auction, she forgot her
instructions. Fine Art refused to pay, and Christie’s filed suit. Is Fine Arts liable for
the unauthorized act of its agent? Argument for Christie’s: Christie’s cannot possibly
ascertain in each case the exact nature of a bidder’s authority. Whether or not Sarah
had actual authority, she certainly had apparent authority, and Fine Arts is liable.
Argument for Fine Arts: Sarah was not authorized to purchase the Dufy tapestry, and
therefore Christie’s must recover from her, not Fine Arts.
CHAPTER 25 Agency Law 613
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DISCUSSION QUESTIONS
1. ETHICS Mercedes has just begun work at
Photobook.com. What a great place to work!
Although the salary is not high, the company has
fabulous perks. The dining room provides great
food from 7 a.m. to midnight, five days a week.
There is also a free laundry and dry-cleaning
service. Mercedes’s social life has never been
better. She invites her friends over for Photobook
meals and has their laundry done for free. And
because her job requires her to be online all the
time, she has plenty of opportunity to stay in touch
with her friends by g-chatting, tweeting, and
checking Facebook updates. She is, however,
shocked that one of her colleagues takes paper
home from the office for his children to use at
home. Are these employees behaving ethically?
2. Kevin was the manager of a radio station, WABC.
A competing station lured him away. In his last
month on the job at WABC, he notified two key
on-air personalities that if they were to leave the
station, he would not hold them to their
noncompete agreements. What can WABC do?
3. Jesse worked as a buyer for the Vegetable Co.
Rachel offered to sell Jesse 10 tons of tomatoes
for the account of Vegetable. Jesse accepted the
offer. Later, Jesse discovered that Rachel was
an agent for Sylvester Co. Who is liable on this
contract?
4. The Pharmaceutical Association holds an annual
convention. At the convention, Brittany, who was
president of the association, told Luke that
Research Corp. had a promising new cancer
vaccine. Luke was so excited that he chartered a
plane to fly to Research’s headquarters. On the
way, the plane crashed and Luke was killed. Is the
Pharmaceutical Association liable for Luke’s
death?
5. Betsy has a two-year contract as a producer at
Jackson Movie Studios. She produces a remake of
the movie Footloose. Unfortunately, it bombs, and
Jackson is so furious that he fires her on the
weekend the movie opens. Does he have the
power to do this?
614 U N I T 3 Commercial Transactions
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UNIT4
Employment, Business
Organizations and Property
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

CHAPTER26
EMPLOYMENT
AND LABOR
LAW
“On the killing beds you were apt to be covered
with blood, and it would freeze solid; if you
leaned against a pillar, you would freeze to that,
and if you put your hand upon the blade of your
knife, you would run a chance of leaving your
skin on it. The men would tie up their feet in
newspapers and old sacks, and these would be soaked in
blood and frozen, and then soaked again, and so on, until
by nighttime a man would be walking on great lumps
the size of the feet of an elephant. Now and then, when
the bosses were not looking, you would see them plunging
their feet and ankles into the steaming hot carcass of the
steer.… The cruelest thing of all was that nearly all of
them—all of those who used knives—were unable to wear
gloves, and their arms would be white with frost and their
hands would grow numb, and then of course there would
be accidents.”1
… you would see them
plunging their feet and
ankles into the steaming
hot carcass of the steer.
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1From Upton Sinclair, The Jungle (New York: Bantam Books, 1981), p. 80, a 1906 novel about the meat-packing industry.
616 U N I T 4 Employment, Business Organizations and Property
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26-1 INTRODUCTION
For most of history, the concept of career planning was unknown. By and large, people were
born into their jobs. Whatever their parents had been—landowner, soldier, farmer, servant,
merchant, or beggar—they became, too. People not only knew their place, they also
understood the rights and obligations inherent in each position. The landowner had the
right to receive labor from his tenants, but he also cared for them if they fell ill. Certainly,
there were abuses, but at a time when people held religious convictions about their position
in life and workers had few expectations that their lives would be better than their parents’,
the role of law was limited.
The primary English law of employment simply established that, in the absence of a
contract, an employee was hired for a year at a time. This rule was designed to prevent
injustice in a farming society. If an employee worked through harvest time, the landowner
could not fire him in the unproductive winter. Conversely, a worker could not stay the
winter and then leave for greener pastures in the spring.
In the eighteenth and nineteenth centuries, the Industrial Revolution profoundly
altered the employment relationship. Many workers left the farms and villages for large
factories in the city. Bosses no longer knew their workers personally, so they felt little
responsibility toward them. The old laws that had suited an agrarian economy with stable
relationships did not fit the new employment conditions. Instead of duties and responsi-
bilities, courts emphasized the freedom to contract. Since employees could quit their factory
jobs whenever they wanted, it seemed only fair for employers to have the same freedom to
fire a worker. That was indeed the rule adopted by the courts: Unless workers had an
explicit employment contract, they were employees at will. An employee at will could be
fired for a good reason, a bad reason, or no reason at all. For nearly a century, this was the
basic common law rule of employment. A court explained the rule this way:
Precisely as may the employee cease labor at his whim or pleasure, and, whatever be his reason,
good, bad, or indifferent, leave no one a legal right to complain; so, upon the other hand, may the
employer discharge, and, whatever be his reason, good, bad, or indifferent, no one has suffered a
legal wrong.2
However evenhanded this common law rule of employment may have sounded in
theory, in practice, it could lead to harsh results. The lives of factory workers were
grim. It was not as if they could simply pack up and leave; conditions were no better
elsewhere. Courts and legislatures gradually began to recognize that individual work-
ers were generally unable to negotiate fair contracts with powerful employers. Since
the beginning of the twentieth century, employment law has changed dramatically.
Now, the employment relationship is more strictly regulated by statutes and by the
common law.
Note well, though: In the absence of a specific legal exception, the rule in the United
States is still that an employee at will can be fired for any reason. But today there are several
important exceptions to this rule. Many of the statutes discussed in this chapter and the
next were passed by Congress and therefore apply nationally. The common law, however,
comes from state courts and only applies locally. We will look at a sampling of cases that
illustrates national trends, even though the law may not be the same in every state.
This chapter covers five topics in employment law: (1) employment security, (2) privacy
in the workplace, (3) safety issues, (4) financial protection, and (5) labor law. Chapter 27
covers employment discrimination.
2Union Labor Hospital Assn. v. Vance Redwood Lumber Co., 112 P.886, 888, 1910 Cal. LEXIS 417
(Cal., 1910).
CHAPTER 26 Employment and Labor Law 617
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26-2 EMPLOYMENT SECURITY
26-2a Family and Medical Leave Act
The Family and Medical Leave Act (FMLA) guarantees both men and women up to
12 weeks of unpaid leave each year for childbirth, adoption, or a serious health condition
of their own or in their immediate family. This statute defines an immediate family member
as a spouse, child, or parent—but not a sibling, grandchild, or in-law. An employee who
takes a leave must be allowed to return to the same or an equivalent job with the same pay
and benefits. The FMLA applies only to companies with at least 50 workers and to
employees who have been with the company full time for at least a year.
Here are some examples of what counts as a “serious health condition” under this
statute:
• Any health issue that requires hospitalization.
• A condition that requires more than one visit to a health care provider. The visits may
be spread out over as long as a year.
• A condition that requires only one visit to a health care provider, but which also
requires a course of treatment such as physical therapy or prescription medication.
Thus, the FMLA would apply in the case of a heart attack, ongoing kidney dialysis, and
an ear infection that required antibiotics. It would generally not cover food poisoning that
did not require hospitalization, the common cold, or a sprained ankle.
Kevin Knussman was the first person to win a lawsuit under the FMLA. While a
Maryland state trooper, he requested eight weeks of leave to care for his pregnant wife,
who was suffering severe complications. His boss granted only two weeks. After Knussman’s
daughter was born, his boss again denied leave, saying that “God made women to have
babies.” Knussman ultimately recovered $40,000.3
In many FMLA lawsuits, a worker claims that he or she was fired in retaliation for
taking leave, while the employer argues that the termination was for some other reason. The
following case illustrates this dynamic.
PETERSON V. EXIDE TECHNOLOGIES
2012 U.S. App. LEXIS 7139
Tenth Circuit Court of Appeals, 2012
Facts: Exide Technologies repeatedly warned Robert
Peterson that he was driving forklifts too fast and violating
other safety rules. After he was injured in a forklift crash,
Exide granted him FMLA leave for 10 days while he
recovered.
Peterson’s manager fired him during the leave for
“flagrant violations of safety rules.” Peterson sued, claiming
that he was terminated in retaliation for exercising his right
to take FMLA leave. The lower court granted summary
judgment to Exide, and Peterson appealed.
Issue: Was Peterson fired in retaliation for taking FMLA
leave?
Decision: No, Peterson was fired for violating safety
rules. The grant of summary judgment is affirmed.
Reasoning: The FMLA prohibits an employer from
retaliating against a worker for exercising his rights under
the statute. The analysis of such a claim requires three
steps:
3Eyal Press, “Family-Leave Values,” New York Times, July 29, 2007.
618 U N I T 4 Employment, Business Organizations and Property
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Ethics Although the FMLA offers important protections, the United States is the
only wealthy country that does not provide mandatory paid maternity leave.
Should Congress modify the FMLA to require some period of paid leave for new mothers? If
so, for how long? A few weeks while they recuperate from childbirth? Or a few months to
care for the newborn? What about paternity leave, which many countries require? And how
about workers who take FMLA leave to deal with a serious illness? Should they be paid?
26-2b Health Insurance
Companies are not required to provide their employees with health insurance. However,
current legislation specifies that, starting in 2015, employers who have more than
50 full-time employees must pay a penalty if they do not provide basic health insurance.
In addition, company insurance policies must now cover employees’ children up to the age
of 26.
Losing your job does not mean that you must also give up your health insurance—at
least not right away. Under the Consolidated Omnibus Budget Reconciliation Act
(COBRA), former employees must be allowed to continue their health insurance for
18 months after being terminated from their job. The catch is that employees must pay
for it themselves, up to 102 percent of the cost. (The extra 2 percent covers administrative
expenses.) COBRA applies to any company with 20 or more workers.
26-2c Common Law Protections
The employment-at-will doctrine was created by the courts. Because that rule has some-
times led to grossly unfair results, the courts have now created a major exception to the
rule—wrongful discharge.
WRONGFUL DISCHARGE: VIOLATING PUBLIC POLICY
Olga Monge was a schoolteacher in her native Costa Rica. After moving to New Hampshire,
she attended college in the evenings to earn U.S. teaching credentials. At night, she worked
at the Beebe Rubber Co. During the day, she cared for her husband and three children.
When she applied for a better job at her plant, the foreman offered to promote her if she
would be “nice” and go out on a date with him. When she refused, he assigned her to a
1. the worker must present evidence of retaliation
2. the company then has to show a legitimate reason
for the firing
3. the worker must provide evidence that the
company’s reason was just a pretext.
Peterson was fired while on FMLA leave. That fact
is evidence of retaliation. But Exide presented a legitimate
reason for the firing. Photographs of thedamage causedby the
forklift crash indicated that Petersonhadbeendriving fast and
recklessly. Such conduct was a dangerous violation of the
company’s policies. Moreover, Peterson had a history of such
unsafe behavior.
The burden was then on Peterson to show that this
reason was simply an excuse. He argued that the accident
had been too minor to justify his firing. It is not at all clear
that the accident was minor. But, in any event, Exide had
the right to fire employees even for minor safety viola-
tions. And when a worker has a history of unsafe behavior,
a minor accident could well be the last straw.
In short, Peterson did not meet the requirements of
the statute to show that the company retaliated against
him for exercising his FMLA rights.
Wrongful discharge
An employer may not fire a
worker for a reason that
violates basic social rights,
duties or responsibilities.
CHAPTER 26 Employment and Labor Law 619
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lower-wage job, took away her overtime, made her clean the washrooms, and generally
ridiculed her. Finally, she collapsed at work, and he fired her.4
Imagine that you are one of the judges who decided this case. Olga Monge has been
treated abominably, but she was an employee at will and, as you well know, could be fired
for any reason. But how can you let the foreman get away with this despicable behavior?
The New Hampshire Supreme Court decided that even an employee at will has some
rights:
We hold that a termination by the employer of a contract of employment at will which is
motivated by bad faith or malice or based on retaliation is not in the best interest of the economic
system or the public good and constitutes a breach of the employment contract.5
The Monge case illustrates the concept of wrongful discharge, which prohibits an
employer from firing a worker for certain particularly bad reasons.
How do the courts define a “bad reason”? It is a reason that violates public policy.
Unfortunately, this public policy rule is easier to name than it is to define because its
definition and application vary from state to state. In essence, the public policy rule prohibits
an employer from firing a worker for a reason that violates basic social rights, duties, or
responsibilities. Almost every employee who has ever been fired feels that a horrible injustice
has been done. The difficulty, from the courts’ perspective, is to distinguish those cases of
dismissal that are offensive enough to affront the community at large from those that outrage
only the employee. The courts have primarily applied the public policy rule when an
employee refuses to violate the law, performs a legal duty, exercises a legal right, or supports
basic societal values.
Refusing to Violate the Law Larry Downs went to Duke Hospital for surgery on his
cleft palate. When he came out of the operating room, the doctor instructed a nurse,
Marie Sides, to give Downs enough anesthetic to immobilize him. Sides refused because
she thought the anesthetic was wrong for this patient. The doctor angrily administered
the anesthetic himself. Shortly thereafter, Downs stopped breathing. Before the doctors
could resuscitate him, he suffered permanent brain damage. When Downs’s family sued the
hospital, Sides was called to testify. A number of Duke doctors told her that she would be
“in trouble” if she testified. She did testify, and after three months of harassment, she was
fired. When she sued Duke University, the court held:
It would be obnoxious to the interests of the state and contrary to public policy and sound
morality to allow an employer to discharge any employee, whether the employment be for a
designated or unspecified duration, on the ground that the employee declined to commit perjury,
an act specifically enjoined by statute. To hold otherwise would be without reason and contrary to
the spirit of the law.6
As a general rule, employees may not be discharged for refusing to break the law. For
example, courts have protected employees who refused to participate in an illegal price-
fixing scheme, falsify pollution control records required by state law, pollute navigable
waters in violation of federal law, or assist a supervisor in stealing from customers.7
4Monge v. Beebe, 114 N.H. 130, 316 A.2d 549, 1974 N.H. LEXIS 223 (NH S. Ct., 1974).
5Id. at 133.
6Sides v. Duke University, 74 N.C. App. 331, 328 S.E.2d 818, 1985 N.C. App. LEXIS 3501 (N.C. Ct.
App. 1985).
7Tameny v. Atlantic Richfield Co., 27 Cal. 3d 167, 610 P.2d 1330, 1980 Cal. LEXIS 171 (1980); Trombetta
v. Detroit, T. & I. R., 81 Mich. App. 489, 265 N.W.2d 385, 1978 Mich. App. LEXIS 2153 (Mich. Ct.
App. 1978); Sabine Pilot Service, Inc. v. Hauck, 28 Tex. Sup. J. 339, 687 S.W.2d 733, 1985 Tex. LEXIS
755 (1985); Vermillion v. AAA Pro Moving & Storage, 146 Ariz. 215, 704 P.2d 1360, 1985 Ariz. App.
LEXIS 592 (Ariz. Ct. App. 1985).
620 U N I T 4 Employment, Business Organizations and Property
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Performing a Legal Duty Courts have consistently held that an employee may not be
fired for serving on a jury. Employers sometimes have difficulty replacing employees who are
called up for jury duty and, therefore, prefer that their workers find some excuse for not serving.
But jury duty is an important civic obligation that employers are not permitted to undermine.
Exercising a Legal Right As a general rule, an employer may not discharge a worker
for exercising a legal right if that right supports public policy. Dorothy Frampton injured her
arm while working at the Central Indiana Gas Co. Her employer (and its insurance
company) paid her medical expenses and her salary during the four months she was unable
to work. When she discovered that she also qualified for benefits under the state’s workers’
compensation plan, she filed a claim and received payment. One month later, the company
fired her without giving a reason. In her suit against the gas company, the court held:
The [Workers’ Compensation] Act creates a duty in the employer to compensate employees for
work-related injuries and a right in the employee to receive such compensation. If employers are
permitted to penalize employees for filing workmen’s compensation claims, a most important
public policy will be undermined. Employees will not file claims for justly deserved compensa-
tion—opting, instead, to continue their employment without incident. The end result, of course,
is that the employer is effectively relieved of his obligation.8
Supporting Societal Values Courts are sometimes willing to protect employees who
do the right thing, even if they violate the boss’s orders. Kevin Gardner had just parked his
armored truck in front of a bank in Spokane, Washington, when he saw a man with a knife
chase the manager out of the bank. While running past the truck, the manager looked directly
at Gardner and yelled, “Help me, help me.” Gardner got out of his truck and locked the door.
By then, the suspect had grabbed another woman, put his knife to her throat, and dragged her
into the bank. Gardner followed them in, tackled the suspect, and disarmed him. The rescued
woman hailed Gardner as a hero, but his employer fired him for violating a “fundamental”
company rule that prohibited drivers from leaving their armored trucks unattended. However,
the court held for Gardner on the grounds that, although he had no affirmative legal duty to
intervene in such a situation, society values and encourages voluntary rescuers when a life is
in danger.9 This issue is, however, one on which the courts are divided. Not all would have
made the same decision.
In the following case, two employees objected when their company supplied defective
human tissue for transplantation into live patients. Should the court protect them from
termination?
KOZLOSKI V. AMERICAN TISSUE SERVICES FOUNDATION
2006 U.S. Dist. LEXIS 95435
United States District Court for the District of Minnesota, 2006
C A S E S U M M A R Y
Facts: American Tissue Services Foundation (ATSF)
was in the business of supplying human tissue from cada-
vers for transplantation into live patients. Mike Slack, an
employee of ATSF, revealed to his boss that he had
falsified a donor medical record and changed the donor’s
blood type on the form. This falsification was not only
dangerous to recipients of the tissue, it violated Food and
Drug Administration (FDA) regulations. Slack was fired
and the infractions were reported to the FDA, as required
by law.
8Frampton v. Central Indiana Gas Co., 260 Ind. 249, 297 N.E.2d 425, 1973 Ind. LEXIS 522 (1973).
9Gardner v. Loomis Armored, Inc., 913 P.2d 377, 1996 Wash. LEXIS 109 (1996).
CHAPTER 26 Employment and Labor Law 621
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CONTRACT LAW
Traditionally, many employers (and employees) thought that only a formal, signed
document qualified as an employment contract. Increasingly, however, courts have been
willing to enforce an employer’s more casual promises, whether written or oral. Some-
times courts have also been willing to imply contract terms in the absence of an express
agreement.
Truth in Hiring Oral promises made during the hiring process can be enforceable, even
if not approved by the company’s top executives. When the Tanana Valley Medical-
Surgical Group, Inc., hired James Eales as a physician’s assistant, it promised him that
so long as he did his job, he could stay there until retirement age. Six years later, the
company fired him without cause. The Alaska Supreme Court held that the clinic’s
promise was enforceable.10
Employee Handbooks The employee handbook at Blue Cross & Blue Shield stated
that employees could be fired only for just cause and then only after warnings, notice, a
hearing, and other procedures. Charles Toussaint was fired summarily five years after he
joined the company. Although this decision was ultimately reviewed by the personnel
department, company president, and chairman of the board of trustees, Toussaint was not
given the benefit of all of the procedures in the handbook. The court held that an employee
handbook creates a contract.11
Covenant of Good Faith and Fair Dealing A covenant of good faith and fair
dealing prohibits one party to a contract from interfering with the other’s right to benefit
under the contract. All parties are expected to behave in a fair, decent, and reasonable
manner. In almost all states, courts will imply a covenant of good faith and fair dealing in an
at-will employment relationship. These cases, however, have all arisen in situations in
which an employer fires a worker to avoid paying promised income or benefits.
It turned out, however, that Slack was the foster child
of the company’s chairman. And, in this case, (foster) blood
was thicker than water. The chairman not only hired Slack
at another company as a quality assurance specialist
(believe it or not), but he fired Slack’s boss and the two
men who had reported the problem to the FDA. The men
filed suit against ATSF for wrongful discharge, but the
company filed a motion to dismiss on the grounds that
the public policy doctrine in Minnesota applied only to
employees who had refused to violate the law.
Issues: Does the public policy doctrine in Minnesota
apply only to employees who refuse to violate the law? Do
the plaintiffs have the right to proceed with their lawsuit?
Decision: The wrongful discharge doctrine also applies
to situations in which an employee is fired for a reason
that clearly violates public policy. The defendants may
proceed with their lawsuit.
Reasoning: These plaintiffs were fired because they
reported to their employer and the FDA their concerns
that human tissue was wrongly labeled. This wrong-
doing not only created grave risks for the recipients it
also violated federal law. ATSF alleges that under
Minnesota law, employees can bring a wrongful dis-
charge claim only if they were fired for refusing to
violate the law. This reading of the law is incorrect.
Wrongful discharge also applies when the termination
is for a reason that clearly violates public policy. This
termination meets that standard. The safe use of human
tissue in live patients is clearly a matter of public safety
and, therefore, public policy.
10Eales v. Tanana Valley Medical-Surgical Group, Inc., 663 P.2d 958, 1983 Alas. LEXIS 430 (Alaska
1983).
11Toussaint v. Blue Cross & Blue Shield, 408 Mich. 579, 292 N.W.2d 880, 1980 Mich. LEXIS 227 (1980).
622 U N I T 4 Employment, Business Organizations and Property
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When Forrest Fleming went to work for Parametric Technology Corp., the company
promised him valuable stock options if he met his sales goals. He would not be able to
exercise the options (i.e., purchase the stock), however, until several years after they were
granted, and then only if he was still employed by the company. During his four years with
Parametric, Fleming received options to purchase about 18,000 shares for a price as low as
25 cents each. The shares ultimately traded in the market for as much as $50. Although
Fleming exercised some options, the company fired him three months before he became
eligible to purchase an additional 1,000 shares. The jury awarded him $1.6 million in
damages. Although Parametric had not violated the explicit terms of the option agreement,
the jury believed it had violated the covenant of good faith and fair dealing by firing
Fleming to prevent him from exercising his remaining options.12
TORT LAW
Workers have successfully sued their employers under the following tort theories.
Defamation Employers may be liable for defamation when they give false and unfavor-
able references about a former employee. In his job as a bartender at the Capitol Grille
restaurant, Christopher Kane often flirted with customers. After he was fired from his job, his
ex-boss claimed that Kane had been “fired fromevery job he ever had for sexual misconduct.” In
fact, Kane had never been fired before. He recovered $300,000 in damages for this defamation.
More than half of the states, however, recognize a qualified privilege for employers who
give references about former employees. A qualified privilege means that employers are
liable only for false statements that they know to be false or that are primarily motivated by
ill will. After Becky Chambers left her job at American Trans Air, Inc., she discovered that her
former boss was telling anyone who called for a reference that Chambers “does not work good
with other people,” is a “troublemaker,” and “would not be a good person to rehire.”
Chambers was unable, however, to present compelling evidence that her boss had been
primarily motivated by ill will. Neither Trans Air nor the boss was held liable for these
statements because they were protected by the qualified privilege.13
Even if the employer wins, a trial is an expensive and time-consuming undertaking. Not
surprisingly, companies are leery about offering any references for former employees. The
company gains little benefit from giving an honest evaluation and may suffer substantial
liability. As a matter of policy, many companies instruct their managers to reveal only a
person’s salary and dates of employment and not to offer an opinion on job performance.
On the flip side, do employers have any obligation to warn about risky workers?
Generally, courts have held that employers do not have a legal obligation to disclose
information about former employees. For example, while Jeffrey St. Clair worked at the
St. Joseph Nursing Home, he was disciplined 24 times for actions ranging from extreme
violence to drug and alcohol use. When he applied for a job with Maintenance Management
Corp., St. Joseph refused to give any information other than St. Clair’s dates of employment.
After he savagely murdered a security guard at his new job, the guard’s family sued, but the
court dismissed the case.14
In some recent cases, however, courts have held that, when a former worker is potentially
dangerous, employers do have an obligation to disclose this information. For example, officials
from two junior high schools gave Robert Gadams glowing letters of recommendation
without mentioning that he had been fired for inappropriate sexual conduct with students.
While an assistant principal at a new school, he molested a 13-year-old. Her parents sued the
12Fleming v. Parametric Tech. Corp., 1999 U.S. App. LEXIS 14864.
13Chambers v. American Trans Air, Inc., 577 N.E.2d 612, 1991 Ind. App. LEXIS 1413 (Ind. Ct. App.
1991).
14Moore v. St. Joseph Nursing Home, Inc., 184 Mich. App. 766, 459 N.W.2d 100, 1990 Mich. App. LEXIS
285 (Mich. Ct. App. 1990).
Qualified privilege
Employers who give references
are liable only for false
statements that they know to
be false or that are primarily
motivated by ill will.
CHAPTER 26 Employment and Labor Law 623
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former employers. The court held that the writer of a letter of recommendation owes to
third parties (in this case, the student) “a duty not to misrepresent the facts in describing the
qualifications and character of a former employee, if making these misrepresentations would
present a substantial, foreseeable risk of physical injury to the third persons.”15 As a result of
cases such as this, it makes sense to disclose past violent behavior.
To assist employers who are asked for references, Lehigh economist Robert Thornton has
written “The Lexicon of Intentional Ambiguous Recommendations” (LIAR). For a candidate
with interpersonal problems, he suggests saying, “I am pleased to say that this person is a former
colleague of mine.”For a candidate with drug or alcohol problems, there are several possibilities:
“She was always high in my opinion,” “We remember the hours she spent working with us as
happy hours,” or “I would say that her real talent is getting wasted at her current job.”16
Ethics All joking aside, what if someone calls you to check references on a former
employee who had a drinking problem? The job is driving a van for junior high
school sports teams. What is the manager’s ethical obligation in this situation? Many
managers say that, in the case of a serious problem such as alcoholism, sexual harassment,
or drug use, they will find a way to communicate that an employee is unsuitable. What if the
ex-employee says she is reformed? Aren’t people entitled to a second chance? Is it right to
risk a defamation suit against your company to protect others from harm?
Intentional Infliction of Emotional Distress Employers who condone cruel treat-
ment of their workers may face liability under the tort of intentional infliction of emotional
distress. For example, when a 57-year-old social-work manager at Yale–New Haven Hospital
was fired, she was forced to place her personal belongings in a plastic bag and was escorted
out the door by security guards in full view of gaping coworkers. A supervisor told her that
she would be arrested for trespassing if she returned. A jury awarded her $105,000.
26-2d Whistleblowing
No one likes to be accused of wrongdoing even if (or, perhaps, especially if) the accusa-
tions are true. This is exactly what whistleblowers do: They are employees who disclose
illegal behavior on the part of their employer. Not surprisingly, some companies, when
faced with such an accusation by an employee, prefer to shoot the messenger. Rather than
fixing the reported problem, they retaliate against the informer. Here is one such story.
Although FMC Corp. sold 9,000 Bradley Fighting Vehicles to the U.S. Army, there had
been doubts about the Bradley from the beginning. It was designed to ferry soldiers across
rivers, but prototypes leaked badly when driven into water. Testing supervisor Henry
Boisvert refused to sign a report stating that the Bradley functioned well, and FMC fired
him. A jury ultimately agreed with his version of events and awarded him $171 million.
The law on whistleblowers varies across the country. As a general rule, however,
whistleblowers are protected in the following situations:
• The False Claims Act. Boisvert recovered under the federal False Claims Act, a statute
that permits lawsuits against anyone who defrauds the government. The recovery is shared
by thegovernment (who receives 75percent to 85percent) and thewhistleblower (whogets
the rest). The Act prohibits employers from firing workers who file suit under the statute.
15Randi W. v. Muroc Joint Unified School District, 14 Cal. 4th 1066, 929 P.2d 582, 1997 Cal. LEXIS 10
(1997), modified, 14 Cal. 4th 1282c, 97 Cal. Daily Op. Service 1439.
16Robert J. Thornton, Lexicon of Intentionally Ambiguous Recommendations, Barnes and Noble Books,
2005.
624 U N I T 4 Employment, Business Organizations and Property
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• The Dodd-Frank Wall Street Reform and Consumer Protection Act. Anyone who
provides information to the government about violations of securities or commodities
laws is entitled to a payout of from 10 to 30 percent of whatever award the
government receives, provided that the award tops $1 million. If a company retaliates
against tipsters, they are entitled to reinstatement, double back pay, and attorney’s
fees. The whistleblowing provision is intended to encourage tips to the government,
but companies fear it may also discourage employees from reporting wrongdoing to
corporate compliance offices—why report a problem to your own company for free
when you could get paid a lot of money to report it to the government?
• Sarbanes-Oxley Act of 2002. This act protects employees of publicly traded companies
who provide evidence of fraud to investigators (whether in or outside the company). A
successful plaintiff is entitled to reinstatement, back pay, and attorney’s fees.
• Constitutional protection for government employees. Employees of federal, state,
and local governments have a right to free speech under the United States
Constitution. Therefore, the government cannot retaliate against public employees
who blow the whistle if the employee is speaking out on a matter of public concern. For
example, a New York City social worker complained on TV that the city child welfare
agency was not adequately protecting children from horrible abuse. When the city
suspended the social worker from her job, she sued. The court ruled that the
government has the right to prohibit some employee speech, but if the employee
speaks on matters of public concern, the government bears the burden of justifying
any retaliation. In this case, the court held for the social worker.17
• Statutory protection for federal employees. The Civil Service Reform Act and the
Whistleblower Protection Act prevent retaliation against federal employees who
report wrongdoing. They also permit the award of back pay and attorney’s fees to the
whistleblower. This statute was used to prevent the National Park Service from
disciplining two managers who wrote a report expressing concern over development
in Yellowstone National Park.
• State laws. The good news is that all 50 states have laws that protect whistleblowers
from retaliation by their employers. The bad news is that the scope of this protection
varies greatly from state to state. Most courts, however, prohibit the discharge of
employees who report illegal activity. For example, a Connecticut court held a
company liable when it fired a quality control director who reported to his boss that
some products had failed quality tests.18
EXAM Strategy
Question: When Shiloh interviewed for a sales job at a medical supply company, the
interviewer promised that she could work exclusively selling medical devices and
would not have to be involved in the sale of drugs. Once she began work (as an
employee at will), Shiloh discovered that the sales force was organized around regions,
not products, so she had to sell both devices and drugs. When she complained to her
boss over lunch in the employee lunchroom, he said in a loud voice, “You are a big
girl now—it’s time you learned that you don’t always get what you want.” That
afternoon, she was fired. Does she have a valid claim against the company?
17Harman v. City of New York, 140 F.3d 111, 1998 U.S. App. LEXIS 5567 (2d Cir. 1998).
18Smith v. Calgon Carbon Corp., 917 F.2d 1338, 1990 U.S. App. LEXIS 19193 (3rd Cir. 1990).
CHAPTER 26 Employment and Labor Law 625
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Strategy: We know that Shiloh is an employee at will. We also know that she is not
protected by any statute we have studied. What about the common law? Shiloh has had
two key interactions with the company—being hired and being fired. What
protections does the common law provide during the hiring process? The employer’s
promises are enforceable. Here, the company is liable because the interviewer clearly
made a promise that the company did not keep. What about the way in which Shiloh
was fired? Is it intentional infliction of emotional distress? Was this treatment cruel?
Probably not cruel enough to constitute intentional infliction of emotional distress.
Result: The company is liable to Shiloh for making false promises to her during the
hiring process, but not for the manner in which she was fired.
26-3 PRIVACY IN THE WORKPLACE
Upon opening the country’s first moving assembly line in the early 1900s, Henry Ford
issued a booklet, “Helpful Hints and Advice to Employees,” that warned against drinking,
gambling, borrowing money, taking in boarders, and practicing poor hygiene. Ford also
created a department of 100 investigators for door-to-door checks on his employees’ drink-
ing habits, sexual practices, and housekeeping skills.
The right to hire, fire, and make an honest profit is enshrined in American tradition. But
so is the right to privacy. Justice Louis D. Brandeis called it the “right to be let alone—the
most comprehensive of rights and the right most valued by civilized men.” Workers are
entitled under the common law to a reasonable expectation of privacy. Thus, employers no
longer have the right to conduct home inspections, even if, say, looking for items that the
worker might have stolen from the company.
However, in the absence of a specific law to the contrary, employers do have the right to
fire workers for off-duty conduct. Employees have been fired or disciplined for such
extracurricular activities as taking part in dangerous sports (such as sky-diving), dating
coworkers, smoking, or even having high cholesterol. But some governments have passed
statutes that change this common law rule. These statutes take two forms: (1) general
lifestyle statutes and (2) laws that protect specific behavior.
26-3a Lifestyle Laws
A few states, such as California, have passed so-called lifestyle laws that protect the right of
employees to engage in any lawful activity or use any lawful product when off duty. Thus, if
California residents sky-dive while smoking a cigarette, they may lose their lives, but not
their jobs.
About half the states and the federal government have passed laws that protect particular
off-duty conduct, such as smoking or use of legal drugs.
SMOKING
Smokers tend to take more sick days and have higher healthcare expenses than other
employees. Indeed, the federal government estimates that it costs an extra $3,400 a year
to employ a worker who smokes. As a result, several thousand employers, including Union
Pacific and Alaska Airlines, simply refuse to hire those who light up. Such a policy is legal
unless state law prohibits it.
Massachusetts is a state that does not specifically protect smokers from employment
discrimination. But in the following case, the plaintiff argued that his employer’s actions
violated his privacy rights. Does his argument have merit? You be the judge.
626 U N I T 4 Employment, Business Organizations and Property
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Some workers have also claimed that nicotine addiction is a disability under the Amer-
icans with Disabilities Act (ADA; see Chapter 27 for more information about that statute), but
so far, courts have been skeptical that Congress intended ADA coverage for the roughly
60 million Americans who smoke.19 Several amendments to the ADA passed in 2008 could
provide more protection for smokers, but the courts have not yet decided such a case.
ALCOHOL AND DRUG USE
Private Employers Under federal law, private employers are permitted to test job
applicants and workers for alcohol and illegal drugs. They may sanction workers who fail
the test, even if the drug or alcohol use was off duty. State laws on drug testing vary widely.
Although employers were traditionally most concerned about illegal drugs, they now also
worry about legal use of prescription drugs such as Xanax and Oxycodone because these
medications may cause impairment. In one study, workers drug-tested after accidents in the
workplace were four times more likely to have opiates in their system than job applicants.
However, the Equal Employment Opportunity Commission (EEOC), the federal agency
charged with enforcing federal employment laws, prohibits testing for prescription drugs unless
a worker seems impaired. The EEOC filed suit against a company that randomly tested for
legal use of prescription drugs, and a jury awarded substantial damages to the employees.20
You Be the Judge
Facts: Scotts Lawnser-
vice refused to hire
tobacco users. It also tested
all employees for both ille-
gal drugs and nicotine.
Scotts offered Rodri-
gues a job “contingent
upon successful comple-
tion of a pre-hire screening which includes a nicotine
test.” Rodrigues voluntarily submitted a urine sample
and started work.
Shortly thereafter, a Scotts supervisor saw a pack of
cigarettes on Rodrigues’s dashboard and issued a warning.
Two weeks later, when Rodrigues’s test came back posi-
tive for nicotine, he was fired. He sued, claiming a violation
of his privacy rights. Massachusetts law states: “A person
shall have a right against unreasonable, substantial, or ser-
ious interference with his privacy.”
You Be the Judge: Did Scotts’ enforcement of its anti-
tobacco policy violate Rodrigues’s privacy rights?
Argument for Rodrigues: Under Massachusetts law,
people have the right to be free from unreasonable interfer-
ence with their privacy. Thus employers are limited in how
much they can interfere in their employees’ personal lives.
For Scotts to require a test that reveals what Rodrigues has
been doing at home or in
his car is a clear violation of
these privacy rights. Smok-
ing outside of work has
nothing to do with Rodri-
gues’s job performance.
We would have no
argument with Scotts if
the company prohibited employees from smoking while
on duty. But a policy that disallows tobacco use at any time
goes too far. Tobacco is a legal substance, and it is unrea-
sonable for a private business to ban what the government
does not.
Argument for Scotts: There is nothing private about
smoking. Smokers typically light up in their cars and in
public places. They purchase cigarettes openly. Rodrigues
had a pack of cigarettes in his truck while at work. A
person loses his right to privacy if he does not attempt
to keep information private. Rodrigues made no effort to
keep his tobacco use secret.
Scotts has a legitimate interest in hiring workers who
do not use tobacco. It is seeking a healthy workforce with
high productivity and low health care costs. No law,
including the Massachusetts privacy statute, prohibits
the company’s anti-tobacco policy.
19See Brashear v. Simms, 138 F.Supp.2d 693 (D.Md. 2001).
20Bates v. Dura Auto Sys Inc., 2011 U.S. Dist. LEXIS 97469 (M.D. Tenn 2011).
RODRIGUES V. SCOTTS
LAWNSERVICE
639 F. Supp. 2d 131
United States District Court for the District of
Massachusetts, 2009
CHAPTER 26 Employment and Labor Law 627
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Government Employers Governments are sometimes allowed to conduct drug and
alcohol tests of their employees. Public safety workers, such as police and firefighters, can
be randomly tested for illegal drugs, and they may also be required to report legal drug use
that could compromise their ability to perform their jobs. If their drug use (legal or not) is a
threat to public safety, they may be suspended or fired from their jobs. Other government
employees, whose work does not involve public safety, can be tested only if they show signs
of impairment.
POLYGRAPH TESTS
A polygraph exam is a type of lie detector test. Under the Employee Polygraph Protection
Act of 1988, employers may not require, or even suggest, that an employee or job candidate
submit to a polygraph test except in the following cases:
• An employee who is part of an “ongoing investigation” into crimes that have already
occurred,
• An applicant applying for a government job, or
• An applicant for a job in public transport or banking, or at pharmaceutical firms that
deal with controlled substances.
If an employer requires a polygraph test, it must give advance written notice of when
the test will be given and advise workers that they are entitled to legal counsel. A private
employer may not fire or discriminate against an employee who fails a polygraph exam
unless it also finds supporting evidence that the worker has done something wrong.
Ethics By law, there are few situations in which private employers may require
polygraph tests. What would be the advantages and disadvantages of
requiring polygraph tests? Should there be different rules for job applicants, as opposed to
employees?
ELECTRONIC MONITORING OF THE WORKPLACE
Technological advances in communications have raised a host of new privacy issues. Many
companies monitor employee use of electronic equipment in the workplace: telephone calls,
voicemail, email, and Internet usage. The Electronic Communications Privacy Act of 1986
(ECPA) permits employers to monitor workers’ telephone calls and email messages if (1) the
employee consents, (2) the monitoring occurs in the ordinary course of business, or (3) in
the case of email, the employer provides the email system. However, bosses may not disclose
any private information revealed by the monitoring.
Sending personal emails through a company server is dangerous. In one case, a court
permitted an employer to fire two workers who exchanged (they claimed) joking emails
threatening violence to sales managers even though the company had an explicit policy
stating that emails were confidential and would not be intercepted or used against an
employee.21 Over 75 percent of U.S. firms monitor their employees’ computer usage. About
one third of companies have fired a worker over inappropriate email or Internet use.
A few courts have carved out narrow rights for employees. For example, a New Jersey
court recently held that unless company policy explicitly informs workers otherwise, the
company does not have the right to monitor a personal, password-protected, web-based
21Smyth v. Pillsbury, 914 F. Supp. 97, 1996 U.S. Dist. LEXIS 776 (Fed. Dist. Ct., 1996).
628 U N I T 4 Employment, Business Organizations and Property
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email account.22 But unless you enjoy the prospect of engaging in years of litigation to
clarify this issue, it is still good advice to consider all email you send through a company
server to be public.
SOCIAL MEDIA
Social media are the newest challenge facing both employers and workers. On the one
hand, employers may find themselves liable for statements that their workers make
electronically. For example, Cisco Systems Inc., has settled two lawsuits brought against
the company for statements made by a company lawyer on his blog. Not surprisingly,
employers have fired workers who posted inappropriate information in cyberspace. But
companies may find themselves liable for violations of employee privacy if a boss reads
workers’ Facebook or MySpace pages. A high school teacher in Georgia sued her school
district after she was forced to resign because of vacation photos on Facebook that showed
her holding a glass of wine.
And privacy rights aside, some workers have discovered a new way to fight back. The
National Labor Relations Act (NLRA; discussed later in this chapter) gives employees the
right to discuss wages, hours, and working conditions. So when American Medical Response
fired an employee for making negative comments about her boss on Facebook, the National
Labor Relations Board (NLRB) filed a complaint against the company. American Medical
Response settled the complaint by promising it would not fire or discipline workers for
discussing wages, hours, and working conditions. But in some similar cases, the NLRB has
deemed online rants against employers to be mere venting, not a genuine discussion of their
jobs, which means that these employees could be fired for their hostile postings.
In short, the law is evolving, subtle, and varies by state, so employees at will should err
on the side of caution and remember that the law often does not protect their electronic
lives from employer prying. They should consider anything they publish on the Internet to
be public.
As for companies, it makes sense to establish policies providing that:
1. Employees should never reveal their company’s name on a blog or social website such
as Facebook.
2. In addition, all employees’ personal blogs must contain a disclaimer that “All postings
on this blog are my opinion and not those of my employer, who has neither vetted nor
approved them.” The blogger should not reveal the company’s name.
3. Blog comments should never be offensive, impolite, or reflect badly on the employer.
Nor should they reveal confidential or proprietary information.
4. Supervisors have the right to read and take action based on most kinds of electronic
information posted by an employee.
IMMIGRATION
Because of discrimination laws, employers should not ask about an applicant’s country of
origin, but they are permitted to inquire if the person is authorized to work in the United
States. If the applicant says, “Yes,” the interviewer cannot ask for evidence until the person
is hired. At that point, the employer must complete an I-9 form—Employment Eligibility
Verification—within three days. This form lists the acceptable documents that can be used
for verification. Employees have the right to present whichever documents they want from
the list of acceptable items. The employer may not ask for some other document. The I-9
forms must be kept for three years after the worker is hired or one year after termination.
22Stengart v. Loving Care Agency, Inc., 201 N.J. 300, 2010 N.J. LEXIS 241 (S.Ct. NJ, 2010).
CHAPTER 26 Employment and Labor Law 629
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EXAM Strategy
Question: To ensure that its employees did not use illegal drugs in or outside the
workplace, Marvel Grocery Store required all employees to take a polygraph exam.
Moreover, managers began to screen the company email system for drug references.
Jagger was fired for refusing to take the polygraph test. Jonathan was dismissed when
a search of his email revealed that he had used cocaine during the prior weekend. Has
the company acted legally?
Strategy: First: As employees at will, are Jagger and Jonathan protected by
a statute? The Employee Polygraph Protection Act permits employers to require
a polygraph test as part of ongoing investigations into crimes that have occurred.
Here, Marvel has no reason to believe that a crime occurred, so it cannot require
a polygraph test.
Second: What about Jonathan’s cocaine use? The ECPA permits Marvel to
monitor email messages on its own system. But can the company fire Jonathan for
illegal off-duty conduct? Some statutes protect employees for legal behavior outside
the workplace, but no state protects employees for behavior that violates the law.
Result: The company is liable to Jagger for requiring him to take the polygraph
exam, but not to Jonathan for monitoring his email or firing him for illegal drug use.
26-4 WORKPLACE SAFETY
In 1970, Congress passed the Occupational Safety and Health Act (OSHA) to ensure safe
working conditions. Under OSHA:
• Employers must comply with specific health and safety standards. For example,
health care personnel who work with blood are not permitted to eat or drink in areas
where the blood is kept. Protective clothing—gloves, gowns, and laboratory coats—
must be impermeable to blood.
• Employers are under a general obligation to keep their workplace “free from
recognized hazards that are causing or are likely to cause death or serious physical
harm” to employees.
• Employers must keep records of all workplace injuries and accidents.
• The Occupational Safety and Health Administration (which is also known as OSHA)
may inspect workplaces to ensure that they are safe. OSHA may assess fines for
violations and order employers to correct unsafe conditions.
OSHA has done a lot to make the American workplace safer. In 1900, roughly 35,000
workers died at work. A century later, the workforce had grown five times larger, but the
number of annual deaths had fallen to about 5,500.
26-5 FINANCIAL PROTECTION
Congress and the states have enacted laws designed to provide employees with a measure
of financial security. All of the laws in this section were created by statute, not by the
courts.
630 U N I T 4 Employment, Business Organizations and Property
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26-5a Fair Labor Standards Act: Minimum Wage,
Overtime, and Child Labor
Passed in 1938, the Fair Labor Standards Act (FLSA) regulates wages and limits child labor
nationally. It provides that hourly workers must be paid a minimum wage of $7.25 per hour,
plus time and a half for any hours over 40 in one week. These wage provisions do not apply
to salaried workers, such as managerial, administrative, or professional staff. More than half
the states set a higher minimum wage, so it is important to check state guidelines as well.
Today, the biggest issue that employers face under the FLSA is: “What counts as work,
and how do you keep track of it?” What if a worker answers email during lunch or takes a
phone call on the train ride home? Although these activities count as work, how can the
employer keep track of it? Carla Bird, an assistant at Oprah Winfrey’s production company,
submitted timesheets showing 800 hours of overtime in 17 weeks. She said she had worked
12 or 13 hours a day, seven days a week, for four months. The company paid her $32,000 in
overtime.23 If employees work all the time, or even if they are just on call, they are entitled
to be paid for those hours.
The FLSA also prohibits “oppressive child labor,” which means that children under
fourteen may work only in agriculture and entertainment. Fourteen-and fifteen-year-olds
are permitted to work limited hours after school in nonhazardous jobs. Sixteen-and
seventeen-year-olds may work unlimited hours in nonhazardous jobs.
26-5b Workers’ Compensation
Workers’ compensation statutes ensure that employees receive payment for injuries incurred
at work. Before workers’ comp, injured employees could recover damages only if they sued
their employer. It is the brave (or carefree) worker who is willing to risk a suit against his
own boss. Lawsuits poison the atmosphere at work. Moreover, employers frequently won
these suits by claiming that (1) the injured worker was contributorily negligent, (2) a
fellow employee had caused the accident, or (3) the injured worker had assumed the risk
of injury. As a result, seriously injured workers (or their families) often had no recourse
against the employer.
Workers’ comp statutes provide a fixed, certain recovery to the injured employee, no
matter who was at fault for the accident. In return, employees are not permitted to sue their
employers for negligence. The amounts allowed (for medical expenses and lost wages)
under workers’ comp statutes are often less than a worker might recover in court, but the
injured employee trades the certainty of some recovery for the higher risk of rolling the dice
at trial. Payments are approved by an administrative board that conducts an informal hearing
into each claim.
26-5c Social Security
The federal social security system began in 1935, during the depths of the Great Depres-
sion, to provide a basic safety net for the elderly, ill, and unemployed. Currently, the social
security system pays benefits to workers who are retired, disabled, or temporarily unem-
ployed and to the spouses and children of disabled or deceased workers. It also provides
medical insurance to the retired and disabled. The social security program is financed
through a tax on wages that is paid by employers, employees, and the self-employed.
Although the social security system has done much to reduce poverty among the
elderly, many worry that it cannot survive in its current form. The system was designed
to be “pay as you go”; that is, when workers pay taxes, the proceeds do not go into a savings
account for their retirement, but instead are used to pay benefits to current retirees. In 1940,
23Lisa Belkin, “O.T. Isn’t as Simple as Telling Time,” New York Times, September 20, 2007.
CHAPTER 26 Employment and Labor Law 631
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there were 40 workers for each retiree; currently, there are 3.3. As a result, the system now
pays out more in benefits each year than it receives in tax revenues. By 2025, when the last
baby boomers retire, there will be only 2 workers to support each retiree—a prohibitive
burden. No wonder younger workers are often cautioned not to count on social security
when making their retirement plans.
The Federal Unemployment Tax Act (FUTA) is the part of the social security system
that provides support to the unemployed. FUTA establishes some national standards, but
states are free to set their own benefit levels and payment schedules. A worker who quits
voluntarily or is fired for just cause is ineligible for benefits. While receiving payments, she
must make a good-faith effort to look for other employment.
26-5d Pension Benefits
In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) to
protect workers covered by private pension plans. Under ERISA, employers are not required
to establish pension plans, but if they do, they must follow these federal rules. The law was
aimed, in particular, at protecting benefits of retired workers if their companies
subsequently go bankrupt. The statute also prohibits risky investments by pension plans.
In addition, the statute sets rules on the vesting of benefits. (An employer cannot cancel
vested benefits; nonvested benefits are forfeited when the employee leaves.) Before ERISA,
retirement benefits at some companies did not vest until the employee retired—if he quit or
was fired before retirement, even after years of service, he lost his pension. Under current
law, employee benefits normally must vest within five years of employment.
26-6 LABOR LAW AND COLLECTIVE
BARGAINING
The opening scenario of this chapter provides a graphic example of how painful (literally)
working conditions could be. Indeed, during the nineteenth and early twentieth centuries,
as industrialization spread across the United States, many workers found their employment
environment unbearable. Seeking better pay and improved working conditions, some began
to band together into unions. But in this era, American courts regarded any coordinated
effort by workers as a criminal conspiracy. Courts convicted workers merely for the act of
joining together, even if no strike took place. A company could usually obtain an immedi-
ate injunction merely by alleging that a strike might cause harm. Courts were so quick to
issue injunctions that most companies became immune to union efforts. But with the
economic collapse of 1929 and the vast suffering of the Great Depression, public
sympathy shifted to the workers. Congress responded with two landmark statutes.
26-6a Key Pro-Union Statutes
In 1932, Congress passed the Norris-LaGuardia Act which prohibited federal court
injunctions in nonviolent labor disputes. No longer could management stop a strike merely
by mentioning the word “strike.” By taking away the injunction remedy, Congress was
declaring that workers should be permitted to organize unions and to use their collective
power to achieve legitimate economic ends. The statute led to explosive growth in union
membership.
In 1935, Congress passed the Wagner Act, generally known as the National Labor
Relations Act (NLRA). This is the most important of all labor laws. A fundamental aim of
the NLRA is the establishment and maintenance of industrial peace, to preserve the flow of
Norris-LaGuardia Act
Prohibits federal court
injunctions in nonviolent labor
disputes.
National Labor Relations
Act (NLRA)
Ensures the right of workers to
form unions and encourages
management and unions to
bargain collectively and
productively.
632 U N I T 4 Employment, Business Organizations and Property
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commerce. The NLRA ensures the right of workers to form unions and encourages manage-
ment and unions to bargain collectively and productively. For our purposes, §§7 and 8 of the
NLRA are the most important.
Section 7 guarantees employees the right to organize and join unions, bargain
collectively through representatives of their own choosing, and engage in other concerted
activities. This is the cornerstone of union power. With the enactment of the NLRA,
Congress put an end to any notion that unions were inherently illegal by explicitly
recognizing that workers could join together, bargain as a group, and use their collective
power to seek better conditions.
Section 8 prohibits employers from engaging in the following unfair labor practices (ULPs):
• Interfering with union organizing efforts,
• Dominating or interfering with any union,
• Discriminating against a union member, or
• Refusing to bargain collectively with a union.
The NLRA also established the National Labor Relations Board (NLRB) to administer
and interpret the statute and to adjudicate labor cases. For example, when a union charges
that an employer has committed a ULP—say, by refusing to bargain—the claim goes first to
the NLRB.
26-6b Labor Unions Today
Organized labor is in flux in the United States. In the 1950s, about 1 in 4 workers belonged
to a union. Today, only about 1 in 8, or 15 million total U.S. workers, are union members.
Employers point to this figure with satisfaction and claim that it shows that unions have
failed their memberships. In an increasingly high-tech, service-oriented economy,
employers argue, there is no place for organized labor. Union supporters respond that
although the country has shed many old factories, workers have not benefited. Throughout
the last 20 years, they assert, compensation for executives has soared into the stratosphere
while wages for the average worker, in real dollars, have fallen.
Unions continue to attract political attention. For example, legislators in Wisconsin
voted to strip most collective bargaining rights from schoolteachers and other state govern-
ment workers. Public employees are five times more likely to be union members than
private sector workers, but they are generally not protected by the NLRA. Instead, state
labor laws apply, which tend to provide less protection than federal statutes.
Crowds of as many as 100,000 gathered in Madison, Wisconsin, to protest the proposed
legislation, but it passed nonetheless. Commentators on the left forecast significant political
consequences for the Wisconsin lawmakers, while editorialists on the right predicted that
many states would soon follow the Wisconsin model.
Although overall membership is down, unions still matter.
26-6c Organizing a Union
EXCLUSIVITY
Management is generally opposed—sometimes fiercely opposed—to any union organizing
effort. The fight can become ugly, and all because of one principle: exclusivity.
Under §9 of the NLRA, a validly recognized union is the exclusive representative of the
employees. This means that the union represents all of the designated employees, regard-
less of whether a particular worker wants to be represented. The company may not bargain
directly with any employee in the group, nor with any other organization representing the
designated employees.
National Labor Relations
Board (NLRB)
Administers and interprets the
NLRA and adjudicates labor
cases.
CHAPTER 26 Employment and Labor Law 633
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However, a union may not exercise power any way it likes: Along with a union’s exclusive
bargainingpower goes a duty of fair representation,which requires that a union treat allmembers
fairly, impartially, and in good faith. A unionmay not favor somemembers over others, normay a
union discriminate against a member based on characteristics such as race or gender.
ORGANIZING: STAGES
A union organizing effort generally involves the following pattern.
Campaign Union organizers talk—or attempt to talk—with employees and interest them
in forming a union. The organizers may be employees of the company, who simply chat with
fellow workers about unsatisfactory conditions; or a union may send nonemployees of the
company to hand out union leaflets to workers as they arrive and depart from work.
Authorization Cards Union organizers ask workers to sign authorization cards, which
state that the particular worker requests the specified union to act as her sole bargaining
representative.
If a union obtains authorization cards from a sizable percentage of workers, it seeks
recognition as the exclusive representative for the bargaining unit. The union may ask the
employer to recognize it as the bargaining representative, but most of the time, employers
refuse to recognize the union voluntarily.
Petition Assuming that the employer does not voluntarily recognize a union, the union
generally petitions the NLRB for an election. It must submit to the NLRB regional office
authorization cards signed by at least 30 percent of the workers. The regional office verifies
whether there are enough valid cards to warrant an election and looks closely at the
proposed bargaining unit to make sure that it is appropriate. If the regional director
determines that the union has identified an appropriate bargaining unit and has enough
valid cards, it orders an election.
Election The NLRB closely supervises the election to ensure fairness. All members of
the proposed bargaining unit vote on whether they want the union to represent them. If
more than 50 percent of the workers vote for the union, the NLRB designates that union as
the exclusive representative of all members of the bargaining unit. When unions hold
representation elections in private corporations, they win about half the time.
The “Card-Check” Debate Before becoming president, then–U.S. senator Barack
Obama co-introduced a bill called the Employee Free Choice Act. This bill provides that
when more than 50 percent of workers sign an authorization card, the NLRB must
immediately designate that union as the exclusive representative of all members in the
bargaining unit without an election.
Supporters argue that, if a majority of workers return authorization cards, an election is
unnecessary and only gives companies an opportunity to intimidate workers. Those who
dislike the bill argue that workers may feel bullied into signing an authorization card and
should always have the right to a final vote by secret ballot.
The bill has generated much debate but has not passed Congress at the time of this writing.
ORGANIZING: ACTIONS
The NLRA guarantees employees the right to talk among themselves about forming a
union, to hand out literature, and ultimately to join a union.24 Workers may urge other
employees to sign authorization cards and may vigorously push their cause. When
employees hand out leaflets, the employer generally may not limit the content, so long as
it is somewhat related to union activity.
24NLRA §7.
634 U N I T 4 Employment, Business Organizations and Property
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There are, of course, limits to what union organizers may do. The statute permits an
employer to restrict organizing discussions if they interfere with discipline or production. A
worker on a moving assembly line has no right to walk away from his task to talk with other
employees about organizing a union; these discussions must be left until lunch or some
other break time.25
May the employer speak out against a union organizing drive? Yes. Management is
entitled to communicate to the employees why it believes a union will be harmful to the
company. But the employer’s efforts must be limited to explanation and advocacy. The
employer may vigorously present anti-union views to its employees but may not use either
threats or promises of benefits to defeat a union drive.26
EXAM Strategy
Question: We Haul is a trucking company. The Teamsters Union is attempting to
organize the drivers. Workers who favor a union have been using the lunchroom to
hand out petitions and urge other drivers to sign authorization cards. The company
posts a notice in the lunchroom: “No Union Discussions. Many employees do not
want unions discussed in the lunchroom. Out of respect for them, we are prohibiting
further union efforts in this lunchroom.” Comment.
Strategy: The NLRA guarantees employees the right to talk among themselves
about forming a union and to hand out literature. Union workers may vigorously push
their cause. Management is entitled to communicate to the employees why it believes
a union will be harmful to the company, but the employer’s efforts must be limited to
explanation and advocacy.
Result: We Haul has violated the NLRA. The company has the right to urge
employees not to join the union. However, it is not entitled to block the union from
its organizing campaign. Even assuming the company is correct that some employees
do not want unions discussed, it has no right to prohibit such advocacy.
26-6d Collective Bargaining
Once a union is formed, a company must then bargain with it toward the goal of creating a
new contract, which is called a collective bargaining agreement (CBA).
The NLRA permits the parties to bargain almost any subject they wish, but it only
requires them to bargain certain issues. Mandatory subjects include wages, hours, and other
terms and conditions of employment. Courts generally also find these subjects to be
mandatory: benefits, order of layoffs and recalls, production quotas, work rules (such as
safety practices), retirement benefits, and onsite food service and prices. An employer may
not unilaterally make changes in conditions of employment without first bargaining with
the union.
Both the union and the employer must bargain in good faith. However, they are not
obligated to reach an agreement. In the end, this means that the two sides must meet with
open minds and make a reasonable effort to reach a contract. In the following case, the
Supreme Court examined the requirements of bargaining in good faith.
Collective bargaining
agreement (CBA)
A contract between a union
and management.
25NLRB v. Babcock & Wilcox Co., 351 U.S. 105, 76 S. Ct. 679, 1956 U.S. LEXIS 1721 (1956).
26NLRB v. Gissel Packing Co., 395 U.S. 575, 89 S. Ct. 1918, 1969 U.S. LEXIS 3172 (1969).
CHAPTER 26 Employment and Labor Law 635
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26-6e Concerted Action
Concerted action refers to any tactics that union members take in unison to gain some
bargaining advantage. It is this power that gives a union strength. The NLRA guarantees the
right of employees to engage in concerted action for mutual aid or protection.27 The most
common forms of concerted action are strikes and picketing.
STRIKES
The NLRA guarantees employees the right to strike, but with some limitations.28 A
union has a guaranteed right to call a strike if the parties are unable to reach a CBA.
A union may call a strike to exert economic pressure on management, to protest a
ULP, or to preserve work that the employer is considering sending elsewhere. Note
that the right to strike can be waived. Management will generally insist that the CBA
include a no-strike clause, which prohibits the union from striking while the CBA is in
force. A strike is illegal in several other situations as well; here, we mention the most
important.
Cooling-Off Period Before striking to terminate or modify a CBA, a union must give
management 60 days’ notice. Suppose a union contract expires July 1. The two sides attempt
to bargain a new contract, but progress is slow. The union may strike as an economic weapon,
Landmark Case
Facts: A union repre-
senting workers at Truitt
Manufacturing Company
requested a raise of 10 cents
per hour for all members. In
offering an increase of only
2.5 cents per hour, the com-
pany argued that a larger
raise would bankrupt the company. The union demanded to
examine Truitt’s books, and when the company refused, the
union complained to the NLRB.
The NLRB determined that the company had failed
to bargain in good faith and ordered it to allow union
representatives to examine its finances. A court of appeals
found no unfair labor practice and refused to enforce the
Board’s order. The Supreme Court granted certiorari.
Issue: Did the company refuse to bargain in good faith?
Does the union have the right to examine the company’s
finances?
Decision: Yes, the com-
pany committed an
unfair labor practice by
refusing to bargain in
good faith. The union
has the right to examine
its finances.
Reasoning: The NLRA
does not force employers and unions to reach agreement,
but it does require both sides to exert every reasonable
effort to achieve this goal.
Good-faith bargaining necessarily requires that both
sides make honest claims. In this case, the company’s ability
to afford raises was a crucial issue. In the past, unions have
sometimes abandoned their requests for raises or even
accepted reductions if the company’s financial condition
required it. In any event, if an argument is important
enough to make in the give and take of bargaining, it is
important enough to require some proof of its accuracy.
27NLRA §7.
28NLRA §13.
NLRB V. TRUITT
MANUFACTURING CO.
351 U.S. 149
United States Supreme Court,1956
Concerted action
Tactics taken by union
members to gain bargaining
advantage.
No-strike clause
A clause in a CBA that prohibits
the union from striking while the
CBA is in force.
636 U N I T 4 Employment, Business Organizations and Property
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but it must notify management of its intention to do so and then must wait 60 days. This
cooling-off period is designed to give both sides a chance to reassess negotiations and to
decide whether some additional compromise would be wiser than enduring a strike.
Statutory Prohibition Many states have outlawed strikes by public employees. In
some states, the prohibition applies to selected employees, such as firefighters or teachers.
In other states, all public employees are barred from striking, whether or not they have a
contract. The purpose of these statutes is to ensure that unions do not use the public health
or welfare as a weapon to secure an unfair bargaining advantage. However, even employees
subject to such a rule may find other tactics to press their cause.
Violent Strikes The NLRA prohibits violent strikes. Violence does sometimes occur
on the picket line when union members attempt to prevent other workers from entering the
job site. Or a union may stage a sit-down strike, in which members stop working but remain
at their job posts, physically blocking replacement workers from taking their places. Any
such action is illegal.
Partial Strikes A partial strike occurs when employees stop working temporarily, then
resume, then stop again, and so forth. This tactic is particularly disruptive because manage-
ment cannot bring in replacement workers. A union may either walk off the job or stay on it,
but it may not alternate.
REPLACEMENT WORKERS
When employees go on strike, management generally wants to replace them to keep the
company operating. When replacement workers begin to cross a union picket line,
tempers are certain to explode, and entire communities may feel the repercussions. Are
replacement workers legal? Yes. Management has the right to hire replacement workers
during a strike. May the employer offer the replacement workers permanent jobs, or must
the company give union members their jobs back when the strike is over? It depends on
the type of strike.
After an economic strike, an employer may not discriminate against a striker, but the
employer is not obligated to lay off a replacement worker to give a striker his job back. An
economic strike is one intended to gain wages or benefits. When a union bargains for a pay
raise but fails to get it and walks off the job, that is an economic strike. During such a strike,
an employer may hire permanent replacement workers. When the strike is over,
the company has no obligation to lay off the replacement workers to make room for the
strikers. However, if the company does hire more workers, it may not discriminate against
the strikers.
After a unfair labor practices (ULP) strike, a union member is entitled to her job
back, even if that means the employer must lay off a replacement worker. Suppose that
management refuses to bargain in good faith by claiming poverty, without producing
records to substantiate its claim. The union strikes. Management’s refusal to bargain
was a ULP, and the strike is a ULP strike. When it ends, the striking workers must get
their jobs back.
PICKETING
Picketing the employer’s workplace in support of a strike is generally lawful. Striking work-
ers are permitted to establish picket lines at the employer’s job site and to urge all others—
employees, replacement workers, and customers—not to cross the line. But the picketers
are not permitted to use physical force to prevent anyone from crossing the line. The
company may terminate violent picketers and permanently replace them, regardless of
the nature of the strike.
Sit-down strike
Union members stop working
but remain at their job posts,
physically blocking replacement
workers from taking their
places.
CHAPTER 26 Employment and Labor Law 637
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LOCKOUTS
The workers have bargained with management for weeks,
and discussions have turned belligerent. It is 6:00 a.m., the
start of another day at the factory. But as 150 employees
arrive for work, they are amazed to find the company’s gate
locked and armed guards standing on the other side. In a
so-called lockout, management prohibits workers from
entering the premises and earning their paychecks. Most
lockouts are legal.
Chapter Conclusion
Since the first time one person hired another, there has
been tension in the workplace. The law attempts to bal-
ance the right of a boss to run a business with the right of a
worker to fair treatment. Other countries balance these
rights differently. For instance, Japan, Great Britain,
France, Germany, and Canada all require employers to
show just cause before terminating workers. Indeed, the
United States guarantees its workers fewer rights than
virtually any other industrialized nation. On the one hand, being mistreated at work or fired
can be a terrible, life-altering experience; but on the other, companies that cannot lay off
unproductive employees are less likely to add to their workforce, which may be one
reason that Europe tends to have a higher unemployment rate than the United States.
Although American bosses are not insulated from minimum standards of fairness, reasonable
behavior, and compliance with important policies, they still have great freedom to manage
their employees.
EXAM REVIEW
1. TRADITIONAL COMMON LAW RULE The traditional common law rule of
employment provided that an employee at will could be fired for a good reason, a
bad reason, or no reason at all. (p. 617)
2. FMLA The Family and Medical Leave Act guarantees workers up to 12 weeks of
unpaid leave each year for childbirth, adoption, a serious health condition of their
own or in their immediate family. (pp. 618–619)
3. HEALTH INSURANCE Starting in 2015, employers who have more than
50 full-time employees must pay a penalty if they do not provide basic health
insurance. Under the Consolidated Omnibus Budget Reconciliation Act, former
employees must be allowed to continue their health insurance for 18 months
after being terminated from their job, but they must pay for it themselves.
(p. 619)
The workers have
bargained with
management for weeks,
and discussions have
turned belligerent.… as
150 employees arrive for
work, they are amazed to
find the company’s gate
locked and armed guards
standing on the other side.
638 U N I T 4 Employment, Business Organizations and Property
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4. WRONGFUL DISCHARGE AND PUBLIC POLICY An employer who
fires a worker for certain bad reasons may be liable under a theory of wrongful
discharge. Generally, an employee may not be fired for refusing to violate the law,
performing a legal duty, exercising a legal right, or supporting basic societal values.
(pp. 619–622)
Question: When Theodore Staats went to his company’s “Council of Honor
Convention,” he was accompanied by a woman who was not his wife, although he
told everyone she was. The company fired him. Staats alleged that his termination
violated public policy because it infringed upon his freedom of association. He
also alleged that he had been fired because he was too successful—his
commissions were so high, he outearned even the highest-paid officer of the
company. Has Staat’s employer violated public policy?
Strategy: Is Staats protected by a statute? No. Is he being asked to break the law?
No. Is he trying to perform a legal duty? No. Is he being denied a legal right? (See
the “Result” at the end of this section.)
5. PROMISES MADE DURING THE HIRING PROCESS Promises made
during the hiring process may be enforceable, even if not approved by the company’s
top executives. An employee handbook may also create a contract. (pp.622–623)
Question: When Phil McConkey interviewed for a job as an insurance agent
with Alexander & Alexander, the company did not tell him that it was engaged in
secret negotiations to merge with Aon. When the merger went through soon
thereafter, Aon fired McConkey. Was Alexander liable for not telling McConkey
about the possible merger?
Strategy: Was McConkey protected by a statute? No. Did the company make
any promises to him during the hiring process? (See the “Result” at the end of this
section.)
6. COVENANT OF GOOD FAITH AND FAIR DEALING In almost all states,
courts will imply this covenant in an at-will employment relationship. (pp. 622–623)
7. DEFAMATION Employers may be liable for defamation if they give false and
unfavorable references. (pp. 623–624)
8. WHISTLEBLOWERS Whistleblowers receive some protection under both
federal and state laws. (pp. 624–626)
9. EMPLOYEE PRIVACY An employer may not violate a worker’s reasonable
expectation of privacy. However, unless a state has passed a statute to the contrary,
employers may monitor many types of off-duty conduct (even legal activities such as
smoking). Most states permit private employers to administer alcohol and drug tests,
and employers are generally free to monitor employees’ email and social media
pages. But many employers are restricted by the Employee Polygraph Protection Act
if they wish to administer polygraph exams. (p. 629)
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10. OSHA The goal of the Occupational Safety and Health Act is to ensure safe
conditions in the workplace. (p. 630)
11. WORKERS’ COMPENSATION Workers’ compensation statutes ensure that
employees receive payment for injuries incurred at work. (p. 631)
12. SOCIAL SECURITY The social security system pays benefits to workers who are
retired, disabled, or temporarily unemployed and to the spouses and children of
disabled or deceased workers. (pp. 631–632)
13. ERISA The Employee Retirement Income Security Act regulates private pension
plans. (p. 632)
14. RIGHT TO ORGANIZE Section 7 of the National Labor Relations Act (NLRA)
guarantees employees the right to organize and join unions, bargain collectively, and
engage in other concerted activities. Section 8 of the NLRA makes it a ULP for an
employer to interfere with union organizing, discriminate against a union member, or
refuse to bargain collectively. (p. 633)
15. DISCRIMINATION Section 8 of the NLRA makes it a ULP for a union to
interfere with employees who are exercising their rights under §7, to encourage an
employer to discriminate against an employee because of a labor dispute, or to refuse
to bargain collectively. (p. 633)
16. EXCLUSIVITY Section 9 of the NLRA makes a validly recognized union the
exclusive representative of the employees. Along with exclusivity comes a duty of fair
representation, which requires that a union treat all members fairly, impartially, and in
good faith. (pp. 633–634)
17. EMPLOYER OPPOSITION During a union organizing campaign, an employer
may vigorously present anti-union views to its employees, but it may not use threats
or promises of benefits to defeat the union effort. (p. 635)
Question: Power, Inc., which operated a coal mine, suffered financial losses
and had to lay off employees. The United Mine Workers of America (UMWA)
began an organizing drive. Power’s general manager warned miners that if the
company was unionized, it would be shut down. An office manager told one of
the miners that the company would get rid of union supporters. Shortly before
the election was to take place, Power laid off 13 employees, all of whom had
signed union cards. A low-seniority employee who had not signed a union card
was not laid off. The union claimed that Power had committed ULPs.
Comment.
Strategy: Section 7 of the NLRA guarantees employees the right to organize. An
employer may vigorously advocate against a union organizing campaign. However,
§8 makes it a ULP to interfere with union organizing or discriminate against a
union member. (See the “Result” at the end of this section.)
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18. BARGAINING The employer and the union must bargain over wages, hours, and
other terms and conditions of employment. They may bargain other subjects, but
neither side may insist on doing so. The union and the employer must bargain in
good faith, but they are not obligated to reach an agreement. (pp. 635–636)
19. STRIKES The NLRA guarantees employees the right to strike, with some
limitations. After an economic strike, an employer is not obligated to lay off
replacement workers to give a striker her job back, but it may not discriminate against
a striker when filling job openings. After a ULP strike, the striking worker must get
her job back. (pp. 636–637)
20. LOCKOUTS Most lockouts are legal. (p. 638)
4. Result: The court held that freedom of association is an important social right
and should be protected. However, being fired for bringing a lover to an employer’s
convention is not a threat to public policy. Nor is discharge for being too successful.
5. Result: The court held that when Alexander hired him, it was making an
implied promise that he would not be fired immediately. The company was liable
for not having revealed the merger negotiations.
17. Result: Each of the acts described was a ULP. Threatening layoffs or company
closure are classic examples of ULPs. Laying off those who had signed union cards,
but not those who refused, was clear discrimination. In this case, the NLRB found
the violations so extreme that it certified the union without an election and issued
an order to bargain.
MULTIPLE-CHOICE QUESTIONS
1. Brook moved from Denver to San Francisco to take a job with an advertising agency.
His employment contract stated that he was “at will and could be terminated at any
time.” After 28 months with the company, he was fired without explanation. Which of
the following statements is true?
(a) His contract implied that he could only be fired for cause.
(b) Because he had a contract, he was not an employee at will.
(c) He could only be fired for a good reason.
(d) He could be fired for any reason.
(e) He could be fired for any reason except a bad reason.
2. CPA QUESTION An unemployed CPA generally would receive unemployment
compensation benefits if the CPA:
(a) was fired as a result of the employer’s business reversals.
(b) refused to accept a job as an accountant while receiving extended benefits.
(c) was fired for embezzling from a client.
(d) left work voluntarily without good cause.
CHAPTER 26 Employment and Labor Law 641
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3. During a job interview with Venetia, Jack reveals that he and his wife are expecting
twins. Venetia asks him if he is planning to take a leave once the babies are born.
When Jack admits that he would like to take a month off work, he can see her face
fall. She ultimately decides not to hire him because of the twins. Which of the
following statements are true?
(a) Venetia has violated the FMLA.
(b) Venetia has violated COBRA.
(c) Both (a) and (b)
(d) None of the above
4. Which of the following statutes defines ULPs and ensures workers’ right to form a
union?
(a) The Norris-LaGuardia Act
(b) The National Labor Relations Act
(c) Both (a) and (b)
(d) None of the above
5. Alpha Company’s workers go on strike. The company hires replacement workers so
that it can continue to operate its business. When the strike ends, Alpha must rehire
the original workers if the strike was over
(a) wages
(b) a ULP
(c) both (a) and (b)
(d) none of the above
ESSAY QUESTIONS
1. Debra Agis worked as a waitress in a Ground Round restaurant. The manager
informed the waitresses that “there was some stealing going on.” Until he found
out who was doing it, he intended to fire all the waitresses in alphabetical order,
starting with the letter “A.” Dionne then fired Agis. Does she have a valid claim
against her employer?
2. YOU BE THE JUDGE WRITING PROBLEM FedEx gave Marcie Dutschmann
an employment handbook stating that (1) she was an at-will employee, (2) the
handbook did not create any contractual rights, and (3) employees who were fired
had the right to a termination hearing. The company fired Dutschmann, claiming that
she had falsified delivery records. She said that FedEx was retaliating against her
because she had complained of sexual harassment. FedEx refused her request for a
termination hearing. Did the employee handbook create an implied contract
guaranteeing Dutschmann a hearing? Argument for FedEx: The handbook could not
have been clearer—it did not create a contract. Dutschmann is an employee at will
and is not entitled to a hearing. Argument for Dutschmann: FedEx intended that
employees would rely on the handbook. The company used promises of a hearing to
attract and retain good employees. Dutschmann was entitled to a hearing.
642 U N I T 4 Employment, Business Organizations and Property
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3. Triec, Inc., is a small electrical contracting company in Springfield, Ohio, owned by its
executives, Yeazell, Jones, and Heaton. Employees contacted the International
Brotherhood of Electrical Workers, which began an organizing drive, and 6 of the
11 employees in the bargaining unit signed authorization cards. The company
declined to recognize the union, which petitioned the NLRB to schedule an election.
The company then granted several new benefits for all workers, including higher
wages, paid vacations, and other measures. When the election was held, only 2 of the
11 bargaining unit members voted for the union. Did the company violate the NLRA?
4. Q-1 Motor Express was an interstate trucking company. When a union attempted to
organize Q-1’s drivers, it met heavy resistance. A supervisor told one driver that if he
knew what was good for him, he would stay away from the union organizer. The
company president told another employee that he had the right to fire everybody, close
the company, and then rehire new drivers after 72 hours. He made numerous other
threats to workers and their families. Based on the extreme nature of the company’s
opposition, what exceptional remedy did the union seek before the NLRB?
5. Billy comes down with chicken pox and is sent home from school. His mother takes
him to a pediatrician. The doctor tells her, “Well … he should be fine in about a
week. Bed rest is all he really needs—and plenty of fluids.” Billy’s mother calls her
employer and requests FMLA leave to take care of Billy for the next few days. Must
the employer grant the leave? Why or why not?
DISCUSSION QUESTIONS
1. When Walton Weiner interviewed for a job with
McGraw-Hill, Inc., he was assured that the
company would not terminate an employee
without “just cause.” Weiner also signed a
contract specifying that his employment would
be subject to the provisions of McGraw-Hill’s
handbook. The handbook said, “[The] company
will resort to dismissal for just and sufficient
cause only, and only after all practical steps
toward rehabilitation or salvage of the employee
have been taken and failed. However, if the
welfare of the company indicates that dismissal
is necessary, then that decision is arrived at and
is carried out forthrightly.” After eight years,
Weiner was fired suddenly for “lack of
application.” Does Weiner have a valid claim
against McGraw-Hill?
2. Some companies now require all job applicants
to provide their Facebook login information so
that the potential employer can learn more about
them. Is this behavior ethical on the part of an
employer?
3. Should employers be allowed to fire smokers?
Nicotine is highly addictive and many smokers begin
as teenagers, when theymay not fully understand the
consequences of their decisions. As Mark Twain,
who began smoking at 12, famously said, “Giving up
smoking is the easiest thing in the world. I know
because I’ve done it thousands of times.”
4. Union membership has fallen steadily in recent
decades, in part because many unionized
manufacturing jobs have been shipped overseas. Do
you believe that unions will make a comeback in
new industries? Would you prefer to be a member
of a union if you had a choice? Why or why not?
5. Would you personally be less likely to apply for a
job if you were required to first pass a polygraph
exam? What if you were required to pass a drug
test? For legal or illegal drugs? Would you be less
likely to apply because you thought the company
was too intrusive or because you want the right to
use these substances? What if the company
required you to quit smoking or chewing tobacco?
CHAPTER 26 Employment and Labor Law 643
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CHAPTER27
EMPLOYMENT
DISCRIMINATION
Imagine that you are on the hiring committee of
a top San Francisco law firm. You come across a
resume from a candidate who grew up on an
isolated ranch in Arizona. Raised in a house
without electricity or running water, he had
worked alongside the ranch hands his entire
childhood. At the age of 16, he left home for
Stanford University, and from there had gone on
to Stanford Law School, where he finished third
in his class. You think to yourself, “This sounds like a
real American success story. A great combination of grit
and intelligence.” But without hesitation, you toss the
resume into the wastebasket.
But without hesitation,
you toss the resume into
the wastebasket.
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This is a true story. Indeed, there was a candidate with these credentials who was unable to
find a job in any San Francisco law firm. The only jobs on offer were as a secretary, because
this candidate was a woman—Sandra Day O’Connor, who went on to become one of the
most influential lawyers of her era and the first woman justice on the Supreme Court of the
United States. When she graduated from law school, women and minorities had limited job
options, and not just in the legal profession. Before 1960, you might never see a female or
African American doctor, engineer, police officer, or firefighter. What a terrible waste of
resources—so many talented people unable to use their abilities.
27-1 INTRODUCTION
This chapter is the story of how the United States has travelled the long and bumpy
road toward equality of opportunity in the workplace. This story begins after the Civil
War, when a torn and bleeding country sought to protect the rights of freed slaves and
undo the terrible harm of a century of slavery. The country began by ratifying three
Constitutional amendments: The Thirteenth prohibits slavery, the Fourteenth guaran-
tees due process of law and equal protection under the law, and the Fifteenth prohibits
restrictions on the right to vote because of race or color. In addition, Congress passed
the Civil Rights Act of 1866, which provided that all people born in the United States
(except Native Americans) were citizens of the United States and had the same rights
as white citizens.1
However, in response to these laws, many states passed (and the Supreme Court
upheld) statutes that made these protections worthless. The most notorious case was Plessy
v. Ferguson, in which the Supreme Court upheld the constitutionality of a Louisiana law that
prohibited blacks from riding in railroad cars reserved for whites. Blacks were provided with
“separate but equal” cars.2
Not until 1954, almost a century after the Civil War, did the Supreme Court reverse its
Plessy decision. In the landmark case Brown v. Board of Education, the high court ruled that
“separate but equal” policies were unconstitutional.3 In particular, it prohibited segregated
public schools. However, many school districts were slow to apply the case, and even ten
years later, segregated public schools still existed. Nonetheless, Brown inspired a generation
of civil rights leaders such as Martin Luther King, Jr. and Rosa Parks, who led protests,
boycotts, and voter registration drives.
These actions inspired Congress to pass the Civil Rights Act of 1964. Title VII of this
Act prohibits certain types of employment discrimination and is the focus of this chapter.
However, the statute was even more far-reaching because it prohibited a broad range of
discrimination: in, for example, education, voting, and public accommodations (such as
hotels, restaurants, and movie theaters).
We begin now with a review of constitutional provisions that prohibit discrimination in
the workplace and follow with a discussion of the major federal anti-discrimination statutes:
the Civil Rights Act of 1866, Title VII of the Civil Rights Act of 1964, the Equal Pay Act,
the Pregnancy Discrimination Act, the Age Discrimination in Employment Act, the Reha-
bilitation Act of 1973, the Americans with Disabilities Act, and the Genetic Information
Nondiscrimination Act.
142 USC 21 §1981.
2163 U.S. 537 (S. Ct. 1896).
3347 U.S. 483 (S. Ct. 1954).
CHAPTER 27 Employment Discrimination 645
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27-2 THE UNITED STATES
CONSTITUTION
The Fifth Amendment to the Constitution prohibits the federal government from depriving
individuals of “life, liberty, or property” without due process of law. The Fourteenth
Amendment prohibits state governments from violating an individual’s right to due process
and equal protection. The courts have interpreted these provisions to prohibit employment
discrimination by federal, state, and local governments.
27-3 CIVIL RIGHTS ACT OF 1866
As we have seen, the Civil Rights Act of 1866 was meant to provide freed slaves with the
same rights as white citizens. It has been interpreted to prohibit racial discrimination in both
private and public employment (except it does not apply to the federal government). As we
will see later in the Enforcement section of this chapter, it offers plaintiffs some significant
advantages over Title VII.
27-4 TITLE VII OF THE CIVIL RIGHTS
ACT OF 1964
Under Title VII of the Civil Rights Act of 1964, it is illegal for employers with 15 or more
employees to discriminate on the basis of race, color, religion, sex, or national origin.
Discrimination under Title VII applies to every aspect of the employment process, from
job ads to postemployment references, and includes hiring, firing, promoting, placement,
wages, benefits, and working conditions of anyone who is in one or more of the so-called
protected categories under the statute.
27-4a Prohibited Activities
There are four types of illegal activity under this statute: disparate treatment, disparate
impact, hostile environment, and retaliation. All of these activities are illegal if used against
anyone in a protected category.
DISPARATE TREATMENT
To prove a disparate treatment case, the plaintiff must show that she was treated less
favorably than others because of her sex, race, color, religion, or national origin. Note that
the burden of proof is on the plaintiff: She must prove that the employer intentionally
discriminated, but this motive can be inferred from the mere fact of differences in treat-
ment. The required steps in a disparate treatment case are:
Step 1. The plaintiff presents evidence that:
• He belongs to a protected category under Title VII.
• Hewas treated differently fromother similar peoplewho are not protected underTitle VII.
If the plaintiff can show these facts, he has made a prima facie case. The plaintiff is
not required to prove discrimination; he need only create a presumption that discrimination
occurred.
Prima facie
From the Latin, meaning “from
its first appearance,”
something that appears to be
true upon a first look.
646 U N I T 4 Employment, Business Organizations and Property
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Suppose that Louisa applies for a job coaching a boys’ high school hockey team. She
was an All-American hockey star in college. Although Louisa is obviously qualified for
the job, Harry, the school principal, rejects her and continues to interview other people.
This is not proof of discrimination because Harry may have a perfectly good, nondiscrim-
inatory explanation. However, his behavior could have been motivated by discrimination.
Step 2. The defendant must present evidence that its decision was based on legitimate,
nondiscriminatory reasons. Harry might say, for example, that he wanted someone with
prior coaching experience. Although Louisa is clearly a great player, she has never
coached before.
Step 3. To win, the plaintiff must now prove that the employer intentionally
discriminated. She may do so either by showing that (1) the reasons offered were
simply a pretext or (2) that a discriminatory intent is more likely than not. Louisa might
show that Harry had recently hired a male tennis coach who had no prior coaching
experience (pretext), or Harry’s assistant might testify that Harry said, “No way I’m
going to put a woman on the ice with those guys.” If she can present evidence such as
this, Louisa wins.
In the following case, was the bartender treated differently because of her sex? You be
the judge.
You Be the Judge
Facts: Darlene Jespersen
was a bartender at the
sports bar in Harrah’s
Casino in Reno, Nevada.
She was an outstanding
employee, frequently prais-
ed by both her supervisors and customers.
After Jespersen had been at Harrah’s for almost
20 years, the casino implemented a program that required
bartenders to be “well groomed, appealing to the eye.”
More explicitly, for men:
• Hair must not extend below top of shirt collar.
Ponytails are prohibited.
• Hands and fingernails must be clean and nails
neatly trimmed at all times.
• No colored polish is permitted.
• Eye and facial makeup is not permitted.
• Shoes will be solid black leather or leather type
with rubber (non-skid) soles.
The rules for women were:
• Hair must be teased, curled, or styled. Hair must be
worn down at all times, no exceptions.
• Nail polish can be clear, white, pink, or red color
only. No exotic nail art or length.
• Shoes will be solid
black leather or
leather type with
rubber (non-skid)
soles.
• Makeup (foundation/concealer and/or face powder,
as well as blush and mascara) must be worn and
applied neatly in complimentary colors, and lip
color must be worn at all times.
An expert was brought in to show the employees
(both male and female) how to dress. The workers were
then photographed and told that they must look like the
photographs every day at work.
Jespersen tried wearing makeup for a short period of
time but then refused to do so. She did not like the feel of
it and also believed that this new appearance interfered
with her ability to deal with unruly, intoxicated guests
because it “took away [her] credibility as an individual
and as a person.”
After Harrah’s fired Jespersen, she sued under Title
VII. The district court granted Harrah’s motion for sum-
mary judgment. Jespersen appealed.
You Be the Judge: Did Harrah’s requirement that women
wear makeup violate Title VII?
Argument for Jespersen: Jespersen refused to wear
makeup to work because the cost—in time, money, and
personal dignity—was too high.
JESPERSEN V. HARRAH’S
444 F.3D 1104, 2006 U.S. APP. LEXIS 9307
United States Court of Appeals
for the Ninth Circuit, 2006
CHAPTER 27 Employment Discrimination 647
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DISPARATE IMPACT
Disparate impact applies if the employer has a rule that, on its face, is not discriminatory, but
in practice excludes too many people in a protected category. Unlike disparate treatment, in a
disparate impact case, the plaintiff does not have to prove intentional discrimination. The
following landmark case established the principle of disparate impact. (You have already
seen this case in Chapter 4, but it is important enough to study a second time.)
Employers are free to adopt different appearance
standards for each sex, but these standards may not
impose a greater burden on one sex than the other. Men
were not required to wear makeup, but women were.
That difference meant a savings for men of hundreds of
dollars and hours of time.4 Harrah’s did not have the right
to fire Jespersen for violating a rule that applies only to
women, with no equivalent for men. Argument for Har-
rah’s: Employers are permitted to impose different
appearance rules on women than on men so long as the
overall burden on employees is the same. For example, it
is not discriminatory to require men to wear their hair
short. On balance, Harrah’s rules did not impose a heavier
burden on women than on men.
Landmark Case
Facts: Before Title VII,
Duke Power would hire
black employees only in
the Labor department,
where the highest pay was
less than the lowest earn-
ings in the other depart-
ments. After Title VII, the
company required all new
hires for jobs in the desirable departments to have a high
school education or satisfactory scores on two tests that
measured intelligence and mechanical ability. Neither
test gauged the ability to perform a particular job. The
pass rate for whites was much higher than for blacks and
whites were also more likely than blacks to have a high
school diploma. The new policy did not apply to the
(exclusively white) employees who were already working
in the preferred departments. These “unqualified”whites
all performed their jobs satisfactorily.
Black employees sued Duke Power, alleging that this
hiring policy violated Title VII.
Issue: Does a policy violate Title VII if it has the effect of
discriminating, even though the intent was not discriminatory?
Decision: Yes, a policy
violates Title VII if it has
a discriminatory impact,
regardless of intent.
Reasoning: Under Title
VII, employers may estab-
lish job requirements that
exclude more blacks
than whites, but only if
the requirements are necessary to do that particular
work. In this case, there was no evidence that either
a high school diploma or the two tests bore any
relationship to the job in question. Indeed, white
employees without any of these qualifications had
been doing the jobs well for years and had even been
promoted.
Whether or not Duke Power intended to discriminate
is irrelevant. Title VII is concerned with the consequences of
an employer’s practices, not its motivation. The burden is
on the employer to show that all job requirements have an
important relationship to the work in question. Any tests
must measure the person for the job and not the person in
the abstract.
4See, for example, Michael Kinsley, “Making Up Is Hard to Do,” The Washington Post, March 26, 2008.
GRIGGS V. DUKE POWER CO.
401 U.S. 424, 91 S. Ct. 849, 1971 U.S. LEXIS 134
United States Supreme Court, 1971
C A S E S U M M A R Y
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The steps in a disparate impact case are:
Step 1. The plaintiff must present a prima facie case. The plaintiff is not required to prove
discrimination; he need only show a disparate impact—that the employment practice
in question excludes a disproportionate number of people in a protected group
(women and minorities, for instance). In the Griggs case, a far higher percentage of
whites than blacks passed the tests required for a job in one of the good departments.
The Equal Employment Opportunity Commission (EEOC) defines a disparate
impact as one in which the pass rate for a protected category is less than 80 percent of
that for others. (As we will see, the EEOC is the federal agency charged with
enforcing most discrimination statutes.)
Step 2. The defendant must offer some evidence that the employment practice was a job-
related business necessity. Duke Power would have to show that the tests predicted job
performance.
Step 3. To win, the plaintiff must now prove either that the employer’s reason is a pretext
or that other, less discriminatory, rules would achieve the same results. The plaintiffs in
Griggs showed that the tests were not a job-related business necessity—after all, whites
who had not passed any of these tests performed the jobs well. Duke Power could no
longer use them as a hiring screen. If the power company wanted to use tests, it would
have to find some that measured an employee’s ability to perform particular jobs.
Hiring tests remain controversial. For example, NewHaven, Connecticut, used an exam to
determine which firefighters to promote. When twice as many whites as blacks passed the test,
black firefighters threatened to sue on the grounds that the exams were discriminatory. But the
city could not win for losing—when it decided to discard the test results, the white firefighters
(and one Hispanic) who had done well on the test sued, alleging that the city was now
discriminating against them.5 Ultimately, the Supreme Court ruled against the city, holding
that an employer cannot discard test results unless it first clearly shows that it would have lost a
disparate impact case. In this case, ruled the court, New Haven could not make this showing
because, indeed, the tests were valid and the city would have won a disparate impact lawsuit.
The court reached this decision despite the fact that the test in question consisted of written
multiple-choice questions, which are generally thought to be a less useful gauge in employ-
ment decisions than actually requiring candidates to perform necessary tasks. In short, the mere
existence of a disparate impact does not mean that an employment practice violates the law.
HOSTILE WORK ENVIRONMENT
Employers violate Title VII if they permit a work environment that is so hostile toward people
in a protected category that it affects their ability to work. This rule applies whether the hostility
is based on race, color, religion, sex, or national origin. (As we
shall see, this rule also applies to those treated badly because
of pregnancy, age, or disability.) This concept of hostile
environment first arose in the context of sexual harassment.
Sexual Harassment When Professor Anita Hill
accused Supreme Court nominee Clarence Thomas of
sexually harassing her, people across the country were
glued to their televisions, watching the Senate hearings
on her charges. Thomas was ultimately confirmed to the
Supreme Court, but “sexual harassment” became a house-
hold phrase. The number of cases—and the size of the
damage awards—skyrocketed.
Everyone has heard of
sexual harassment, but
few people know exactly
what it is.
5Ricci v. DeStefano, 129 S. Ct. 2658, 2009 U.S. LEXIS 4945 (S. Ct. 2009).
CHAPTER 27 Employment Discrimination 649
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Everyone has heard of sexual harassment, but few people know exactly what it is. Men
fear that a casual comment or glance will be met with career-ruining charges; women claim
that men “just don’t get it.” So what is sexual harassment anyway? Sexual harassment
involves unwelcome sexual advances, requests for sexual favors, and other verbal or physical
conduct of a sexual nature which are so severe and pervasive that they interfere with an
employee’s ability to work. There are two categories: (1) quid pro quo and (2) hostile work
environment.
Named for a Latin phrase that means “one thing in return for another,” quid pro quo
harassment occurs if any aspect of a job is made contingent upon sexual activity. In other
words, when a banker says to an assistant, “You can be promoted to teller if you sleep with
me,” that is quid pro quo sexual harassment. As for hostile environment, courts have found
that offensive jokes, intrusive comments about clothes or body parts, and public displays of
pornographic pictures can create a hostile environment.
Text messages have become a new frontier in sexual harassment—so-called textual
harassment. In behavior that can only make you ask, “What were they thinking?” bosses
have sent wildly inappropriate text messages to their subordinates—in some cases offering
promotions in return for sex—that provide clear evidence of wrongdoing. News flash: Text
messages can be recovered, and juries can read. “She said, he said” cases are a lot harder to
win than “She said, he texted.”
In the following case, the Supreme Court defined the standard for a hostile work
environment.
TERESA HARRIS V. FORKLIFT SYSTEMS, INC.
510 U.S. 17, 114 S. Ct. 367, 1993 U.S. LEXIS 7155
United States Supreme Court, 1993
C A S E S U M M A R Y
Facts: Teresa Harris was a manager at Forklift Systems;
Charles Hardy was its president. Hardy frequently made
inappropriate sexual comments to Harris and other women
at the company. For example, he said to Harris, in the
presence of others, “You’re a woman, what do you know?”
and “We need a man as the rental manager.” He called her
“a dumb ass woman” and suggested that the two of them
“go to the Holiday Inn to negotiate her raise.” He also
asked Harris and other female employees to get coins from
his front pants pocket. He insisted that Harris and other
women pick up objects he had thrown on the ground.
When Harris complained to Hardy, he apologized and
claimed he was only joking. A month later, while Harris
was arranging a deal with one of Forklift’s customers, he
asked her, in front of other employees, “What did you do,
promise the guy some sex Saturday night?”
Harris sued Forklift, claiming that Hardy had
created an abusive work environment. The federal
trial court ruled against Harris on the grounds that,
while Hardy’s comments might offend a reasonable
woman, they were not severe enough to have a serious
impact on Harris’s psychological well-being. The
appeals court confirmed, and the Supreme Court
granted certiorari.
Issue: To be a violation of Title VII, must sexual harassment
seriously affect the employee’s psychological well-being?
Decision: No, a hostile or abusive environment violates
Title VII, whether or not the plaintiff suffered psycholo-
gical injury.
Reasoning: Title VII is not limited to economic or tan-
gible discrimination. A workplace loaded with intimida-
tion, ridicule, and insult creates an abusive environment
that violates Title VII.
Merely uttering a swear word or two is not a violation
because a reasonable person would not find that hostile or
abusive. But Title VII does come into play before the
victim has a nervous breakdown. An abusive environment
that does not seriously affect employees’ psychological
well-being, nonetheless, may detract from their job per-
formance and keep them from advancing in their careers.
If the environment would reasonably be perceived, and is
perceived, as hostile or abusive, Title VII does not require
it also to be psychologically injurious.
650 U N I T 4 Employment, Business Organizations and Property
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Same-Sex Harassment Suppose that one man makes unwelcome sexual overtures to
another man in the workplace. The Supreme Court ruled that same-sex harassment is also a
violation of Title VII.6
Employer Liability for Sexual Harassment Employees who commit sexual harass-
ment are liable for their own misdeeds. But is their company also liable? The Supreme
Court has held that:
• The company is liable if it knew or should have known about the conduct and failed
to stop it.
• Even if the company was unaware of the misbehavior, it is nonetheless liable if the
victimized employee suffered a “tangible employment action” such as firing,
demotion, or reassignment.
• If the company was unaware of the behavior and the victimized employee did not
suffer a tangible employment action, the company is still liable unless it can prove
that (1) it used reasonable care to prevent and correct sexually harassing behavior,
and (2) the employee unreasonably failed to take advantage of the complaint
procedure or other preventive opportunities provided by the company.7
Corning Consumer Products Co. provides a set of practical guidelines for eliminating
sexual harassment. It asks employees to apply four tests in determining whether their
behavior violates Title VII:
• Would you say or do this in front of your spouse or parents?
• What about in front of a colleague of the opposite sex?
• Would you like your behavior reported in your local newspaper?
• Does it need to be said or done at all?
Hostile Environment Based on Race When African American Brenda Chaney
worked at the Plainfield nursing home, one of its patients refused to allow people of color
to enter her room. In addition, Chaney’s coworkers called her racial slurs.
The court ruled that the nursing home had violated Title VII by permitting a hostile
work environment.8
Hostile Environment Based on Color Title VII prohibits discrimination based on
both race and color. Although many people assume that they are essentially the same, that is
not necessarily the case. For example, Dwight Burch alleged that his coworkers at an
Applebee’s restaurant created a hostile work environment when they called him hateful
names because of his dark skin color. These colleagues were also African American but were
lighter-skinned. While denying any wrongdoing, Applebee’s settled the case by paying
Burch $40,000 and agreeing to conduct antidiscrimination training.
Hostile Environment Based on National Origin Title VII also prohibits a hostile
environment based on national origin. While working at Steel Technologies, Inc., Tony Cerros
was promoted several times. So what was the problem? Coworkers and supervisors called him
“brown boy,” “spic,” “wetback,” “Julio,” and “Javier” (although those were not his names).
They also told him that “if it ain’t white, it ain’t right,” and “Go Back to Mexico” was written
6Oncale v. Sundowner Offshore Services, Inc., 523 U.S. 75 (S. Ct. 1998).
7Burlington Industries, Inc. v. Ellerth, 524 U.S. 742, 118 S. Ct. 2257, 1998 U.S. LEXIS 4217 (1998);
Faragher v. Boca Raton, 524 U.S. 775, 118 S. Ct. 2275, 1998 U.S. LEXIS 4216 (1998).
8Chaney v. Plainfield Healthcare Ctr., 612 F.3d 908 (7th Cir. 2010).
CHAPTER 27 Employment Discrimination 651
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on the bathroom wall. Although the company removed the bathroom graffiti, it did not
investigate Cerros’s complaints until he filed suit. At that point, it determined that Cerros
had not been discriminated against. The trial court agreed because Cerros had, after all, been
promoted. However, the appeals court overturned the decision, finding for Cerros on the
grounds that he had suffered a hostile work environment, which is in itself a violation of Title
VII, even if there is no evidence of adverse employment actions.9
RETALIATION
Title VII also prohibits employers from retaliating against workers who oppose discrimina-
tion, bring a claim under the statute, or take part in an investigation or hearing. Retaliation
means that the employer has done something that would deter a reasonable worker from
complaining about discrimination. For example, a company was found liable when it
demoted a woman who complained about sexual harassment by her boss.10 Research
indicates that retaliation occurs in as many as 60 percent of discrimination cases.
Title VII prohibits disparate treatment, disparate impact, hostile environment, and retalia-
tion when used against any of the categories protected by Title VII—race, color, religion, sex,
and national origin. Now we look at particular rules that apply to only some of these categories.
27-4b Religion
Employers cannot discriminate against a worker because of his religious beliefs. In addition,
employers must make reasonable accommodation for a worker’s religious practices unless
the request would cause undue hardship for the business. A common issue involves
employees who cannot work on their Sabbath. This refusal might be an “undue hardship”
if there are no other employees who could perform that work on those days. What would
you do in the following cases if you were the boss?
1. A Christian says he cannot work at Walmart on Sundays—his Sabbath. It also happens
to be one of the store’s busiest days.
2. A Jewish police officer wants to wear a beard and yarmulke as part of his religious
observance. Facial hair and headgear are banned by the force.
3. Muslim workers at a meat-packing plant want to pray at sundown, but specific break
times were specified in the labor contract and sundown changes from day to day. The
workers begin to take bathroom breaks at sundown, stopping work on the production
line.
Disputes such as these are on the rise and are not easy to handle fairly. In the end,
Walmart fired the Christian, but when he sued on the grounds of religious discrimination,
the company settled the case. A judge ruled that the police officer could keep his beard
because the force allowed other employees with medical conditions to wear facial hair, but
the head covering had to go. The boss at the meat-packing plant fired the Muslim
employees who left their posts to pray.
27-4c Sex
Title VII has had an enormous impact on the American workplace—half of all workers are
now women. But women are still underrepresented at the top of the employment ladder, as
CEOs, partners in law and consulting firms, or department heads in hospitals. On average,
women working full time earn only 80 percent as much as male coworkers, even after
accounting for occupation, industry, race, marital status, and job tenure. Although there are
9Cerros v. Steel Techs, Inc., 288 F.3d 1040 (7th Cir. 2002).
10Burlington Northern v. White, 126 S.Ct. 2405 (S.Ct. 2006).
652 U N I T 4 Employment, Business Organizations and Property
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undoubtedly many reasons for this inequality, such as women taking time out of work to
care for children, gender discrimination also seems to play a role. For example, male CFOs
in public companies earn 16 percent ($215,000) more than female CFOs, even after
controlling for age, time in the job, company size, and market capitalization.11
What does discrimination on the basis of sex mean? In a landmark case that defined this
provision of Title VII, the Supreme Court ruled that “gender must be irrelevant to employ-
ment decisions.”12 In this case, the accounting firm Price Waterhouse had refused to promote
Ann Hopkins to partner. Of the 88 people who came up for partner that year, she was the only
woman. She was not only a high performer, she was also the most successful in bringing in
business. The problem? She was “sometimes overly aggressive, unduly harsh, difficult to work
with, and impatient with staff.” Partners commented that she was macho, overcompensated for
being a woman, and needed to take a course at charm school. They were opposed to her use of
profanity because it was a “lady using foul language.” A partner explicitly told her that she
should “walk more femininely, talk more femininely, dress more femininely, wear makeup,
have her hair styled, and wear jewelry.” In ruling in her favor, the Supreme Court held that
Title VII forbids sex stereotyping. The opinion said, “An employer who objects to aggressive-
ness in women but whose positions require this trait places women in an intolerable and
impermissible catch-22: out of a job if they behave aggressively and out of a job if they do not.
Title VII lifts women out of this bind.”
27-4d Family Responsibility Discrimination
Suppose that you are in charge of hiring at your company. You receive applications from four
people: a mother, a father, a childless woman, and a childless man. All have equivalent
qualifications. Which one would you hire? In studies, participants repeatedly rank mothers
as less qualified than other employees and fathers as most desirable, even when their
credentials are exactly the same.
Is parenthood a protected category under Title VII? Increasingly, courts have held that
it is. For example, after Dawn Gallina, an associate at the Mintz, Levin law firm, revealed to
her boss that she had a young child, he began to treat her differently from her male
colleagues and spoke to her “about the commitment differential between men and
women.” The court ruled that her belief of illegal discrimination was reasonable.13 The
EEOC has issued guidelines indicating that stereotypes are not a legitimate basis for
personnel decisions and may violate Title VII.
27-4e Sexual Orientation
Neither Title VII nor any other federal statute protects against discrimination based on
sexual orientation (being gay). However, President Bill Clinton did sign an executive order
prohibiting discrimination based on sexual orientation in federal training and education
programs.14 In addition, almost half the states and hundreds of cities have statutes that
prohibit discrimination based on sexual orientation.
27-4f Gender Identity
David Schroer was in the Army for 25 years, including a stint tracking terrorists. The Library
of Congress offered him a job as a specialist in terrorism. (Who knew that libraries needed
terrorism specialists?) However, when he revealed that he was in the process of becomingDiane
Schroer, the Library of Congress withdrew the offer. As you can guess, he sued under Title VII.
11http://www3.cfo.com/article/2012/4/compensation_gmi-gender-gap-gofoernance-metrics.
12Price Waterhouse v. Hopkins, 490 U.S. 228 (S. Ct. 1989).
13Gallina v. Mintz, Levin, 2005 U.S. App. LEXIS 1710 (4th Cir. 2005).
14Executive Order 13160.
CHAPTER 27 Employment Discrimination 653
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Traditionally, courts took the view that sex under Title VII applied only to how people
were born, not what they chose to become. Employers could and did fire workers for
changing sex. However, a federal court found the Library of Congress in violation of Title
VII for withdrawing Schroer’s offer.15 And the EEOC recently ruled that discriminating
against someone for being transgender is a violation of Title VII. In addition, almost one-
quarter of the states and hundreds of cities prohibit gender identity discrimination.
27-4g Defenses to Charges of Discrimination
Under Title VII, the defendant has four possible defenses.
MERIT
A defendant is not liable if he shows that the person he favored was the most qualified. Test
results, education, or productivity can all be used to demonstrate merit, provided they relate
to the job in question. Harry can show that he hired Bruce for a coaching job instead of
Louisa because Bruce has a master’s degree in physical education and seven years of
coaching experience. On the other hand, the fact that Bruce scored higher on the National
Latin Exam in the eighth grade is not a good reason to hire him over Louisa.
SENIORITY
Many companies use seniority as an important factor in determining everything from
compensation to layoffs. While such systems offer many advantages—they encourage a
commitment to the company, an incentive to learn job-specific skills, and a willingness to
train other workers without fear of losing one’s job—they also tend to perpetrate prior
discriminatory practices. If historic trends result in black employees having less seniority,
they will also be paid less and laid off more. However, a seniority system violates Title VII
only if it was designed with the intention to discriminate. A legitimate seniority system is
legal even if it perpetuates past discrimination. Suppose that Harry has always chosen the
most senior assistant coach to take over as head coach when a vacancy occurs. Because the
majority of the senior assistant coaches are male, most of the head coaches are, too. Such a
system does not violate Title VII.
BONA FIDE OCCUPATIONAL QUALIFICATION (BFOQ)
An employer is permitted to establish discriminatory job requirements if they are essential to the
position in question. The business must show that it cannot fulfill its primary function unless it
discriminates. Such a requirement is called a bona fide occupational qualification (BFOQ).
(Note that only religion, sex, or national origin can be a BFOQ—never race or color.)
Catholic schools may, if they choose, refuse to hire non-Catholic teachers; clothing
companies may refuse to hire men to model women’s attire. Generally, however, courts are
not sympathetic to claims of BFOQ. They have almost always rejected BFOQ claims that
are based on customer preference. For example, an employer violated the law when it
refused to appoint a woman to a position as vice president of international operations
because of its fear that men in other countries might not want to work with her.16
However, the courts recognize three situations in which employers may consider
customer preference:
• Safety: The Supreme Court ruled that a maximum security men’s prison could refuse
to hire women correctional officers. If a woman wanted to risk her life, that was her
15Schroer v. Billington, 577 F. Supp. 2d 293, 2008 U.S. Dist. LEXIS 71358, (U.S. Dt. Ct. 2008).
16Fernandez v. Wynn Oil Co., 653 F.2d 1273, (9th Cir. 1981).
Bona fide occupational
qualification (BFOQ)
An employer is permitted to
establish discriminatory job
requirements if they are
essential to the position in
question.
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choice, but the Court feared that an attack on her would threaten the safety of both
male guards and inmates.17
• Privacy: An employer may refuse to hire women to work in a men’s bathroom, and
vice versa.
• Authenticity: An employer may refuse to hire a man for a woman’s role in a movie. In
addition, a court ruled that Disney could fire an Asian man from the Norwegian
exhibit at its Epcot international theme park, not because he was Asian, but because
he was not culturally authentic. He did not have first-hand knowledge of Norwegian
culture and did not speak Norwegian.18
AFFIRMATIVE ACTION
The goal of affirmative action programs is to remedy the effects of past discrimination. How
people feel about affirmative action tends to be a function of how they define the term.
Most people are opposed to quotas, but at the same time, they support outreach and
recruitment efforts aimed at women and disadvantaged minorities.
Affirmative action is not required by Title VII, nor is it prohibited. Affirmative action
programs have three different sources.
Litigation Courts have the power under Title VII to order affirmative action to remedy
the effects of past discrimination.
Voluntary Action Employers can voluntarily introduce an affirmative action plan to
remedy the effects of past practices or to achieve (but not to maintain) equitable representa-
tion of minorities and women, provided that the plan is not too unfair to majority members.19
For example, in the university and community college system in Nevada, only 1 percent of
the faculty were black (and roughly 25 percent were female). In response, the university
instituted a policy that permitted any department that hired a minority candidate to also hire
an additional candidate of any race. Although Yvette Farmer was one of three finalists for a job
in the sociology department, it hired a black African male without even granting her an
interview. The Court ruled that the university’s affirmative action plan was legal.20
Government Contracts In 1965, President Lyndon Johnson signed Executive Order
11246, which prohibits discrimination by federal contractors. This order had a profound
impact on the American workplace because one-third of all workers are employed by
companies that do business with the federal government. If an employer found that women
or minorities were underrepresented in its workplace, it was required to establish goals and
timetables to correct the deficiency.
In 1995, however, the Supreme Court dramatically limited the extent to which the
government can require contractors to establish affirmative action programs. The Court ruled
that, under the Fourteenth Amendment to the Constitution, these programs are permissible
only if they serve a “compelling governmental interest” and are “narrowly tailored” so that
they minimize the harm to white males.21 This case led to a sharp decrease in the number of
federal contracts awarded to companies owned by women and minorities.
17Dothard v. Rawlinson, 433 U.S. 321, (S. Ct. 1977).
18Gupta v. Walt Disney World Co., 256 Fed. Appx. 279 (11th Cir. 2007).
19In United Steelworkers of America v. Weber, 443 US 193 (S. Ct. 1979).
20University and Community College System of Nevada v. Farmer, 113 Nev. 90 (S. Ct. Nev. 1997).
21Adarand Constructors, Inc. v. Pena, 515 U.S. 200, 115 S. Ct. 2097, 1995 U.S. LEXIS 4037 (S. Ct. 1995).
CHAPTER 27 Employment Discrimination 655
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27-5 EQUAL PAY ACT OF 1963
Under the Equal Pay Act, an employee may not be paid at a lesser rate than employees of
the opposite sex for equal work. “Equal work” means tasks that require equal skill, effort,
and responsibility under similar working conditions. For example, Corning Glass Works
paid the inspectors on its night shift, who were all male, significantly more than the day
inspectors who performed the same tasks but were female. After it allowed women to work
at night, it equalized wages on the two shifts but grandfathered in the men who had been on
the night shift and continued to pay them higher wages. The Supreme Court ruled that this
practice violated the Equal Pay Act, on the grounds that:
• The term “working conditions” meant physical surroundings, not time of day.
• Men were paid more not because they worked at night, but because they would not
work at the low rates paid to women.
• Grandfathering in the men at higher wages perpetuated the discrimination.22
If the employee proves that she is not being paid equally, the employer will be found
liable unless the pay difference is based on merit, productivity, seniority, or some factor
other than sex. A “factor other than sex” includes prior wages, training, profitability,
performance in an interview, and value to the company. For example, female agents sued
Allstate Insurance Co. because its salary for new agents was based, in part, on prior salary.
The women argued that this system was unfair because it perpetuated the historic wage
differences between men and women. The court, however, held for Allstate.23
27-6 PREGNANCY DISCRIMINATION ACT
Under the Pregnancy Discrimination Act, an employer may not fire, refuse to hire, or fail to
promote a woman because she is pregnant. An employer also violates this statute if the work
environment is so hostile towards a pregnant woman that it affects her ability to do her job.
And an employer must treat pregnancy and childbirth as any other temporary disability. If,
for example, employees are allowed paid time off from work for other medical disabilities,
women must also be allowed a paid maternity leave.
The Pregnancy Discrimination Act also protects a woman’s right to terminate a preg-
nancy. An employer cannot fire a woman for having an abortion.24
27-7 AGE DISCRIMINATION IN
EMPLOYMENT ACT
During the last decade, the number of workers over the age of 65 has doubled and the
number of age discrimination cases has also increased dramatically. Under the Age Dis-
crimination in Employment Act (ADEA), an employer with 20 or more workers may not fire,
refuse to hire, fail to promote, or otherwise reduce a person’s employment opportunities
because he is 40 or older. Nor may an employer require workers to retire at a certain age.
22Corning Glass Works v. Brennan, 417 U.S. 188 (S. Ct. 1974).
23Kouba v. Allstate Insurance Co., 691 F.2d 873, 1982 U.S. App. LEXIS 24479 (9th Cir. 1982).
24Doe v. C.A.R.S Protection Plus, Inc., 527 F.3d 358 (3rd Cir. 2008).
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(This retirement rule does not apply to police and top-level corporate executives.) The goal
of the statute is to counteract stereotypes about the abilities of older workers. A plaintiff in
an age discrimination case can show discrimination in three ways: disparate treatment,
disparate impact, and hostile work environment.
27-7a Disparate Treatment
In a disparate treatment claim, the plaintiff must show that the employer intentionally
discriminated against him because of his age, or enacted a policy that intentionally treated
employees differently because of their age. Proof of intent involves obvious statements and
behavior or more subtle circumstantial evidence.
Under the ADEA, a disparate treatment case requires three steps.
Step 1. The plaintiff must show that:
• He is 40 or older.
• He suffered an adverse employment action.
• He was qualified for the job for which he was fired or not hired.
• He was replaced by a younger person.
Step 2. The employer must present evidence that its decision was based on legitimate,
nondiscriminatory reasons.
Step 3. The plaintiff must now show that the employer’s reasons are a pretext and, in fact,
the employer intentionally discriminated. Note that the standard of proof is tougher in an
age discrimination case than in Title VII litigation. Under the ADEA, the plaintiff must
show that but for his age, the employer would not have taken the action it did. In other
words, to win a case, the plaintiff must show that age was not just one factor, it was the
deciding factor. For example, when Jack Gross was 54 years old, his employer transferred
most of his responsibilities to a younger woman and “reassigned” him to a different job.
Whatever the terminology used, this move was effectively a demotion. Evidence at trial
indicated that age may have been one factor in his employer’s decision, but there were
other reasons as well. The Supreme Court ruled for the employer, on the grounds that
Gross had not shown that age was the “but-for” cause of the disputed decision.25 This
case makes the road steeper for ADEA plaintiffs.
What protection does the ADEA provide? In passing this statute, Congress was particu-
larly concerned about employers who relied on unfavorable stereotypes rather than job
performance. The following case illustrates this issue.
REID V. GOOGLE, INC.
50 Cal. 4th 512, 2010 Cal. LEXIS 7544
Supreme Court of California, 2010
C A S E S U M M A R Y
Facts: Google’s vice-president of engineering, Wayne
Rosing (aged 55), hired Brian Reid (52) as director of
operations and director of engineering. At the time, the
top executives at Google were CEO Eric Schmidt (47),
vice-president of engineering operations Urs Hölzle (38),
and founders Sergey Brin (28) and Larry Page (29).
During his two years at Google, Reid’s only written
performance review stated that he had consistently met
25Gross v. FBL Financial Services, Inc., 129 S. Ct. 2343; 2009 U.S. LEXIS 4535 (S. Ct., 2009).
CHAPTER 27 Employment Discrimination 657
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27-7b Disparate Impact
Disparate impact claims arise when an employer’s actions do not explicitly discriminate, but
nonetheless have an adverse impact on people aged 40 or over. Here, too, the standards are
different under the ADEA from those under Title VII. Under the ADEA:
Step 1. The plaintiffs must present a prima facie case that the employment practice in
question excludes a disproportionate number of people 40 and older.
Step 2. The employer wins if it can show that the discriminatory decision was based on a
“reasonable factor other than age.”
One reasonable factor other than age is cost. As a general rule, people in their 60s
earn 50 percent more than workers in their early 30s. The older folks are more efficient, but
not 50 percent more. So sometimes companies fire older workers because they are paid more,
receive higher pension benefits, or generally cost more (e.g., higher healthcare expenses). Courts
have supported these decisions, holding that an employer is entitled to prefer lower-paidworkers
even if that preference results in the company also choosing youngerworkers. As the court put it in
one case, “An action based on price differentials represents the very quintessence of a legitimate
business decision.”26 Indeed, economists argue that the U.S. economy’s strength is based at least
in part on its flexibility—an American employer can hire workers without fear of being stuck with
them until retirement. Thus, for example, Circuit City Stores fired 8 percent of its employees
because they could be replaced with people who would work for less. The fired workers were
more experienced—and older. This action was legal under the ADEA.
27-7c Hostile Work Environment
Diane Kassner (age 79) and Marsha Reiffe (61) worked for 2nd Avenue Delicatessen. They
filed suit under the ADEA, alleging that their boss and coworkers made comments to them
about their age, such as “Drop dead,” “Retire early,” “Take off all of that makeup,” and
expectations. The comments indicated that Reid had an
extraordinarily broad range of knowledge, an aptitude
and orientation towards operational and IT issues, an excel-
lent attitude, and that he projected confidence when dealing
with fast-changing situations, was very intelligent and crea-
tive, and was a terrific problem solver. The review also
commented that “Adapting to Google culture is the primary
task. Right or wrong, Google is simply different: Younger
contributors, inexperienced first line managers, and the super
fast pace are just a few examples of the environment.”
According to Reid, even as he received a positive
review, Hölzle and other employees made derogatory
age-related remarks such as his ideas were “obsolete,”
“ancient,” and “too old to matter,” that he was “slow,”
“fuzzy,” “sluggish,” and “lethargic,” an “old man,” an
“old guy,” and an “old fuddy-duddy,” and that he did
not “display a sense of urgency” and “lacked energy.”
Nineteenmonths after Reid joinedGoogle, he was fired.
Google says it was because of his poor performance. Reid
alleges he was told it was based on a lack of “cultural fit.”
Reid sued Google for age discrimination. The trial
court granted Google’s motion for summary judgment on
the grounds that Reid did not have sufficient evidence of
discrimination. He appealed.
Issues: Did Reid have enough evidence of age discrimina-
tion to warrant a trial? Should the summary judgment motion
be granted?
Decision: The trial court was overruled and summary
judgment denied.
Reasoning: Google argued that the trial court should
have ignored the ageist comments about Reid because
they were “stray remarks,” made neither by decision-
makers nor during the decision process. But stray remarks
may be relevant, circumstantial evidence of discrimina-
tion. The jury should decide how relevant.
An ageist remark, in and of itself, does not
prove discrimination. But when combined with other tes-
timony, it may provide enough evidence to find liability.
26Marks v. Loral Corp., 57 Cal. App. 4th 30, 1997 Cal. App. LEXIS 611 (Cal. Ct. App., 1997).
658 U N I T 4 Employment, Business Organizations and Property
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“Take off your wig.” In addition, their boss pressured the two women to retire and pointed to
the front of the restaurant and said, “There’s the door.” But the two women were never fired.
The court ruled that the ADEA prohibits a hostile work environment based on age. A
workplace is considered hostile if a reasonable person would find that intimidation, ridicule,
and insult based on age are pervasive.27 In short, this case, combined with the Google case,
indicate that it is wise to avoid any comments about an employee’s age.
27-7d Bona Fide Occupational Qualification
As is the case under Title VII, age is rarely a BFOQ. To set a maximum age, the employer
must show that:
• The age limit is reasonably necessary to the essence of the business; and either
• Virtually everyone that age is unqualified for the job, or
• Age is the only way an employer can determine who is qualified.
Although some courts have held that age can be a BFOQ in cases where public safety is
at issue, such as for pilots and bus drivers, the EEOC is not always in agreement. In short,
the BFOQ defense is very limited in ADEA cases.
EXAM Strategy
Question: Solapere ran a job ad on Monster.com, which said that the company
would only consider hiring people who either had a job or had been unemployed for
less than six months. The average length of unemployment in the United States at
that time was nine months, which meant that such a policy eliminated millions of job
applicants. Did this ad violate federal law?
Strategy: Solapere was not intentionally discriminating against anyone, thus no
disparate treatment claim. What about a disparate impact claim? Did this policy exclude
too many people in a protected category? The unemployed are not a protected category
under Title VII, but this policy might have had an impact on groups that are protected.
Result: Older people and some minority groups have higher unemployment rates
than other workers. Therefore, this practice could violate both Title VII and the
ADEA unless Solapere could show that it was a job-related business necessity. Could
it be a job-related business necessity?
27-8 DISCRIMINATION ON THE BASIS
OF DISABILITY
27-8a The Rehabilitation Act of 1973
The Rehabilitation Act of 1973 prohibits discrimination on the basis of disability by the
executive branch of the federal government, federal contractors, and entities that receive
federal funds. It also requires these organizations to develop affirmative action plans for the
27Kassner v. 2nd Ave. Delicatessen, Inc., 496 F.3d 229, (2nd Cir. 2007).
CHAPTER 27 Employment Discrimination 659
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hiring, placement, and promotion of the disabled. The same legal standards apply to both
this statute and the Americans with Disabilities Act, discussed next. Cases interpreting one
statute also apply to the other.
27-8b Americans with Disabilities Act
The Americans with Disabilities Act (ADA) prohibits employers with 15 or more workers
from discriminating on the basis of disability.
DISABILITY
A disabled person is:
• Someone with a physical or mental impairment that substantially limits a major life
activity or the operation of a major bodily function, or
• Someone who is regarded as having such an impairment.
Major life activities include the following tasks: caring for oneself, performing manual
tasks, seeing, hearing, eating, sleeping, walking, standing, lifting, bending, speaking, breath-
ing, learning, reading, concentrating, thinking, communicating, and working. Major bodily
functions include functions of the immune system, normal cell growth, digestive, bowel,
bladder, neurological, brain, respiratory, circulatory, endocrine, and reproductive functions.
The ADA applies to recovered drug addicts but not to the current use of drugs, sexual
disorders, pyromania, exhibitionism, or compulsive gambling. Although the ADA protects
alcoholics who can meet the definition of disabled, employers can nonetheless fire alco-
holics if their drinking adversely affects job performance.
Suppose an employee has a disabling illness, but one that can be successfully treated. The
employee is still considered to be disabled, even if the illness is well controlled. Thus, someone
with diabetes is disabled, even if the illness is managed so well that it does not interfere with
major life activities. There is one important exception—someone whose vision is normal when
wearing glasses or contact lenses is not disabled for purposes of the ADA.
This description of the ADA reflects changes Congress made to the statute in 2008. It
expanded the definition of “disability” as the term had been interpreted by the Supreme
Court. The following case is one of the first by a circuit court of appeals to interpret
the amended ADA. As you can see, despite Congress’s intent to expand the scope of the
statute, the appeals court did not support the plaintiff’s claim. Indeed, by upholding a grant
of summary judgment, it prevented her from even presenting her case to a jury.
ALLEN V. SOUTHCREST HOSPITAL
2011 U.S. App. LEXIS 25488
United States Court of Appeals for the Tenth Circuit, 2011
Facts: After some years as a medical assistant at SouthCrest
Hospital, Alethia Allen requested a transfer to work for a
different physician in the same hospital. Unfortunately, Allen
found her new job to be much more stressful than the old
one. Indeed, it was so stressful that she began suffering
severe migraine headaches several times a week. Prior to this
new job, she had only had one migraine headache in her life.
Ultimately, Allen resigned because of the migraines.
The hospital asked that she stay on to cover for some
assistants who were on vacation. Allen agreed to do so and
then decided she did not want to quit after all. But before
the hospital made a decision about whether she could
stay, she left work one day to seek treatment for a
migraine at the emergency room. That night, the doctors
660 U N I T 4 Employment, Business Organizations and Property
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ACCOMMODATING THE DISABLED WORKER
Once it is established that a worker is disabled, employers may not discriminate on the basis
of disability so long as the worker can, with reasonable accommodation, perform the essential
functions of the job. An accommodation is not reasonable if it would create undue hardship
for the employer. Let’s look at those terms more closely.
Reasonable Accommodation To meet this standard, employers are expected to:
• Make facilities accessible,
• Permit part-time schedules,
• Acquire or modify equipment, and
• Assign a disabled person to an open position that he can perform. (Note that the
employer is not required to create a new job or find a perfect position, just a
reasonable one.)
Essential Functions of the Job A juvenile corrections officer was hit by a baseball
that fractured her wrist. Nine months after returning to her job, she was assigned to the
night shift, where the only other officer was a newcomer. Concerned that her wrist was not
strong enough for her to restrain some of the children in the facility on her own, she asked to
be paired with an experienced officer. Her employer fired her on the grounds that she could
not perform the essential functions of the job. But the court ruled that since she had been
working successfully as an officer during the day, clearly she could perform the essential
functions.28
Undue Hardship What constitutes undue hardship is the subject of much litigation. Many
courts hold that employers may use cost-benefit analysis—they are not required to make an
expensive accommodation that provides little benefit. Nor are they required to provide identical
working conditions for all employees. For example, a woman who was wheelchair-bound asked
her employer to lower the sink in the kitchenettes that were being built in her building.
Otherwise, she would have to use the bathroom sink, which she felt segregated and stigmatized
in her practice decided she could not continue in her job.
After leaving SouthCrest, her migraines stopped.
Allen filed suit against SouthCrest for violating the
ADA. During discovery, she testified that on most days,
she could care for herself and go to work, but that on days
on which she took the migraine medication, she would
come home from work and immediately “crash and burn.”
In other words, she could not care for herself but instead
would go straight to bed.
The trial court granted SouthCrest’s motion for sum-
mary judgment. Allen appealed.
Issue: Did Allen have a disability that interfered with one
or more major life activities?
Decision: No, Allen failed to show that her disability
interfered with any major life activities.
Reasoning: Allen alleged that taking migraine medication
interfered with her ability to care for herself in the evenings,
which is a major life activity. But even the average person
sometimes goes to bed early and is unable to care for herself
when asleep. Allen had to show how much worse off she
was than the average person who sometimes comes home
from work exhausted. Furthermore, Ms. Allen needed to
show: how much earlier she went to bed on migraine days,
which activities she could not perform, how long she slept,
and whether she could complete in the morning the activ-
ities she had failed to do the night before.
Ms. Allen also alleged that her migraines interfered
with her ability to work, which is certainly a major life
activity. However, she had to show that she was unable to
perform a general class of jobs for which she had appro-
priate training and skills, not one single specific job.
28Leuzinger v. County of Lake, 2007 U.S. Dist. LEXIS 35955 (N.D. CA 2007).
CHAPTER 27 Employment Discrimination 661
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her. The cost to lower the kitchen sinks ranged from as much as $2,000 (to do all the sinks in the
building) to as little as $150 (for just the sink on her floor). The court ruled that the employer had
no obligation to provide identical conditions and that it had already made a reasonable accom-
modation by lowering the sink in the bathroom. Although the employer could, in theory, afford
this request, it did not have an obligation to spend so much money for so little benefit.29
MEDICAL EXAMS
Employers interact with workers at three key stages: applying, entering (after hiring but
before the job starts), and working. The ADA sets different standards for medical exams at
these three stages:
• With applicants, an employer generally may not require a medical exam or ask about
disabilities, except that the interviewer may ask:
� whether an applicant can perform the work (provided that the same question is asked of
all applicants);
� the applicant to demonstrate how he would perform the job; and
� (in the event that a disability is obvious) what accommodation the applicant would need.
• With entering employees, the company may require a medical test and make it a
condition of employment, but the test must be:
� Required of all employees, whether or not they are disabled; and
� Treated as a confidential medical record (except in the case of managers who need to
know).
• With existing employees, an employer may require medical exams or discuss any
suspected disability, but only to determine if a worker is still able to perform the
existing functions of her job.
RELATIONSHIP WITH A DISABLED PERSON
An employer may not discriminate against someone because of his relationship with a
disabled person. For example, an employer cannot refuse to hire an applicant because he
has a disabled child or a spouse with cancer.
MENTAL DISABILITIES
Under EEOC rules, physical and mental disabilities are to be treated the same. Physical
ailments such as diabetes and deafness may sometimes be easier to diagnose, but psychological
disabilities are also covered by the ADA. Among other accommodations, the EEOC rules indicate
that employers should be willing to put up barriers to isolate people who have difficulty concentrat-
ing, provide detailed day-to-day feedback to those who need greater structure in performing their
jobs, or allow workers on antidepressants to come to work later if they are groggy in the morning.
DISPARATE TREATMENT AND DISPARATE IMPACT
Both disparate treatment and disparate impact claims are valid under the ADA. The steps in
a disparate treatment case are:
Step 1. The plaintiff must offer prima facie evidence that the employer discriminated
because of his disability.
Step 2. The employer must then offer a legitimate, nondiscriminatory reason for
its action.
29Vande Zande v. Wisconsin Department of Administration, 44 F.3d 538 (7th Cir. 1995).
662 U N I T 4 Employment, Business Organizations and Property
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Step 3. To win, the plaintiff must now prove that the employer intentionally
discriminated. She may do so either by showing that (1) the reasons offered
were simply a pretext or (2) that a discriminatory intent is more likely than not.
To win a disparate impact case, the plaintiff must show that a policy that looks neutral
falls more harshly on a protected group and cannot be justified by business necessity.
The following Exam Strategy illustrates how disparate treatment and disparate impact are
applied in an ADA case and also demonstrates the importance of choosing the correct theory.
EXAM Strategy
Question: Hughes Missile Systems fired Joel Hernandez because he tested positive
for cocaine, which, not surprisingly, was a violation of workplace rules. He, however,
had no hard feelings, and two years later, he reapplied for a job at Hughes. At the
time, he provided evidence that he was clean. However, the company rejected his
application because it had a policy against hiring anyone who had been fired for cause.
Did the company violate the ADA?
Strategy: Under the ADA, it is legal to discriminate against a drug user, but not
against a recovered drug addict. To win a disparate treatment case, Hernandez had to
show that Hughes’s excuse for not rehiring him was just a pretext and its decision was
really motivated by an intent to discriminate based on his disability. To win a
disparate impact claim, Hernandez had to show that the no-rehire policy affected
disabled people more than others and that it was not justified by business necessity.
Could he prove either of these claims?
Result: The Supreme Court ruled that Hernandez could not prove his disparate
treatment claim because its no-rehire rule was legitimate and not just a pretext for
discrimination. And because Hernandez had not raised the issue of disparate impact in
the lower courts, the Supreme Court refused to consider it. So he lost his case.30
HOSTILE WORK ENVIRONMENT
An employee may bring a claim under the ADA if she is subjected to a hostile work
environment because of her disability. For example, Sandra Flowers’s boss fired her eight
months after finding out that she was HIV-positive. During that eight months, Flowers’s
entire work environment changed. Before, Flowers and her boss had been friends who went
out together for lunch, drinks, and the movies. Afterward, the socializing stopped, the boss
began monitoring Flowers’s phone calls, and then subjected her to four “random” drug tests
in one week. A jury found that Flowers’s termination was not based on her disability, but
that her boss had nonetheless created a hostile work environment by unreasonably inter-
fering with Flowers’s ability to work.31
While lauding the ADA’s objectives, many managers have been apprehensive about its
impact on the workplace. Most acknowledge, however, that society is better off if every member
has the opportunity to work. And as advocates for the disabled point out, we are all, at best, only
temporarily able-bodied. Evenwith the ADA, only 35 percent of the disabled population who are
of working age are employed, whereas 78 percent of able-bodied people have jobs.
30Raytheon Co. v. Hernandez, 540 U.S. 44 (S. Ct. 2003).
31Flowers v. S. Reg’l Physician Servs, 247 F.3d 229 (5th Cir. 2001).
CHAPTER 27 Employment Discrimination 663
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27-9 GENETIC INFORMATION
NONDISCRIMINATION ACT
Suppose you want to promote someone to CFO, but you know that his father and brothers
both died young of prostate cancer. Is it legal to consider that information in making a
decision? Not since Congress passed the Genetic Information Nondiscrimination Act (GINA).
Under this statute, employers with 15 or more workers may not require genetic testing or
discriminate against workers because of their genetic makeup. Nor may health insurers use
such information to decide coverage or premiums. Thus, neither employers nor health
insurers may require you to provide your family medical history—who has died of cancer or
heart disease, for instance. And if they find this information out from another source (such as a
newspaper obituary), they may not use it in making an employment decision.
27-10 ENFORCEMENT
Employment laws provide plaintiffs with different enforcement options.
27-10a Constitutional Claims
People bringing a claim under the Constitution must file suit on their own.
27-10b The Civil Rights Act of 1866
For plaintiffs alleging racial discrimination, the Civil Rights Act of 1866 offers substantial
advantages over Title VII:
• A four-year statute of limitations
• Unlimited compensatory and punitive damages (which, in one case, amounted to
$7 million)32
• Applicability to all employers, not just those with 15 or more employees
However, this statute is not enforced by the EEOC, which means that the plaintiff is on
his own when it comes to negotiating with or filing suit against an employer.
27-10c The Rehabilitation Act of 1973
This statute is enforced by the EEOC (for claims against the executive branch of the federal
government), the Department of Labor (for claims against federal contractors), and the
Department of Justice (for claims against entities that receive federal funds).
27-10d Other Statutory Claims
The EEOC is the federal agency responsible for enforcing Title VII, the Equal Pay Act, the
Pregnancy Discrimination Act, the ADEA, the ADA, and GINA.
Before a plaintiff can bring suit under one of these statutes, she must first file a complaint
with the EEOC. Generally the plaintiff must file within 180 days of the wrongdoing.33 But if
32Edwards v. MBTA. After the verdict, the case settled.
33This is the case unless he resides in a state with an appropriate state agency, in which case he has
300 days.
664 U N I T 4 Employment, Business Organizations and Property
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the plaintiff is alleging that she was paid less than she should have been, each paycheck she
receives starts the statute of limitations all over again. After it receives a filing, the EEOC
conducts an investigation and also attempts to mediate the dispute. If it determines that
discrimination has occurred, it will typically file suit on behalf of the plaintiff. This arrangement
is favorable for the plaintiff because the government pays the legal bill. If the EEOC decides
not to bring the case, or does not make a decision within six months, it issues a right to sue
letter, and the plaintiff may proceed on her own in court within 90 days. Under the ADEA, a
plaintiff may bring suit 60 days after filing a charge with the EEOC.Many states also have their
own version of the EEOC.
Remedies available to the successful plaintiff include hiring, reinstatement, retroactive
seniority, back pay, front pay (to compensate for future lost wages), and reasonable attor-
ney’s fees. Under Title VII and the ADA, plaintiffs are also entitled to compensatory and
punitive damages up to $300,000, but only in certain disparate treatment cases, not disparate
impact suits. Compensatory damages include future monetary losses, mental anguish, loss of
enjoyment of life, and damage to reputation. Punitive damages are available if the defend-
ant acted with malice or reckless indifference to the plaintiff’s rights. Under the ADEA,
plaintiffs can recover compensatory damages but are eligible for punitive damages only in
the case of “willful” violations; that is, knowing or reckless disregard of the law. In the case
of willful violations, the damage award is typically doubled.
Two trends, however, have reduced employees’ chances of taking home substantial
damages. Concerned about a rise in discrimination lawsuits, employers now often require
new hires to agree in advance to arbitrate, not litigate, any future employment claims. The
Supreme Court has upheld the enforceability of mandatory arbitration provisions.34Employees
sometimes receive worse results in the arbitrator’s office than in the courtroom, because some
arbitrators seem to favor repeat customers (such as management) over one-time users (such as
employees). In addition, discovery is more limited in arbitration than in court, whichmeans that
the plaintiff may not be able to make the strongest case. Also, arbitration awards are usually not
disclosed publicly, so employers have less incentive to avoid misbehavior.
But even if a case does go to trial, plaintiffs in job discrimination cases have a much worse
track record than other types of plaintiffs—they win less often at trial, and they lose more often
on appeal. As a result, the number of discrimination cases in the federal courts has declined.35
Every applicant feels slightly apprehensive before a job interview, but interviewers are
also nervous—fearing that every question is a potential land mine of liability. Most inter-
viewers (and students who have read this chapter) would know better than Delta Airlines
interviewers who allegedly asked applicants about their sexual orientation, birth control
methods, and abortion history. The following list provides guidelines for interviewers.
Don’t Even Consider Asking Go Ahead and Ask
Can you perform this function with or without
reasonable accommodation?
Would you need reasonable
accommodation in this job?
How many days were you sick last year? How many days were you absent from
work last year?
What medications are you currently taking? Are you currently using drugs illegally?
Where were you born? Are you a United States
citizen?
Are you authorized to work in the United
States?
34Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (S. Ct. 1991).
35Kevin M. Clermont and Stewart J. Schwab, Employment Discrimination Plaintiffs in Federal Court:
From Bad to Worse? 3 Harv. l. & Pol’y Rev. 103 (2009).
CHAPTER 27 Employment Discrimination 665
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How old are you? What work experience have you had?
How tall are you? How much do you weigh? Could you carry a 100-pound weight, as
required by this job?
When did you graduate from college? Where did you go to college?
How did you learn this language? What languages do you speak and write
fluently?
Have you ever been arrested? Have you ever been convicted of a crime
that would affect the performance of this
job?
Do you plan to have children? How old are your
children? What method of birth control do you
use?
Can you work weekends? Travel
extensively? Would you be willing to
relocate?
What is your corrected vision? Do you have 20/20 corrected vision?
Are you a man or a woman? Are you single or
married? What does your spouse do? What will
happen if your spouse is transferred?What clubs,
societies, or lodges do you belong to?
Talk about the weather instead!
The most common gaffe on the part of interviewers? Asking women about their child-
care arrangements. That question assumes the woman is responsible for child care.
Chapter Conclusion
As adults, we spend more time working than in any other single activity. A job that we love
can permeate our lives with satisfaction and even joy. Work that bores or bedevils us may
shorten our lives. We have devoted two chapters to employment law precisely because work
is so important in our lives. Now you know both your rights as a worker and your obligations
as an employer. We hope that when you have other people’s lives in your hands, you will
treat them as you would wish to be treated.
EXAM REVIEW
1. CONSTITUTION The U.S. Constitution prohibits employment discrimination
by federal, state, and local governments. (p. 646)
2. THE CIVIL RIGHTS ACT OF 1866 The Civil Rights Act of 1866 prohibits
racial discrimination in both private and public employment (except it does not
apply to the federal government). (p. 646)
3. TITLE VII Under Title VII of the Civil Rights Act of 1964, it is illegal for
employers with 15 or more workers to discriminate on the basis of race, color,
religion, sex, or national origin. (pp. 646–655)
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4. TYPES OF DISCRIMINATION There are four types of prohibited activities
under Title VII: disparate treatment, disparate impact, hostile environment, and
retaliation. (p. 646)
5. DISPARATE TREATMENT To prove a disparate treatment case, the plaintiff
must show that she was treated less favorably than others because of her sex, race,
color, religion, or national origin. (pp. 646–647)
6. DISPARATE IMPACT Disparate impact applies if the employer has a rule that,
on its face, is not discriminatory, but in practice excludes too many people in a
protected group and the test is not a job-related business necessity. (pp. 648–649)
7. HOSTILE WORK ENVIRONMENT Employers violate Title VII if they
permit a work environment that is so hostile towards people in a protected category
that it affects their ability to work. (pp. 649–652)
8. RETALIATION Title VII also prohibits employers from retaliating against
workers who oppose discrimination, bring a claim under the statute, or take part in
an investigation or hearing. (p. 652)
9. RELIGION Employers cannot discriminate against a worker because of his
religious beliefs. In addition, employers must make reasonable accommodation for a
worker’s religious practices unless the request would cause undue hardship for the
business. (p. 652)
10. DEFENSES Under Title VII, the defendant has four possible defenses: merit,
seniority, bona fide occupational qualification (BFOQ), and affirmative action.
(pp. 654–655)
11. BONA FIDE OCCUPATIONAL QUALIFICATION Under the BFOQ
standard, an employer is permitted to establish discriminatory job requirements if
they are essential to the position in question. (pp. 654–655)
Question: When Southwest Airlines first started, it refused to hire male flight
attendants because its strategy was to court its (mostly male) customers by
promoting an image of “feminine spirit, fun, and sex appeal.” Its ads featured
women in provocative uniforms serving “love bites” (almonds) and “love potions”
(cocktails). Its ticketing system featured a “quickie machine” to provide “instant
gratification.” Is this refusal to hire men a violation of Title VII?
Strategy: Southwest argued that its “Love” campaign was an essential marketing
tool. Was being a woman a BFOQ? Remember that the courts have almost always
rejected BFOQ claims that are based on customer preference. (See the “Result”
at the end of this section.)
12. EQUAL PAY ACT Under the Equal Pay Act, an employee may not be paid at a
lesser rate than employees of the opposite sex for equal work. (p. 656)
13. PREGNANCY DISCRIMINATION ACT Under the Pregnancy
Discrimination Act, an employer may not fire, refuse to hire, or fail to promote a
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woman because she is pregnant or because she has had an abortion. An employer
must also treat pregnancy as it would any other temporary disability. (p. 656)
14. AGE DISCRIMINATION IN EMPLOYMENT ACT Under the ADEA, an
employer with 20 or more workers may not fire, refuse to hire, fail to promote, or
otherwise reduce a person’s employment opportunities because he is 40 or older.
(pp. 656–659)
Question: Kathy was over 40 when SFI refused to hire her as an insurance agent.
It claimed that it had not hired her because she did not have sales experience, but
the job ad had not specified that sales experience was required. It turned out that
when SFI hired agents from outside the company, it was much more likely to hire
people under 40. But when promoting from within, it was much more likely to
promote people over 40. Did SFI violate the ADEA when it refused to hire Kathy?
Strategy: An ADEA case involves a three-step analysis. In Step 1, Kathy has
shown that she is older than 40, suffered an adverse employment action, was
qualified for the job, and a younger person actually got the job. In Step 2, SFI has
to show that its decision was based on a legitimate reason. No sales experience is a
good reason. In Step 3, Kathy must prove that her age was the deciding factor.
(See the “Result” at the end of this section.)
15. REHABILITATION ACT The Rehabilitation Act of 1973 prohibits
discrimination on the basis of disability by the federal government, federal
contractors, and all entities that receive federal funds. (pp. 659–660)
16. AMERICANS WITH DISABILITIES ACT The ADA prohibits employers
with 15 or more workers from discriminating on the basis of disability. (pp. 660–663)
17. DISABILITY A disabled person is:
• Someone with a physical or mental impairment that substantially limits a major
life activity or the operation of a major bodily function, or
• Someone who is regarded as having such an impairment. (pp. 660–661)
18. TREATMENT OF DISABLED WORKERS Once it is established that a
worker is disabled, employers may not discriminate on the basis of disability so long
as she can, with reasonable accommodation, perform the essential function of the
job. An accommodation is not reasonable if it would create undue hardship for the
employer. (pp. 661–662)
Question: When Thomas Lussier filled out a Postal Service employment
application, he did not reveal that he had twice pleaded guilty to charges of
disorderly conduct. Lussier suffered from Post-Traumatic Stress Disorder (PTSD)
acquired during military service. Because of this disorder, he sometimes had panic
attacks that required him to leave meetings. He was also a recovered alcoholic and
drug user. During his stint with the Postal Service, he had some personality
conflicts with other employees. Once, another employee hit him. He also had one
episode of “erratic emotional behavior and verbal outburst.” In the meantime, a
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postal employee in Ridgewood, New Jersey, killed four colleagues. The
postmaster general encouraged all supervisors to identify workers who had
dangerous propensities. Lussier’s boss discovered that he had lied on his
employment application about the disorderly conduct charges and fired him. Is
the Postal Service in violation of the law?
Strategy: Was Lussier disabled under the ADA? He had a mental impairment
(PTSD) that substantially limited a major life activity. Could Lussier, with
reasonable accommodation, perform his job? Yes. Was his firing illegal? (See the
“Result” at the end of this section.)
19. GENETIC INFORMATION NONDISCRIMINATION ACT Under GINA,
employers with 15 or more workers may not require genetic testing or discriminate
against workers because of their genetic makeup. (p. 664)
11. Result: Safety, privacy, and authenticity are three situations in which customer
preference can be a BFOQ. None of these issues was a factor in this case. The court
ruled against Southwest on the grounds that it was “not a business where vicarious
sex entertainment is the primary service provided.” 36
14. Result: In the absence of specific comments about age, it is very difficult to
show that age is the deciding factor. Kathy is likely to lose her case.
18. Result: The court held that the Postal Service was in violation of the law
because Lussier had been dismissed solely as a result of his disability. Clearly, he
could perform his job with reasonable accommodation.
MULTIPLE-CHOICE QUESTIONS
1. Gregg Young, the CEO of BJY Inc., insisted on calling Mamdouh El-Hakem “Manny”
or “Hank” even when El-Hakem asked him not to. El-Hakem was of Arab heritage.
Young argued that a “Western” name would increase El-Hakem’s chances for success
and would be more acceptable to BJY’s clientele. Does this behavior violate the law?
(a) Yes, Young violated Title VII by discriminating against El-Hakem on the basis of
his national origin.
(b) Yes, Young was creating a hostile work environment.
(c) Both (a) and (b)
(d) No, Manny is just a nickname. No harm was intended and, indeed, no harm resulted.
(e) No, because customers did prefer a Western name.
36Wilson v. Southwest Airlines, 517 F. Supp 292 (N.D. Tex, 1981).
CHAPTER 27 Employment Discrimination 669
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2. The CEO of BankTwo realized that not one single officer of the bank was female
or minority. He announced that henceforth, the bank would only hire people in
these two groups until they made up at least 30 percent of the officers. Is this
plan legal?
(a) Yes, voluntary affirmative action plans are always legal.
(b) Yes, because fewer than 20 percent of the officers are female or minority.
(c) No, to be legal, the goal of an affirmative action plan cannot be greater than
20 percent female or minority.
(d) No, the plan is too unfair to white men, who have no chance of being hired for a
long time.
3. When Allain University was looking for a diversity officer, it decided it would only
hire a person of color. Is this decision legal?
(a) Yes, color is a BFOQ for this position.
(b) No, color is never a BFOQ, but race could be.
(c) No, neither race nor color can be a BFOQ.
(d) No, race and color can be a BFOQ, but is not in this situation. A person does not
have to be a member of a minority group to promote diversity.
4. Ralph has worked as a model builder at Snowdrop Architects for 30 years. The firm
replaces him with Charlotte, who is 24 and willing to work for much less than Ralph’s
salary. The firm never offered to let him stay for less pay. When he left, one of the
partners told him, “Frankly, it’s not a bad thing to have a cute young person working
with the clients.” Which of the following statements is true?
(a) Snowdrop is liable because it had an obligation to offer Ralph the lower salary
before firing him.
(b) Snowdrop is liable because it is illegal to replace an older worker with a younger
one just to save money.
(c) Snowdrop is liable because age was a factor in Ralph’s firing.
(d) Snowdrop is liable under Title VII because it replaced an old man with a young
woman.
(e) Snowdrop is not liable because age was not the deciding factor in Ralph’s firing.
5. During chemotherapy for bone cancer, a delivery person is exhausted, nauseous, and
weak. He has asked permission to come in later, work a shorter day, and limit his
lifting to 10 pounds. Delivery people typically carry packages of up to 70 pounds.
Does Vulcan, his employer, have the right to fire him?
(a) Vulcan must create a new position so that the employee can do something else.
(b) Vulcan must transfer the employee to another position, but only if one is vacant
and he is able to perform it.
(c) Vulcan can fire the man because none of his major life activities has been
affected.
(d) Vulcan can fire the man because he cannot perform the essential functions of his
job.
(e) Vulcan can fire him because he is not disabled—once the chemotherapy
treatments end, he will feel fine again.
670 U N I T 4 Employment, Business Organizations and Property
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ESSAY QUESTIONS
1. Disney World and Abercrombie & Fitch both fired female employees who insisted
upon wearing a Muslim headscarf because such apparel violated the companies’
appearance policies. Can these employers make reasonable accommodation for this
religious practice? Abercrombie also fired a salesperson who converted to a
Christian religion that forbade her from showing skin. When she showed up for
work in an ankle-length skirt, her manager told her she had to either wear jeans or
short skirts with leggings, but she refused. Did Abercrombie violate Title VII in
this case?
2. In the 2008 recession, Roger lost his job as a comptroller. Desperate for work after a
year of unemployment, he began to apply for any accounting job at any company.
But no one would hire him because he was “over-qualified and over-experienced.”
He repeatedly explained that he was eager to fill the job that was available. Have
these companies that refused to hire Roger violated the ADEA?
3. More than 90 percent of employers conduct criminal background checks, and many
of these automatically exclude any job applicant with a criminal record. Is this practice
a violation of the law?
4. The Lillie Rubin boutique in Phoenix would hire only women to work in sales
because fittings and alterations took place in the dressing room or immediately
outside. The customers were buying expensive clothes and demanded a male-free
dressing area. Has the Lillie Rubin store violated Title VII? What would its
defense be?
5. FedEx refused to promote José Rodriguez to a supervisor’s position because of his
accent and “how he speaks.” Is FedEx in violation of the law?
DISCUSSION QUESTIONS
1. In the Griggs disparate impact case, Duke Power
based employment decisions on written tests. Why
do employers use these types of tests? When are
they appropriate in the hiring or promotion
process?
2. In disparate treatment cases, the plaintiff must show
that the defendant intentionally discriminated, but
not in disparate impact cases. Is it fair to hold
employers liable when they have not engaged in
intentional wrongdoing?
3. Generally, the BFOQ defense does not apply to
customer preference. But recently, some clients
have been pressuring their law firms to staff their
cases with female and minority lawyers. If a firm
does so, would the BFOQ defense be valid?
Should it be?
4. Pam Huber worked at Wal-Mart as a grocery order
filler, earning $13 an hour. While on the job, she
suffered a permanent injury to her right arm and
hand. Both she and Wal-Mart agreed that she was
disabled under the ADA. As a reasonable
accommodation, she asked for a job as a router,
which was then vacant. Although she was qualified
for that job, she was not the most qualified. Wal-
Mart filled the job with the most qualified person.
It offered Huber a position as a janitor at $6.20 per
hour. Did Wal-Mart violate the ADA?
CHAPTER 27 Employment Discrimination 671
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5. ETHICS Mary Ann Singleton was the librarian
at a maximum-security prison located in Tazewell
County, Virginia. About four times a week, Gene
Shinault, assistant warden for operations,
persistently complimented Singleton and stared at
her breasts when he spoke to her. On one occasion,
he measured the length of her skirt to judge its
compliance with the prison’s dress code and told
her that it looked “real good”; constantly told her
how attractive he found her; made references to
his physical fitness, considering his advanced
age; asked Singleton if he made her nervous
(she answered “yes”); and repeatedly remarked
to Singleton that if he had a wife as attractive as
Singleton, he would not permit her to work in a
prison facility around so many inmates. Shinault
told Singleton’s supervisor in her presence, “Look
at her. I bet you have to spank her every day.” The
supervisor then laughed and said, “No. I probably
should, but I don’t.” Shinault replied, “Well, I
know I would.” Shinault also had a security camera
installed in her office in a way that permitted him
to observe her as she worked. Singleton reported
this behavior to her supervisor, who simply
responded, “Boys will be boys.” Did Shinault
sexually harass Singleton? Whether or not Shinault
violated the law, what ethical obligation did
Singleton’s supervisor have to protect her from this
type of behavior?
6. Ronald Lockhart, who was deaf, worked for
FedEx as a package handler. Although fluent in
American Sign Language, he could not read lips.
After 9/11, the company held meetings to talk
about security issues. Lockhart complained to the
EEOC that he could not understand these
discussions. FedEx fired him. Has FedEx
violated the law?
672 U N I T 4 Employment, Business Organizations and Property
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CHAPTER28
STARTING A
BUSINESS:
LLCS AND
OTHER
OPTIONS
Poor Jeffrey Horning. If only he had understood business
law. Horning owned a thriving construction company
which operated as a corporation—Horning Construction
Company, Inc. To lighten his crushing workload,
he decided to bring in two partners to handle more
day-to-day responsibility. It seemed a good idea at
the time.
Horning transferred the business to Horning
Construction, LLC and then gave one-third ownership
each to two trusted employees, Klimowski and Holdsworth. But Horning did not pay
enough attention to the legal formalities—the new LLC had no operating agreement.
Nothing worked out as he had planned. The two men did not take on extra work.
Horning’s relationship with them went from bad to worse, with the parties bickering over
every petty detail and each man trying to sabotage the others. It got to the point that
Klimowski sent Horning a letter full of foul language. At his wit’s end, Horning proposed
that the LLC buy out his share of the business. Klimowski and Holdsworth refused. Really
frustrated, Horning asked a court to dissolve the business on the grounds that Klimowski
despised him, Holdsworth resented him, and neither of them trusted him. In his view, it
was their goal “to make my remaining time with Horning, LLC so unbearable that I will
relent and give them for a pittance the remainder of the company for which they have paid
nothing to date.”
Jeffrey Horning was
stuck in purgatory, with
two business partners he
loathed and no way out.
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Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
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Although the court was sympathetic, it refused to help. Because Horning,
LLC did not have an operating agreement that provided for a buyout, it had
to depend upon the LLC statute, which only permitted dissolution “when-
ever it is not reasonably practicable to carry on the business.” Unfortunately,
Horning, LLC was very successful, grossing over $25 million annually.
Jeffrey Horning was stuck in purgatory, with two business partners he
loathed and no way out.1
Every business, nomatter how large, was at one point little more than a gleam in an entrepreneur’s
eye. The goal of the law is to balance the rights, duties, and liabilities of entrepreneurs, managers,
investors, and customers. Time and again in these next chapters, we will see that legal issues can
have as profound an impact on the success of a company as any business decision. The law affects
virtually every aspect of business. Wise (and successful) entrepreneurs know how to use the law to
their advantage. Think of the grief Jeffrey Horning could have saved himself if he had understood
the implications of the LLC statute.
To begin, entrepreneurs must select a form of organization. The correct choice can
reduce taxes, liability, and conflict while facilitating outside investment. If entrepreneurs do
not make a choice for themselves, the law will automatically select a (potentially undesir-
able) default option.
28-1 SOLE PROPRIETORSHIPS
Sole proprietorships are the most common form of business, so we begin there. A sole
proprietorship is an unincorporated business owned by one person. For example, Linda
runs ExSciTe (which stands for Excellence in Science Teaching), a company that helps
teachers prepare hands-on science experiments in the classroom using such basic items as
vinegar, lemon juice, and red cabbage.
If an individual runs a business without taking any formal steps to create an organiza-
tion, she automatically has a sole proprietorship. It is, if you will, the default option. She is
not required to hire a lawyer or register with the government. The company is not even
required to file a separate tax return—because the business is a flow-through tax entity. In
other words, Linda must pay personal income tax on the profits, but the business itself does
not pay income taxes. A very few states, and some cities and towns, require sole proprietors
to obtain a business license. And states generally require sole proprietors to register their
business name if it is different from their own. Linda, for example, would file a “d/b/a” or
“doing business as” certificate for ExSciTe.
Sole proprietorships have some serious disadvantages. First, the owner of the business
is responsible for all of the business’s debts. If ExSciTe cannot pay its suppliers or if a
student is injured by an exploding cabbage, Linda is personally liable. She may have to sell
her house and car to pay the debt. Second, the owner of a sole proprietorship has limited
options for financing her business. Debt is generally her only source of working capital
because she has no stock or memberships to sell. If someone else brings in capital and helps
with the management of the business, then it is a partnership, not a sole proprietorship. For
this reason, sole proprietorships work best for small businesses without large capital needs.
Sole proprietorship
An unincorporated business
owned by one person.
1ln the Matter of Jeffrey M. Horning, 816 N.Y.S.2d 877; 2006 N.Y. Misc. LEXIS 555.
674 U N I T 4 Employment, Business Organizations and Property
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28-2 CORPORATIONS
Corporations are the dominant form of organization for a simple reason—they have been
around for a long time and, as a result, they are numerous and the law that regulates them is
well developed.
The concept of a corporation is very old indeed—it began with the Greeks and spread
from them through the Romans into English law. At the beginning, however, corporations
were viewed with deep suspicion. A British jurist commented that they had “neither bodies
to be punished nor souls to be condemned.” And what were shareholders doing that they
needed limited liability? Why did they have to cower behind a corporate shield? For this
reason, shareholders originally had to obtain special permission to form a corporation. In
England, corporations could be created only by special charter from the monarch or, later,
from Parliament. But with the advent of the Industrial Revolution, large-scale manufactur-
ing enterprises needed huge amounts of capital from investors who were not involved in
management and did not want to be personally liable for the debts of an organization that
they were not managing. In 1811, New York became the first jurisdiction in the United
States to permit routine incorporation.2
Despite the initial suspicion with which corporations were viewed, economists now
suggest that this form of organization, combined with technological advances such as
double-entry bookkeeping and stockmarkets, provided the West with an enormous eco-
nomic advantage. In particular, corporations permitted the investment of outside capital and
were more likely than partnerships to survive the death of their founders. In short, corpora-
tions permitted the development of large, enduring businesses.
28-2a Corporations in General
As is the case for all forms of organization, corporations have their advantages and
disadvantages.
LIMITED LIABILITY
If a business flops and cannot pay its bills, shareholders lose their investment in the
company but not their other assets. Likewise, if an employee is in an accident while driving
a company van, the business is liable for any harm to the other driver, but its shareholders
are not personally liable. Be aware, however, that limited liability does not protect against all
debts. Individuals are always responsible for their own acts. Suppose that the careless
employee who caused the accident was also a company shareholder. Both he and the
company would be liable. If the company did not pay the judgment, the employee would
have to, from his personal assets. A corporation protects managers and investors from
personal liability for the debts of the corporation and the actions of others, but not against
liability for their own negligence (or other torts and crimes).
TRANSFERABILITY OF INTERESTS
Corporations provide flexibility for enterprises small (with one owner) and large (with
thousands of shareholders). As we will see, partnership interests are not transferable without
the permission of the other partners, whereas corporate stock can be bought and sold easily.
DURATION
When a sole proprietor dies, legally so does the business. But corporations have perpetual
existence: They can continue without their founders.
2An Act Relative to Incorporation for Manufacturing Purpose, 1811 N.Y. Laws, ch. 67, §111.
CHAPTER 28 Starting a Business: LLCs and Other Options 675
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LOGISTICS
Corporations require substantial expense and effort to create and operate. The cost of
establishing a corporation includes legal and filing fees, not to mention the cost of the annual
filings that states require. Corporations must also hold meetings for both shareholders and
directors. Minutes of these meetings must be kept indefinitely in the company minute book.
TAXES
Because corporations are taxable entities, they must pay taxes and file returns. This is a
simple sentence that requires a complex explanation. Originally, there were only three ways
to do business: as a sole proprietorship, a partnership, or a corporation. The sole proprietor
pays taxes on all the business’s profits. A partnership is not, as we say, a taxable entity,
which means it does not pay taxes itself. All income and losses are passed through to the
partners and reported on their personal income tax returns. Corporations, by contrast, are
taxable entities and pay income tax on their profits. Shareholders must then pay tax on
dividends from the corporation. Thus a dollar is taxed only once before it ends up in a
partner’s bank account, but twice before it is deposited by a shareholder.
Exhibit 28.1 compares the single taxation of partnerships with the double taxation of
corporations. Suppose, as shown in the exhibit, that a corporation and a partnership each
receives $10,000 in additional income. The corporation pays tax at a top rate of 35 percent.3
$ $
10,000 10,000
$1,734
Bank
$1,734
Bank
$
$1,734
Bank
$ $ $
$2,013
Bank
$2,013
Bank
$2,013
Bank
$2,167
shareholder
$2,167
shareholder
$2,167
shareholder
$3,333
partner
$3,333
partner
Corporation
$3,333
partner
Partnership
$3,500
IRS
$433
IRS
$433
IRS
$433
IRS
$1,320
IRS
$1,320
IRS
$1,320
IRS
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EXHIB IT 28.1 Partners pay less in taxes than shareholders.
3This is the federal tax rate; most states also levy a corporate tax.
676 U N I T 4 Employment, Business Organizations and Property
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Thus the corporation pays $3,500 of the $10,000 in tax. The corporation pays out the
remaining $6,500 as a dividend of $2,167 to each of its three shareholders. Then the
shareholders are taxed at the special dividend rate of 20 percent, which means they each
pay a tax of $433. They are each left with $1,734. Of the initial $10,000, almost 48 percent
($4,799) has gone to the Internal Revenue Service (IRS).
Compare the corporation to a partnership. The partnership itself pays no taxes, so it can
pass on $3,333 to each of its partners. At a 39.6 percent individual rate, each partner pays an
income tax of $1,320. As partners, they pocket $2,013, which is $279 more than they could
keep as shareholders. Of the partnership’s initial $10,000, 39.6 percent ($3,960) has gone to
the IRS, compared with the corporation’s 48 percent.
One further tax issue. Corporations are created and regulated by state law but must
pay both federal and state taxes. Federal law gives favorable tax treatment to some
small corporations, which it calls “S corporations.” Many states also treat small corpora-
tions differently but call them “close corporations.” Federal tax law and state corpora-
tion statutes are completely independent. Thus, an organization could be a close
corporation under state law and not qualify as an S corporation or, conversely, could
be an S corporation under federal law but may or may not be a close corporation for
state purposes. Exhibit 28.2 illustrates the difference between state corporate law and
federal taxation of corporations.
28-2b S Corporations
Although entrepreneurs are often optimistic about the likely success of their new enterprise,
in truth, the majority of new businesses lose money in their early years. Congress created
S corporations (aka “S corps”) to encourage entrepreneurship by offering tax breaks. The
name “S corporation” comes from the provision of the Internal Revenue Code that created
this form of organization.4 Shareholders of S corps have both the limited liability of
C
Corporation
State
S
Corporation
Regular
Corporation
Close
Corporation
IRS
EXHIB IT 28.2 Both a regular and a close corporation can be either a C or an S
corporation.
©
C
en
g
ag
e
Le
ar
n
in
g
426 U.S.C. §1361.
CHAPTER 28 Starting a Business: LLCs and Other Options 677
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a corporation and the tax status of a partnership. Like a partnership, an S corp is not a
taxable entity—all the company’s profits and losses pass through to the shareholders, who
pay tax at their individual rates. It avoids the double taxation of a regular corporation (called
a “C corporation”). If, as is often the case, the startup loses money, investors can deduct
these losses against their other income.
S corps do face some major restrictions:
• There can be only one class of stock (although voting rights can vary within the class).
• There can be no more than 100 shareholders.
• Shareholders must be individuals, estates, charities, pension funds, or trusts, not
partnerships or corporations.
• Shareholders must be citizens or residents of the United States, not nonresident
aliens.
• All shareholders must agree that the company should be an S corporation.
Although most states follow the federal lead on S corporations, a small number require
these companies to pay state corporate tax.
28-2c Close Corporations
Originally, the terms close corporation and closely held corporation referred simply to a
company whose stock was not publicly traded (in other words, a “privately held” company).
Most close corporations are small, although some privately held corporations, such as Hall-
mark Cards, Inc., and Mars, Inc. (maker of M&Ms and Snickers candy bars), are huge.
Beginning in New York in 1948, some states amended their corporation statutes to make
special provisions for entrepreneurs. In some cases, a corporation must affirmatively elect to
be treated as a close corporation; in others, any corporation can take advantage of these
special provisions. Now when lawyers refer to “close corporations,” they usually mean not
merely a privately held company, but one that has taken advantage of the close corporation
provisions of its state code.
Although the provisions of close corporation statutes vary from state to state, they tend
to have certain common themes:
• Protection of minority shareholders. As there is no public market for the stock of a
close corporation, a minority shareholder who is being mistreated by the majority
cannot simply sell his shares and depart. Therefore, close corporation statutes often
provide some protection for minority shareholders. For example, the charter of a close
corporation could require a unanimous vote of all shareholders to choose officers, set
salaries, or pay dividends. It could grant each shareholder veto power over all
important corporate decisions.
• Transfer restrictions. The shareholders of a close corporation often need to work
closely together in the management of the company. Therefore, statutes typically
permit the corporation to require that a shareholder first offer shares to the other
owners before selling them to an outsider. In that way, the remaining shareholders
have some control over who their new co-owners will be.
• Flexibility. Close corporations can typically operate without a board of directors, a
formal set of bylaws, or annual shareholder meetings.
• Dispute resolution. The shareholders are allowed to agree in advance that any one of
them can dissolve the corporation if some particular event occurs or, if they choose,
for any reason at all. If the shareholders are in a stalemate, the problem can be solved
Close corporation
A company whose stock is not
publicly traded. Also known as a
closely held corporation.
678 U N I T 4 Employment, Business Organizations and Property
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by dissolving the corporation. Even without such an agreement, a shareholder can ask
a court to dissolve a close corporation if the other owners behave “oppressively” or
“unfairly.”
EXAM Strategy
Question: Consider these two entrepreneurs: Judith formed a corporation to publish
a newsletter that will not generate substantial revenues. Drexel operated his
construction and remodeling business as a sole proprietorship. Were these forms of
organization right for these businesses?
Strategy: Prepare a list of the advantages and disadvantages of each form of
organization. Sole proprietorships are best for businesses without substantial capital
needs. Corporations can raise capital but are expensive to operate.
Result: Judith would be better off with a sole proprietorship—her revenues will
not support the expenses of a corporation. Also, her debts are likely to be small,
so she will not need the limited liability of a corporation. And no matter what her
form of organization, she would be personally liable for any negligent acts she
commits, so a corporation would not provide any additional protection. But for
Drexel, a sole proprietorship could be disastrous because his construction
company will have substantial expenses and a large number of employees. If an
employee causes an injury, Drexel might be personally liable. And if his business
fails, the court would liquidate his personal assets. He would be better off with a
form of organization that limits his liability, such as a corporation or a limited
liability company.
28-3 LIMITED LIABILITY COMPANIES
An LLC offers the limited liability of a corporation and the tax status of a partnership.
Limited liability companies (LLCs) are a relatively new form of organization.
Wyoming passed the first LLC statute in 1977, but most states did not follow suit
until after 1991. An LLC is an extremely useful form of organization increasingly
favored by entrepreneurs. It is not, however, as simple as it perhaps should be. Owing
to a complex history that involves painful interaction between IRS regulations and state
laws (the details of which we will spare you), the specific provisions of state laws vary
greatly. An effort to remedy this confusion—the Uniform Limited Liability Company
Act—has not at this point been widely accepted. Indeed, it was so heavily criticized that
it was revised, but the revised statute has been adopted by relatively few states. Thus,
we can discuss only general trends in state laws. Before forming an LLC, you should
review carefully the laws in your particular state.
LIMITED LIABILITY
Members are not personally liable for the debts of the company. They risk only their
investment, as if they were shareholders of a corporation. Are the members of the LLC
liable in the following case? You be the judge.
CHAPTER 28 Starting a Business: LLCs and Other Options 679
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TAX STATUS
As in a partnership, income flows through the company to the individual members, avoiding
the double taxation of a corporation.
FORMATION
To organize an LLC, you must have a charter and you should have an operating agree-
ment. The charter is short, containing basic information such as name and address. It must
be filed with the Secretary of State in the jurisdiction in which it is being formed. An
operating agreement sets out the rights and obligations of the owners, who are called
“members.” If an LLC does not adopt its own operating agreement, LLC statutes provide
a default option. However, these standardized provisions may not be what members
would choose if they thought about it. Therefore, it is often better for an LLC to prepare
its own personalized operating agreement. The Horning case that began this chapter
illustrates one of the many things that can go wrong when an LLC does not have an
operating agreement.
On this issue, corporations have an advantage over LLCs. Corporations are so
familiar that the standard documents (such as a charter, bylaws, and shareholder
agreement) are well established and widely available. Lawyers can form a corporation
easily, and the Internet offers a host of free forms. This is not the case with LLCs. As
yet, the law is so unsettled that standard forms may be dangerous, while customized
forms can be expensive. The following case illustrates the importance of a well-drafted
operating agreement.
You Be the Judge
Facts: Norman Costello
and Robert Giordano were
members of Silk, LLC,
which owned a bar and
adult entertainment night-
club in Groton, Connecti-
cut, called Silk Stockings. Anthony Sulls went drinking
there one night—and drinking heavily. Although he was
obviously drunk, employees at Silk Stockings continued
to serve him. Costello and Giordano were working there
that night. They both greeted customers (who numbered
in the hundreds), supervised employees, and performed
“other PR work.” When Sulls left the nightclub at 1:45
a.m. with two friends, he drove off the highway at high
speed, killing himself and one of his passengers, Wil-
liam Ridgaway, Jr.
Ridgaway’s estate sued Costello and Giordano
personally. The defendants filed a motion for summary
judgment seeking dismissal of the complaint.
You Be the Judge: Are Costello and Giordano personally
liable to Ridgaway’s estate?
Argument for Cost-
ello and Giordano:
The defendants did not
own Silk Stockings; they
were simply members of
an LLC that owned the
nightclub. The whole point of an LLC is to protect mem-
bers against personal liability. The assets of Silk, LLC, are
at risk, but not the personal assets of Costello and Giordano.
Argument for Ridgaway’s Estate: The defendants are
not liable for being members of Silk, LLC; they are liable for
their own misdeeds as employees of the LLC. They were
both present at Silk Stockings on the night in question,
meeting and greeting customers and supervising employees.
It is possible that they might actually have served drinks to
Sulls, but in any event, they did not adequately supervise
and train their employees to prevent them from serving
alcohol to someone who was clearly drunk. The world would
be an intolerable place to live if employees were free to be as
careless as they wished, knowing that they were not liable
because they were members of an LLC.
RIDGAWAY V. SILK
2004 Conn . Super. LEXIS 548
Superior Court of Connecticut, 2004
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FLEXIBILITY
Unlike S corporations, LLCs can have members that are corporations, partnerships, or
nonresident aliens. LLCs can also have different classes of stock. Unlike corporations,
LLCs are not required to hold annual meetings or maintain a minute book.
TRANSFERABILITY OF INTERESTS
Unless the operating agreement provides otherwise, the members of the LLC must obtain
the unanimous permission of the remaining members before transferring their ownership
rights. This is yet another reason to have an operating agreement.
LLCs cannot issue stock options, which is potentially a serious problem because
options may be an essential lure in attracting and retaining top talent.
DURATION
It used to be that LLCs automatically dissolved upon the withdrawal of a member (owing
to, for example, death, resignation, or bankruptcy). The current trend in state laws,
however, is to permit an LLC to continue in operation even after a member withdraws.
GOING PUBLIC
Once an LLC goes public, it loses its favorable tax status and is taxed as a corporation, not a
partnership.5 Thus, there is no advantage to using the LLC form of organization for a
publicly traded company. And there are some disadvantages: Unlike corporations, publicly
traded LLCs do not enjoy a well-established set of statutory and case law that is relatively
consistent across the many states. For this reason, privately held companies that begin as
LLCs usually change to corporations when they go public.
WYOMING.COM, LLC V. LIEBERMAN
2005 WY 42; 109 P.3d 883; 2005 Wyo. LEXIS 48
Supreme Court of Wyoming, 2005
C A S E S U M M A R Y
Facts: Lieberman was a member of an LLC called
Wyoming.com. After he withdrew, he and the other
members disagreed about what his membership was
worth. Wyoming.com filed a lawsuit asking the court to
determine the financial rights and obligations of the
parties, if any, upon the withdrawal of a member.
The Supreme Court of Wyoming reached a decision
that may have sounded logical but left Lieberman in a sad
twilight zone—neither in nor out of the LLC. The court
ruled that Lieberman still owned part of the business
despite his withdrawal as a member.
So far, so good. But neither the LLC statute nor the
company’s operating agreement required the LLC to pay
a member the value of his share. In other words, Lieberman
was still an owner, but he was not entitled to any payment
for his ownership. Not quite understanding the implications
of this ruling, Lieberman filed a motion seeking financial
information about the company. The original trial court
denied the request on the theory that, since Lieberman
had no rights to a payout, the company had no obligation
to give him financial data.
Issue: Did Lieberman have a right to any financial data
about Wyoming.com?
Decision: Wyoming.com had no obligation to provide
Lieberman with financial data about the company.
Reasoning: The court in the prior Lieberman case ruled
that Lieberman was not entitled to any payment from
Wyoming.com. Thus, there was no point in requiring the
company to give him financial information. He still owned
a share of the company, but he had no further rights.
526 U.S.C. §7704.
CHAPTER 28 Starting a Business: LLCs and Other Options 681
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It is worth noting, too, that because of securities laws, it is important for an LLC to have
an operating agreement that permits managers the right to convert the LLC into a corpora-
tion at the time of a public offering without the consent of the members.6
CHANGING FORMS
Some companies that are now corporations might prefer to be LLCs. However, the IRS
would consider this change to be a sale of the corporate assets and would levy a tax on the
value of these assets. For this reason, few corporations have made the change. However,
switching from a partnership to an LLC or from an LLC to a corporation is not considered a
sale and does not have the same adverse tax impact.
PIERCING THE LLC VEIL
It has long been the case that, if corporate shareholders do not comply with the techni-
calities of the law, they may be held personally liable for the debts of the corporation (an
issue that is discussed in more depth in Chapter 29). As the following case illustrates,
members of an LLC can also be held liable under the same circumstances.
6In this way, under Rule 144 members can include the time during which they owned interests in the
LLC when calculating their holding period for stock.
BLD PRODUCTS, LTD. V. TECHNICAL PLASTICS OF
OREGON, LLC
2006 U.S. Dist. LEXIS 89874
United States District Court for the District of Oregon, 2006
C A S E S U M M A R Y
Facts: Mark Hardie was the sole member of Technical
Plastics of Oregon, LLC (TPO). He operated the business
out of an office in his home. Hardie regularly used TPO’s
accounts to pay such expenses as landscaping and house-
cleaning. TPO also paid some of Hardie’s personal credit
card bills, loan payments on his Ford truck, the cost of
constructing a deck on his house, his stepson’s college bills,
and the expenses of family vacations to Disneyland. At the
same time, Hardie deposited cash advances from his personal
credit cards into the TPO checking account. Hardie did not
take a salary from TPO. When TPO filed for bankruptcy, it
owed BLD Products approximately $120,000.
In some cases, a court will “pierce the veil” of a
corporation and hold its shareholders personally liable for
the debts of the business. BLD argued that the same
doctrine should apply to LLCs and the court should hold
Hardie personally liable for TPO’s debts.
Issues: Does the doctrine of “piercing the veil” apply to
LLCs? Is Hardie personally liable for TPO’s debts?
Decision: Yes, an LLC’s veil can be pierced. Hardie is
personally liable for TPO’s debts.
Reasoning: An LLC’s veil can be pierced if the follow-
ing three tests are met:
1. The member (that is, Hardie) controlled the LLC;
2. The member engaged in improper conduct; and
3. As a result of that improper conduct, the plaintiff was
unable to collect on a debt against the insolvent LLC.
Hardie, as the sole member and manager of TPO,
clearly controlled the company. In addition, he engaged in
improper conduct when he paid his personal expenses
from the TPO business account. These amounts were
more than occasional dips into petty cash—they indicated
a disregard of TPO’s separate LLC identity. Moreover, he
did not keep records of these personal payments.
It is not clear whether Hardie’s improper conduct pre-
vented BLD from collecting its entire $120,000 debt. A jury
will have to determine the amount that Hardie owes BLD.
682 U N I T 4 Employment, Business Organizations and Property
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LEGAL UNCERTAINTY
As we have observed, LLCs are a relatively new form of organization without a consistent
and widely developed body of law. As a result, members of an LLC may find themselves in
the unhappy position of litigating issues of law which, although well established for
corporations, are not yet clear for LLCs. Win or lose, lawsuits are expensive in both time
and money.
An important area of legal uncertainty involves managers’ duties to the members of the
organization. For example, it is not clear in many jurisdictions if managers of an LLC have a
legal obligation to act in the best interest of members. Delaware courts have recently ruled
that an LLC’s managers do have a fiduciary duty to its members unless the operating
agreement provides otherwise. (In that state, an operating agreement can limit any duty
except the requirement of good faith and fair dealing.) However, this uncertainty means
that, before becoming a member of an LLC, it is important to understand both state law and
the terms of the operating agreement.
Furthermore, when managers of a corporation violate their duty to the organization by,
say, approving a merger without sufficient investigation, shareholders are allowed to bring a
so-called derivative lawsuit in the name of the corporation against the managers. This right
was established by common law. It is unclear, however, if members of an LLC have the
same right, especially in a state such as New York where the LLC statute does not explicitly
authorize derivative lawsuits. The following case resolves this issue, but only for New York
State.
In its reasoning, this court relied on corporate law precedents. However, in a recent case
also involving derivative actions, a Delaware court did not follow that approach. The
Delaware LLC statute clearly provides that members can bring derivative actions. That bit
of clarity is helpful. But what about creditors of an LLC? We know that creditors of a
corporation have that right. Does the same rule apply to LLCs?
TZOLIS V. WOLFF
884 N.E.2d 1005; 855 N.Y.S.2d 6; 2008 N.Y. LEXIS 226
Court of Appeals of New York, 2008
Facts: Soterios Tzolis owned 25 percent of Smith Pen-
nington Property Co. LLC, which owned a Manhattan
hotel. Herbert Wolff managed the LLC. Tzolis alleged
that Wolff first leased and then sold the hotel to family
and friends at a price below market value. Tzolis filed a
derivative suit against Wolff on the grounds that the man
had violated his duties to the LLC.
The trial court ruled that members of an LLC had
no right to bring a derivative action because the LLC
statute had not explicitly permitted such suits. Tzolis
appealed.
Issue: Do members of an LLC have the right to bring a
derivative suit against managers of the company?
Decision: Yes, at least in New York State, members of
an LLC may bring a derivative suit against the managers
of an LLC.
Reasoning: The New York corporation statute did not
authorize derivative lawsuits. But in 1832, a New York
court decreed that shareholders could bring derivative
suits against corporate managers. The court said that to
allow managers to escape liability for wrong-doing would
be an “intolerable grievance.”
The same principle applies to LLCs. If managers
violate their duty, the victims must be able to recover
damages. We can create this right for members of an LLC
just as the court did in 1832 for corporate shareholders.
Derivative lawsuit
Litigation brought in the name
of the corporation against its
managers or some other third
party.
CHAPTER 28 Starting a Business: LLCs and Other Options 683
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In the case in question, the board of JetDirect Aviation LLC approved four major
acquisitions, all the while knowing that its financials were inaccurate. The company ulti-
mately went bankrupt and, thus, was unable to repay a $34 million loan to CML. The
lender filed a derivative action against JetDirect’s careless board members. But, much to
everyone’s surprise, two Delaware courts ruled that CML could not bring a derivative action
because the Delaware LLC statute had not explicitly authorized such lawsuits. CML was
simply out of luck. The lower court observed, “[T]here is nothing absurd about different
legal principles applying to corporations and LLCs.”
CML would not necessarily agree. And the lower court itself acknowledged that
commentators had all assumed that such suits were permitted. It turned out they were
wrong. This result may make lenders less willing to finance LLCs and therefore render
LLCs a less-desirable form of organization.7 In short, many issues of law that are well
established for corporations still reside in foggy territory when it comes to LLCs.
CHOICES: LLC V. CORPORATION
When starting a business, which form makes the most sense—LLC or corporation? The
tax status of an LLC is a major advantage over a corporation. Although an S corporation
has the same tax status as an LLC, it also has all the annoying rules about classes of
stock and number of shareholders. Once an LLC is established, it does not have as
many housekeeping rules as corporations—it does not, for example, have to make
annual filings or hold annual meetings. However, the LLC is not right for everyone.
If done properly, an LLC is more expensive to set up than a corporation because it
needs to have a thoughtfully crafted operating agreement. Also, venture capitalists
almost always refuse to invest in LLCs, preferring C corporations instead. There are
four reasons for this preference: (1) arcane tax issues; (2) C corporations are easier to
merge, sell, or take public; (3) corporations can issue stock options; and (4) the general
legal uncertainty involving LLCs.
EXAM Strategy
Question: Hortense and Gus are each starting a business. Hortense’s business is an
Internet startup. Gus will be opening a yarn store. Hortense needs millions of dollars
in venture capital and expects to go public soon. Gus has borrowed $10,000 from his
girlfriend, which he hopes to pay back soon. Should either of these businesses
organize as an LLC?
Strategy: Sole proprietorships may be best for businesses without substantial
capital needs and without significant liability issues. Corporations are best for
businesses that will need substantial outside capital and expect to go public
shortly.
Result: An LLC is not the best choice for either of these businesses. Venture
capitalists will insist that Hortense’s business be a corporation, especially if it is going
public soon. A yarn store has few liability issues, and Gus does not expect to have any
outside investors. Hence, a sole proprietorship would be more appropriate for Gus’s
business.
7CML V, LLC v. Bax, 2011 Del. LEXIS 480 (S. Ct. Del, 2011).
684 U N I T 4 Employment, Business Organizations and Property
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28-4 SOCIALLY CONSCIOUS
ORGANIZATIONS
More than a dozen states now permit the formation of socially conscious business
organizations. These hybrids are called flexible-purpose organizations, benefit corporations
(B corporations), low-profit limited liability companies (L3Cs), and community interest
companies (CICs). To form this type of organization, a business must pledge to behave in
a socially responsible manner as it pursues profits. Note that these businesses are not
nonprofits. Instead, they focus on the triple bottom line: “people, planet, and profits.” Such
businesses consider the interests of their stakeholders (employees, suppliers, customers, and
creditors), the community, and the environment, in addition to investors. Company directors
are not required to maximize shareholder returns but may instead trade off some profit-
ability in the interests of social responsibility.
To become a socially conscious organization, typically two-thirds of the investors must
first give their approval. Then, in the case of Benefit corporations, the company has to
obtain certification from an independent third party, such as B Lab. Socially conscious
organizations must also prepare regular reports that include an assessment of their societal
and environmental impact. At the moment, these organizations do not receive favorable
tax treatment, but some advocates are pushing Congress to change the tax code.
Businesses that have taken advantage of these new laws include King Arthur Flour
Company, Patagonia, and Seventh Generation. Proponents praise this explicit opportunity
to combine profitability and a social conscience. Critics caution, however, that much
uncertainty remains. How will a board of directors make decisions? How will it decide, for
example, what is more important—being kind to employees or to the environment? The
rules are so vague that shareholders will have virtually no right to challenge board
decisions because management can always say its goal was to promote the public benefit.
Any new form of organization brings with it some legal uncertainty and, as a result,
almost inevitable litigation.
28-5 GENERAL PARTNERSHIPS
A partnership is an unincorporated association of two or more co-owners who carry on a
business for profit.8 Each co-owner is called a general partner.
Traditionally, partnerships were regulated by common law, but a lack of consistency
among the states became troublesome as interstate commerce grew. To solve this problem,
the National Conference of Commissioners on Uniform State Laws proposed the Uniform
Partnership Act (UPA) in 1914. Since then, there have been several revisions, the most
recent coming in 1997. More than two-thirds of the states have now passed the latest
revision, so we base our discussion on that version of the law.
TAXES
As we have seen above, partnerships are not a taxable entity, which means that profits flow
through to the owners.
8Uniform Partnership Act §6(1).
Partnership
An unincorporated association
of two or more co-owners who
operate a business for profit.
CHAPTER 28 Starting a Business: LLCs and Other Options 685
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LIABILITY
Each partner is personally liable for the debts of the enterprise, whether or not she caused
them. Thus, a partner is liable for any injury that another partner or an employee causes
while on partnership business as well as for any contract signed on behalf of the partnership.
This form of organization can be particularly risky if the group of owners is large and the
partners do not know each other.
Daniel Matter knows firsthand about the risks of a partnership. A former partner in
the accounting firm Pannell Kerr Foster, he thought he had heard the last of the firm
when he resigned his partnership. He was wrong. Seven
years later, he and 260 other former partners of the
California firm were served with a 78-page lawsuit seek-
ing $24 million in damages. The lawsuit alleged that
Pannell Kerr had been negligent in preparing financial
reports for a bankrupt Tennessee savings and loan.
Although Daniel Matter had never worked for that par-
ticular client, he was potentially liable because he had
been a partner when the audit was done. At age 53,
Matter feared losing everything he owned.
MANAGEMENT
The management of a partnership can be a significant challenge.
Management Rights Unless the partnership agrees otherwise, partners share both
profits and losses equally, and each partner has an equal right to manage the business.9 In a
large partnership, with hundreds of partners, too many cooks can definitely spoil the firm’s
profitability. That is why large partnerships are almost always run by one or a few partners
who are designated as managing partners or members of the executive committee. Some
firms are run almost dictatorially by the partner who brings in the most business (called a
“rainmaker”). Nonetheless, even in relatively autocratic firms, the atmosphere tends to be
less hierarchical than in a corporation, where employees are accustomed to the concept of
having a boss. Whatever the reality, partners by and large like to think of themselves as
being the equal of every other partner.
Management Duties Partners have a fiduciary duty to thepartnership.This dutymeans that:
• Partners are liable to the partnership for gross negligence or intentional misconduct.
• Partners cannot compete with the partnership. Each partner must turn over to the
partnership all earnings from any activity that is related to the partnership’s business.
Thus, law firms would typically expect a partner to turn over any fees he earned as a
director of a company, but he could keep the royalties he earned from his novel on
scuba diving.
• A partner may not take an opportunity away from the partnership unless the other partners
consent. If the partnership wants to buy a private plane and a partner hears of one for
sale that she wants to buy herself, she must give the partnership an opportunity to
buy it before she does.
• If a partner engages in a conflict of interest, he must turn over to the partnership any profits he
earned from that activity. In the following case, one partner bought partnership property
secretly. Is that a conflict of interest?
9Partnerships have the right to change internal management rules, but they cannot alter the rules
governing their relationship with outsiders (such as the rules on liability).
At age 53, Matter feared
losing everything he
owned.
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TRANSFER OF OWNERSHIP
Financing a partnership may be difficult because the firm cannot sell shares as a corporation
does. The capital needs of the partnership must be provided by contributions from partners or
by borrowing. Likewise, a partner only has the right to transfer the value of her partnership
interest, not the interest itself. She cannot, for example, transfer the right to participate in firm
management. Take the case of Evan and his mother. She is a partner in the immensely
profitable McBain Consulting firm. She dies, leaving him an orphan with no siblings. He
overcomes his grief as best he can and goes to her office on the next Monday to take over her
job and her partnership. Imagine his surprise when her partners tell him that, as her sole heir,
he can inherit the value of her partnership but he has no right to be a partner. He is out on the
sidewalk within the hour. The partners have promised him a check in the mail.
FORMATION
Given the disadvantages, why does anyone do business as a partnership? A partnership has
an important advantage over a sole proprietorship—partners. Sole proprietors are on their
own; partners have colleagues to help them and, equally important, to supply capital for the
business. Sole proprietorships sometimes turn into partnerships for exactly this reason.
In addition, partnerships are easy to form. Although a partnership should have a written
agreement, it is perfectly legal without one. In fact, nothing is required in the way of forms
or filings or agreements. If two or more people do business together, sharing management,
profits and losses, they have a partnership, whether they know it or not, and are subject to all
the rules of partnership law.
MARSH V. GENTRY
642 S.W.2d 574, 1982 KY. LEXIS 315
Supreme Court of Kentucky, 1982
C A S E S U M M A R Y
Facts: Tom Gentry and John Marsh were partners in a
business that bought and sold racehorses. The partnership
paid $155,000 for Champagne Woman, who subsequently
had a foal named Excitable Lady. The partners decided
to sell Champagne Woman at the annual Keeneland
auction, the world’s premier thoroughbred horse auction.
On the day of the auction, Gentry decided to bid on the
horse personally, without telling Marsh. Gentry bought
Champagne Woman for $135,000. Later, he told Marsh
that someone from California had approached him about
buying Excitable Lady. Marsh agreed to the sale.
Although he repeatedly asked Gentry the name of the
purchaser, Gentry refused to tell him. Not until 11 months
later, when Excitable Lady won a race at Churchill
Downs, did Marsh learn that Gentry had been the pur-
chaser. Marsh became the Excitable Man.
Issue: Did Gentry violate his fiduciary duty when he bought
partnership property without telling his partner?
Decision: Yes, Gentry violated his fiduciary duty to his
partner.
Reasoning: Kentucky partnership law required Gentry
to make full disclosure to his partner before buying part-
nership property. Although Gentry did not know that he
would be the winning bidder at auction, he had an obliga-
tion to tell Marsh that he intended to bid.
As for the private sale, although Marsh had agreed to
the price, he still had a right to know that his partner was
the offeror. He would certainly have looked more
carefully at an offer from a partner than from an unknown
third party. Indeed, Marsh said later that he would not
have agreed to either sale if he had known Gentry was the
purchaser.
Gentry claims that partners frequently place secret
bids at auctions of partnership property. Whether or not
this is true, such behavior violates the law and is unaccept-
able. Partners owe each other a high degree of good faith.
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For example, Kevin and Brenda formed an electrical contracting business. The business
did so well that Kevin’s first wife, Cynthia, asked the court to increase his child support
payments. Kevin argued that, because he and Brenda were partners, he was entitled to only
half of the business’s profits. Therefore, his child support should not be increased.
Cynthia claimed that Kevin and Brenda were not partners because Kevin had reported
all the income from the business on his personal tax return, while Brenda had reported
none. Kevin had even put “sole proprietorship” in bold letters on the top of his return. No
written partnership agreement existed. Kevin and Brenda never informed their accountant
that they were a partnership. When Kevin answered interrogatories for Cynthia’s lawsuit, he
stated that he was the sole owner and that Brenda worked for him. Nonetheless, the court
held that Brenda and Kevin were partners because Brenda helped manage the business and
shared in its profits.10
Partnership by Estoppel Brenda and Kevin wanted to be partners so that they could
share the profits of their business. In partnership by estoppel, non-partners are treated as if they
were actually partners and are forced to share liability. A partnership by estoppel exists if:
• Participants tell other people that they are partners (even though they are not), or
they allow other people to say, without contradiction, that they are partners;
• A third party relies on this assertion; and
• The third party suffers harm.
For example, an obstetrician by the name of Dr. William Martin was held liable under a
theory of partnership by estoppel because (1) he told a patient that he and Dr. John
Maceluch were partners (although they were not); (2) in reliance on this statement, a
patient made appointments to see Dr. Maceluch; and (3) she was harmed by Dr. Mace-
luch’s malpractice. He refused to come to the hospital when she was in labor and, as a result,
her child was born with brain damage. Although Dr. Martin was out of the country at the
time, he was as liable as if he had committed the malpractice himself.11
TERMINATION
When a partner quits, that event is called a dissociation. A dissociation is a fork in the road:
The partnership can either buy out the departing partner(s) and continue in business, or
wind up the business and terminate the partnership. Most large firms provide in their
partnership agreement that, upon dissociation, the business continues.
28-6 LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a type of general partnership that most states now
permit. There is a very important distinction, however, between LLPs and general partner-
ships: In an LLP, the partners are not liable for the debts of the partnership.12 They are,
naturally, liable for their own misdeeds, just as if they were a member of an LLC or a
shareholder of a corporation.
To form an LLP, the partners must file a statement of qualification with state officials.
LLPs must also file annual reports. The other attributes of a partnership remain the same.
Thus, an LLP is not a taxable entity, and it has the right to choose its duration (i.e., it can,
but does not have to, survive the dissociation of a member).
10In Re Marriage of Cynthia Hassiepen, 269 Ill. App. 3d 559, 646 N.E.2d 1348, 1995 Ill. App. LEXIS 101.
11Haught v. Maceluch, 681 F.2d 290, 1982 U.S. App. LEXIS 17123 (5th Cir. 1982).
12UPA §306(c).
Dissociation
When a partner quits a
partnership.
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Although an LLP can be much more advantageous for partners than a general partner-
ship, it is absolutely crucial to comply with all the technicalities of the LLP statute.
Otherwise, partners lose protection against personal liability. Note the sad result for Michael
Gaus and John West, who formed a Texas LLP. Unfortunately, they did not renew the
LLP registration each year, as the statute required. Four years after its initial registration,
the partnership entered into a lease. When the partners ultimately stopped paying rent and
abandoned the premises, they were both were held personally liable for the rent because
the LLP registration had expired. As the court pointed out, the statute did not contain a
“substantial compliance” section, nor did it contain a grace period for filing a renewal
application. In short, close only counts in horseshoes and hand grenades, not in LLPs.
28-7 LIMITEDPARTNERSHIPS ANDLIMITED
LIABILITY LIMITED PARTNERSHIPS
Although limited partnerships and limited liability limited partnerships sound confusingly
similar to limited liability partnerships and general partnerships, like many siblings, they
operate very differently. And truth to tell, limited partnerships and limited liability limited
partnerships are relatively rare—they are generally used only for estate planning purposes
(usually, to reduce estate taxes) and for highly sophisticated investment vehicles. You
should be aware of their existence, but you may not see them very often in your business
life. Here are the major features:
STRUCTURE
Limited partnerships must have at least one limited partner and one general partner.
LIABILITY
Limited partners are not personally liable, but general partners are. Like corporate share-
holders, limited partners risk only their investment in the partnership (which is called their
“capital contribution”). In contrast, general partners of a limited partnership are personally
liable for the debts of the organization.
However, the revised version of the Uniform Limited Partnership Act permits a limited
partnership, in its certificate of formation and partnership agreement, simply to declare itself
a limited liability limited partnership.13 In a limited liability limited partnership, the general
partner is not personally liable for the debts of the partnership. This provision effectively
removes the major disadvantage of limited partnerships. Although, at this writing, fewer
than half the states have actually passed the revised version of the Uniform Limited
Partnership Act, this revision would seem to indicate the trend for the future.
TAXES
Limited partnerships are not taxable entities. Income is taxed only once before landing in a
partner’s pocket.
FORMATION
The general partners must file a certificate of limited partnership with their Secretary of
State. Although most limited partnerships do have a partnership agreement, it is not
required.
13ULPA §102(9).
CHAPTER 28 Starting a Business: LLCs and Other Options 689
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MANAGEMENT
General partners have the right to manage a limited partnership. Limited partners are
essentially passive investors with few management rights beyond the right to be informed
about the partnership business. Limited partnership agreements can, however, expand the
rights of limited partners.
TRANSFER OF OWNERSHIP
Limited partners have the right to transfer the value of their partnership interest, but they
can sell or give away the interest itself only if the partnership agreement permits.
DURATION
Unless the partnership agreement provides otherwise, limited partnerships enjoy perpetual
existence—they continue even as partners come and go.
EXAM Strategy
Question: In which one or more of the following forms of organization is it true that
none of the partners are liable for the debts of the partnership?
(a) General partnership
(b) Limited liability partnership
(c) Limited partnership
(d) Limited liability limited partnership
Strategy: All these partnerships sound similar, but they are in fact very different, so
it is important to keep them straight!
Result: In a general partnership, all the partners are liable. In a limited liability
partnership, none are liable. In a limited partnership, the general partners are liable.
In a limited liability limited partnership, none of the partners are liable. The correct
answers are (b) and (d).
28-8 PROFESSIONAL CORPORATIONS
Traditionally, most professionals (such as lawyers and doctors) were not permitted to
incorporate their businesses, so they organized as partnerships. Now professionals are
allowed to incorporate, but in a special way. These organizations are called “professional
corporations” or “PCs.” PCs provide more liability protection than a general partnership. If
a member of a PC commits malpractice, the corporation’s assets are at risk, but not the
personal assets of the innocent members. If Drs. Sharp, Payne, and Graves form a partner-
ship, all the partners will be personally liable when Dr. Payne accidentally leaves her scalpel
inside a patient. If the three doctors have formed a PC instead, Dr. Payne’s Aspen condo
and the assets of the PC will be at risk, but not the personal assets of the two other doctors.
Generally, the shareholders of a PC are not personally liable for the contract debts of
the organization, such as leases or bank loans. Thus, if Sharp, Payne, & Graves, P.C. is
unable to pay its rent, the landlord cannot recover from the personal assets of any of the
doctors. As partners, the doctors would be personally liable.
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PCs have some limitations. First, all shareholders of the corporation must be members
of the same profession. For Sharp, Payne, & Graves, P.C., that means all shareholders must
be licensed physicians. Other valued employees cannot own stock. Second, like other
corporations, the required legal technicalities for forming and maintaining a PC are expen-
sive and time-consuming. Third, tax issues can be complicated. A PC is a separate taxable
entity, like any other corporation. It must pay tax on its profits, and then its shareholders pay
tax on any dividends they receive. Salaries, however, are deductible from firm profits. Thus,
the PC can avoid paying taxes on its profits by paying out all the profits as salary. But any
profits remaining in firm coffers at the end of the year are taxable. To avoid tax, PCs must be
careful to calculate their profits accurately and pay them out before year’s end. This chore
can be time-consuming, and any error may cause unnecessary tax liability.
28-9 JOINT VENTURES
Imax Corp. decided that it would like to partner with cinema operators—it would
supply its big screens to the cinemas in return for a share of the box office revenue.
The arrangement that Imax is describing is not like the other partnerships we have
discussed in this chapter—it is a joint venture. A joint venture is a partnership for a
limited purpose. Imax and the cinema operators would not merge; they would simply
work together. Each organization retains its own identity. Imax would be liable to an
electrician whom the cinema operator had hired to install an Imax screen, but not to the
cinema’s popcorn supplier.
28-10 FRANCHISES
This chapter has presented an overview of the various forms of organization. Franchises are
not, strictly speaking, a separate form of organization. They are included here because they
represent an important option for entrepreneurs. The United States has nearly half a million
franchised businesses, which employ almost 8 million people. Total sales are $1.3 trillion a
year. Well-known franchises include Hampton Hotels, McDonald’s, and Supercuts. Most
franchisors and franchisees are corporations, although they could legally choose to be any of
the forms discussed in this chapter.
Buying a franchise is a compromise between starting one’s own business as an
entrepreneur and working for someone else as an employee. Franchisees are free to
choose which franchise to buy, where to locate it, and how to staff it. But they are not
completely on their own. They are buying an established business with the kinks worked
out. In case the owner has never boiled water before, the McDonald’s operations manual
explains everything from how to set the temperature controls on the stove, to the number
of seconds that fries must cook, to the length of time they can be held in the rack before
being discarded. And a well-known name like McDonald’s or Subway ought, by itself, to
bring customers through the door.
There is, however, a fine line between being helpful and being oppressive. Franchisees
sometimes complain that franchisor control is too tight—tips on cooking fries might be
appreciated, but rules on how often to sweep the floor are not. Sometimes franchisors, in
their zeal to maintain standards, prohibit innovation that appeals to regional tastes. Just
because spicy biscuits are not popular in New England does not mean they should be
banned in the South.
Franchises can be very costly to acquire, anywhere from several thousand dollars to
many millions. That fee is usually payable up front, whether or not a sandwich or burger is
Joint venture
A partnership for a limited
purpose.
CHAPTER 28 Starting a Business: LLCs and Other Options 691
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ever sold. On top of the up-front fee, franchisees also typically pay an annual fee that is a
percentage of gross sales revenues, not profit. Sometimes the fee seems to eat up all the profits.
Franchisees also complain when they are forced to buy supplies from headquarters. In
theory, the franchisors can purchase hamburger meat and paper plates more cheaply in bulk
and also maintain quality controls. On the other hand, the franchisees are a captive
audience, and they sometimes allege that headquarters has little incentive to keep prices
low. Indeed, some franchisors make most of their profit from the products they sell to their
store owners. Often, the franchise agreement permits the company to change the terms of
the agreement by raising fees or expenses. Franchisees also grumble when they are forced
to contribute to expensive “co-op advertising” that benefits all the outlets in the region.
The sandwich franchise Quiznos recently spent $100 million to settle litigation with
potential franchisees, who claimed that the company took their fees without finding a store
location for them, and some existing store owners, who complained that the company forced
them to buy everything (including soap in the bathrooms and the piped-in music) from the
company at inflated prices.
All franchisors must comply with the Federal Trade Commission’s (FTC) Franchise
Rule. In addition, some states also impose their own franchise requirements. Under FTC
rules, a franchisor must deliver to a potential purchaser a so-called Franchise Disclosure
Document (FDD) at least 14 calendar days before any contract is signed or money is paid.
The FDD must provide information on:
• The history of the franchisor and its key executives
• Litigation with franchisees
• Bankruptcy filings by the company and its officers and directors
• Costs to buy and operate a franchise
• Restrictions, if any, on suppliers, products, and customers
• Territory—any limitations (in either the real or virtual worlds) on where the
franchisee can sell or any restrictions on other franchisees selling in the same territory
• Business continuity—under what circumstances can the franchisor fire the franchisee,
and the franchisee’s rights to renew or sell the franchise
• Franchisor’s training program
• Required advertising expenses
• A list of current franchisees and those that have left in the prior three years (a lot of
either may be a bad sign)
• A report on prior owners of stores that the franchisor has reacquired
• Earnings information is not required; but if disclosed, the franchisor must reveal the
basis for this information
• Audited financials for the franchisor
• A sample set of the contracts that a franchisee is expected to sign
The purpose of the FDD is to ensure that the franchisor discloses all relevant facts. It is not
a guarantee of quality because the FTC does not investigate to make sure that the information
is accurate. After the fact, if the FTC discovers the franchisor has violated the rules, it may sue
on the franchisee’s behalf. (The franchisee does not have the right to bring suit personally
against someone who violates FTC franchise rules, but it may be able to sue under state law.)
Suppose you obtain an FDD for “Shrinking Cats,” a franchise that offers psychiatric
services for neurotic felines. The company has lost money on all the outlets it operates
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itself; it has sold only three franchises, two of which have gone out of business; and all the
required contracts are ridiculously favorable to the franchisor. Nevertheless, the FTC will
still permit sales as long as the franchisor discloses all the information required in the FDD.
As the following case illustrates, the franchisor has much of the power in a franchise
relationship.
Chapter Conclusion
The process of starting a business is immensely time-consuming. Eighteen-hour days are
the norm. Not surprisingly, entrepreneurs are sometimes reluctant to spend their valuable
time on legal issues that, after all, do not contribute directly to the bottom line. No customer
buys more fried chicken because the franchise is a limited liability company instead of a
corporation. Wise entrepreneurs know, however, that careful attention to legal issues is an
essential component of success. The form of organization affects everything from taxes to
liability to management control. The idea for the business may come first, but legal
considerations occupy a close second place.
NATIONAL FRANCHISEE ASSOCIATION
V. BURGER KING CORPORATION
2010 U.S. Dist. LEXIS 123065
United States District Court for the Southern District of Florida, 2010
C A S E S U M M A R Y
Facts: The Burger King Corporation would not allow
franchisees to have it their way. Instead, Burger King
forced them to sell double cheeseburgers for $1.00, which
was below cost. Burger King franchisees filed suit alleging
that (1) the company did not have the right to set maximum
prices; and (2) that even if it had such a right, it had violated
its obligation under the franchise agreement to act in good
faith.
The court dismissed the first claim because the
franchise agreement unambiguously permitted Burger
King to set whatever prices it wanted. But the court
allowed the plaintiffs to proceed with the second claim.
Issue: Was Burger King acting in good faith when it forced
franchisees to sell items below cost?
Decision: Yes, the company was acting in good faith.
Reasoning: This case hinges on Burger King’s motives.
To show bad faith, plaintiffs must present evidence that
its goal, in setting these prices, was to harm the franchi-
sees. For example, the franchisees could show that Burger
King’s motive was to weaken them so much that the
company could take them over itself.
Alternatively, the plaintiffs could show (1) that no
reasonable person would have set the price of a double
cheeseburger at $1.00 and (2) this pricing caused severe
harm to the franchises. Clearly, the plaintiffs would never
have agreed to a contract that permitted unreasonable and
harmful behavior.
The franchisees cannot meet any of these tests. First,
there is no evidence that Burger King had any motive other
than helping the franchisees. Second, selling below cost is
not necessarily irrational. Indeed, there are lots of good
reasons why stores might adopt such a strategy—to build
customer loyalty, lure customers away from competitors, or
serve as loss leaders to generate increased sales on other,
higher-priced products. Third, there is no evidence that the
franchises were unprofitable or in danger of bankruptcy.
CHAPTER 28 Starting a Business: LLCs and Other Options 693
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EXAM REVIEW
Separate
Taxable
Entity
Personal
Liability for
Owners
Ease of
Formation
Transferable
Interests
(Easily Bought
and Sold)
Perpetual
Existence Other Features
Sole
Proprietorship
No Yes Very easy No, can only sell
entire business
No
Corporation Yes No Difficult Yes Yes
Close
Corporation
Yes, for C
corporation
No, for S
corporation
No Difficult Transfer
restrictions
Yes Protection of minority
shareholders. No board of
directors required
S Corporation No No Difficult Transfer
restrictions
Yes Only 100 shareholders. Only one
class of stock. Shareholdersmust
be individuals, estates, trusts,
charities, or pension funds and be
citizens or residents of the United
States. All shareholders must
agree to S status
Limited
Liability
Company
No No Difficult Yes, if the
operating
agreement
permits
Varies by
state, but
generally,
yes
No limit on the number of
shareholders, the number of
classes of stock, or the type of
shareholder
General
Partnership
No Yes Easy No Depends
on the
partnership
agreement
Management can be difficult
Limited
Liability
Partnership
No No Difficult No Depends
on the
partnership
agreement
Limited
Partnership
No Yes, for
general
partner
No, for
limited
partners
Difficult Yes (for limited
partners), if
partnership
agreement
permits
Yes
Limited
Liability
Limited
Partnership
No No Difficult Yes (for limited
partners), if
partnership
agreement
permits
Yes
Professional
Corporation
Yes No Difficult Shareholders
must all be
members of
same profession
Yes, as long
as it has
shareholders
Complex tax issues
Joint Venture No Yes Easy No No Partnership for a limited purpose
Franchise All these issues depend on the form of organization chosen by participants. Established business. Name
recognition. Management
assistance. Loss of control.
Fees may be high
©
C
en
g
ag
e
Le
ar
n
in
g
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MULTIPLE-CHOICE QUESTIONS
1. A sole proprietorship:
(a) must file a tax return.
(b) requires no formal steps for its creation.
(c) must register with the Secretary of State.
(d) may sell stock.
(e) provides limited liability to the owner.
2. CPA QUESTION Assuming all other requirements are met, a corporation may
elect to be treated as an S corporation under the Internal Revenue Code if it has:
(a) both common and preferred stockholders.
(b) a partnership as a stockholder.
(c) 100 or fewer stockholders
(d) the consent of a majority of the stockholders.
Strategy: Review the list of requirements for an S corporation. (See the “Result” at
the end of this section.)
3. A limited liability company:
(a) is regulated by a well-established body of law.
(b) pays taxes on its income.
(c) may issue stock options.
(d) must register with state authorities.
(e) protects the owners from personal liability for their own misdeeds.
4. CPA QUESTION A joint venture is a(n):
(a) association limited to no more than two persons in business for profit.
(b) enterprise of numerous co-owners in a nonprofit undertaking.
(c) corporate enterprise for a single undertaking of limited duration.
(d) association of persons engaged as co-owners in a single undertaking for profit.
5. A limited liability partnership:
(a) has ownership interests that cannot be transferred.
(b) protects the partners from liability for the debts of the partnership.
(c) must pay taxes on its income.
(d) requires no formal steps for its creation.
(e) permits a limited number of partners.
E
X
A
M
S
tr
a
te
g
y
CHAPTER 28 Starting a Business: LLCs and Other Options 695
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6. CPA QUESTION Cobb, Inc., a partner in TLC Partnership, assigns its partnership
interest to Bean, who is not made a partner. After the assignment, Bean asserts the
right to (1) participate in the management of TLC and (2) take Cobb’s share of
TLC’s partnership profits. Bean is correct as to which of these rights?
(a) 1 only
(b) 2 only
(c) 1 and 2
(d) Neither 1 nor 2
ESSAY QUESTIONS
1. Question: Alan Dershowitz, a law professor famous for his wealthy clients
(O. J. Simpson, among others), joined with other lawyers to open a kosher
delicatessen, Maven’s Court. Dershowitz met with greater success at the bar
than in the kitchen—the deli failed after barely a year in business. One supplier
sued for overdue bills. What form of organization would have been the best
choice for Maven’s Court?
Strategy: A sole proprietorship would not have worked because there was more
than one owner. A partnership would have been a disaster because of unlimited
liability. They could have met all the requirements of an S corporation or an LLC.
(See the “Result” at the end of this section.)
2. Question: Mrs. Meadows opened a biscuit shop called The Biscuit Bakery.
The business was not incorporated. Whenever she ordered supplies, she was
careful to sign the contract in the name of the business, not personally: the
Biscuit Bakery by Daisy Meadows. Unfortunately, she had no money to pay her
flour bill. When the vendor threatened to sue her, Mrs. Meadows told him that
he could only sue the business because all the contracts were in the business’s
name. Will Mrs. Meadows lose her dough?
Strategy: The first step is to figure out what type of organization her business is.
Then recall what liability protection that organization offers. (See the “Result” at
the end of this section.)
E
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2. Result: An S corporation can have only one class of stock. A partnership cannot be a
stockholder, and all the shareholders must consent to S corporation status. (c) is the correct
answer.
696 U N I T 4 Employment, Business Organizations and Property
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3. YOU BE THE JUDGE WRITING PROBLEM Cellwave was a limited
partnership that applied to the Federal Communications Commission (FCC) for a
license to operate cellular telephone systems. After the FCC awarded the license,
it discovered that, although all the limited partners had signed the limited
partnership agreement, Cellwave had never filed its limited partnership
certificate with the Secretary of State in Delaware. The FCC dismissed
Cellwave’s application on the grounds that the partnership did not exist when
the application was filed. Did the FCC have the right to dismiss Cellwave’s
application? Argument for Cellwave: The limited partnership was effectively in
existence as soon as the limited partners signed the agreement. The Secretary of
State could not refuse to accept the certificate for filing; that was a mere
formality. Argument for the FCC: When Cellwave applied for a license, it did
not exist legally. Formalities matter.
4. Kristine bought a Rocky Mountain Chocolate Factory franchise. Her franchise
agreement required her to purchase a cash register that cost $3,000, with an annual
maintenance fee of $773. The agreement also provided that Rocky Mountain could
change to a more expensive system. Within a few months after signing the agreement,
Kristine learned that she would have to buy a new cash register that cost $20,000, with
annual maintenance fees of $2,000. Does Kristine have to buy this new cash register?
Did Rocky Mountain act in bad faith?
5. What is the difference between close corporations and S corporations?
6. Pedro and Juan have a business selling ties with fraternity insignia. Pedro finds out
that an online shirt business is for sale. It sounds like a great idea—customers send in
their measurements and get back a custom-made shirt at a price no higher than off-
the-rack shirts at the local department store. Does Pedro have to let Juan in on the
great opportunity?
DISCUSSION QUESTIONS
1. ETHICS Lee McNeely told Hardee’s officials that
he was interested in purchasing multiple restaurants
in Arkansas. A Hardee’s officer assured him that any
of the company-owned stores in Arkansas would be
available for purchase. However, the company urged
him to open a new store in Maumelle and sent him a
letter estimating first-year sales at around $800,000.
McNeely built the Maumelle restaurant, but gross
sales the first year were only $508,000. When
McNeely asked to buy an existing restaurant, a
Hardee’s officer refused, informing him that
Hardee’s rarely sold company-owned restaurants.
The disclosure document contained no
misstatements, but McNeely brought suit alleging
fraud in the sale of the Maumelle franchise. Does
McNeely have a valid claim against Hardee’s? Apart
from the legal issues, did Hardee’s officers behave
ethically? What Life Principles were they applying?
1. Result: Maven’s Court would have chosen an LLC or an S corporation.
2. Result: The Biscuit Bakery was a sole proprietorship. No matter how Mrs. Meadows
signed the contracts, she is still personally liable for the debts of the business.
CHAPTER 28 Starting a Business: LLCs and Other Options 697
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2. Leonard, an attorney, was negligent in his
representation of Anthony. In settlement of
Anthony’s claim against him, Leonard signed a
promissory note for $10,400 on behalf of his law firm,
an LLC. When the law firm did not pay, Anthony
filed suit against Leonard personally for payment of
the note. Is a member personally liable for the debt
of an LLC that was caused by his own negligence?
3. Think of a business concept that would be appropriate
for each of the following: a sole proprietorship, a
corporation, and a limited liability company.
4. As you will see in Chapter 29, Facebook began
life as a corporation, not an LLC. Why did the
founder, Mark Zuckerberg, make that decision?
5. Corporations developed to encourage investors
to contribute the capital needed to create
large-scale manufacturing enterprises. But
LLCs are often start-ups or other small
businesses. Why do their members deserve
limited liability? And is it fair that LLCs do not
have to pay income taxes?
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CHAPTER29
CORPORATIONS
On July 26, 2004, Mark Zuckerberg signed a
Certificate of Incorporation for his company,
which he calledTheFacebook, Inc. At 11:34 a.m.
on July 29, 2004, that Certificate was filed with
the Secretary of State for Delaware, and
TheFacebook began its life as a corporation.
Zuckerberg had started this social networking
Internet site the previous February in his dorm
room at Harvard. By December of 2004,
TheFacebook had almost 1 million users. Less
than two years later, the company was estimated
to be worth between $750 million and $2 billion. Since
then, TheFacebook has been valued at more than $100
billion. As Zuckerberg built his company, what did he
need to know about the law?
Most of the country’s largest businesses, and many of
its small ones, are corporations. In this chapter, you will
learn how to form a corporation. You will also learn about
the rights and responsibilities of corporate managers and
shareholders.
Zuckerberg started
TheFacebook in his
dorm room at Harvard.
Within 10 months, it
had almost 1 million
users.
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29-1 PROMOTER’S LIABILITY
Someone who organizes a corporation is called a promoter. It is his idea; he raises the
capital, hires the lawyers, calls the shots. Mark Zuckerberg was TheFacebook’s promoter.
This role can carry some risk. A promoter is personally liable on any contract he signs
before the corporation is formed. After formation, the corporation can adopt the contract, in
which case, both it and the promoter are liable. The promoter can get off the hook
personally only if the other party agrees to a novation—that is, a new contract with the
corporation alone.
EXAM Strategy
Question: Dr. Warfield hired Wolfe, a young carpenter, to build his house. A week
or so after they signed the contract, Wolfe filed Articles of Incorporation for Wolfe
Construction, Inc. Warfield wrote checks to the corporation, which it cashed.
Unfortunately, the work on the house was shoddy. The architect said he did not know
whether to try to salvage the house or just blow it up. Warfield sued Wolfe and Wolfe
Construction, Inc. for damages. Wolfe argued that if he was liable as a promoter, then
the corporation must be absolved and that, conversely, if the corporation was held
liable, he, as an individual, must not be. Who is liable to Warfield?
Strategy: Wolfe’s argument is wrong—Warfield does not have to choose between
suing him individually or suing the corporation. He can sue both.
Result: Wolfe is personally liable on any contract he signed before the corporation is
filed, no matter whose name is on the contract. The corporation is liable only if it
adopts the contract. Did it do so here? The fact that the corporation cashed checks
that were made out to it means that the corporation is also liable. So Warfield can sue
both Wolfe and the corporation.
29-2 INCORPORATION PROCESS
There is no federal corporation code, which means that a company can incorporate only
under state, not federal, law. No matter where a company actually does business, it may
incorporate in any state. This decision is important because the organization must live by
the laws of whichever state it chooses for incorporation. To encourage similarity among state
corporation statutes, the American Bar Association drafted the Model Business Corporation
Act (the Model Act) as a guide. Many states do use the Model Act as a guide, although
Delaware does not. Therefore, in this chapter we will give examples from both the Model
Act and Delaware. Why Delaware? Despite its small size, it has a disproportionate influence
on corporate law. More than half of all public companies have incorporated there, including
60 percent of Fortune 500 companies.
29-2a Where to Incorporate?
A company is called a domestic corporation in the state where it incorporates and a foreign
corporation everywhere else. Companies generally incorporate either in the state where they
do most of their business or in Delaware. They typically must pay filing fees and franchise
Adopt
Agree to be bound by the terms
of a contract.
Novation
A new contract with different
parties.
Domestic corporation
A corporation is a domestic
corporation in the state in
which it was formed.
Foreign corporation
A corporation formed in
another state.
Promoter
Someone who organizes a
corporation.
700 U N I T 4 Employment, Business Organizations and Property
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taxes in their state of incorporation, plus in any state in which they do business. To avoid
this double set of fees, a business that will be operating primarily in one state would probably
select that state for incorporation rather than Delaware. But if a company is going to do
business in several states, it might consider choosing Delaware, which offers several
advantages:
• Laws that Favor Management. For example, if the shareholders want to take a vote in
writing instead of holding a meeting, many other states require the vote to be
unanimous; Delaware requires only a majority to agree. The Delaware legislature also
tries to keep up-to-date by changing its code to reflect new developments in
corporate law.
• An Efficient Court System. Delaware has a special court (called “Chancery Court”)
that hears nothing but business cases and has judges who are experts in
corporate law.
• An Established Body of Precedent. Because so many businesses incorporate in the
state, its courts hear a vast number of corporate cases, creating a large body of
precedent. Thus, lawyers feel they can more easily predict the outcome of a case in
Delaware than in a state where few corporate disputes are tried.
29-2b The Charter
Once a company has decided where to incorporate, the next step is to prepare and file the
charter. The mechanics are easy: Simply download the form and mail or fax it to the
Secretary of State. (Some jurisdictions also require that it be filed in a county office.) But
do not let this easy process fool you; the incorporation document needs to be completed
with some care. The corporate charter defines the corporation, including everything from
the company’s name to the number of shares it will issue.
States use different terms to refer to a charter; some call it the “articles of incorpora-
tion,” others use “articles of organization,” and still others say “certificate” instead of
“articles.” All these terms mean the same thing. Similarly, some states use the term
“shareholders,” and others use “stockholders”; they are both the same.
NAME
The Model Act imposes two requirements in selecting a name. First, all corporations must
use one of the following words in their name: “corporation,” “incorporated,” “company,”
or “limited.” Delaware also accepts some additional terms, such as “association” or
“institute.” Second, under both the Model Act and Delaware law, a new corporate name
must be different from that of any corporation, limited liability company, or
limited partnership that already exists in that state. If your name is Freddy DuPont, you
cannot name your corporation “Freddy DuPont, Inc.,” because Delaware already has a
company named E. I. DuPont de Nemours & Company. It does not matter that Freddy
DuPont is your real name or that the existing company is a large chemical business,
whereas you want to open a game arcade. The names are too similar. Zuckerberg
chose “TheFacebook” because that was what Harvard students called their freshman
directory.
ADDRESS AND REGISTERED AGENT
A company must have an official address in the state in which it is incorporated so that the
Secretary of State knows where to contact it and so that anyone who wants to sue the
corporation can serve the complaint in-state. Because most companies incorporated in
Delaware do not actually have an office there, they hire a registered agent to serve as their
official presence in the state.
CHAPTER 29 Corporations 701
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INCORPORATOR
The incorporator signs the charter and delivers it to the Secretary of State. Incorporators are
not required to buy stock, nor do they necessarily have any future relationship with the
company. Oftentimes, the lawyer who forms the corporation serves as its incorporator. If no
lawyer is involved, typically the promoter is also the incorporator. That is what happened
with TheFacebook—Mark Zuckerberg served as incorporator.
PURPOSE
The corporation is required to give its purpose for existence. Most companies use a very
broad purpose clause such as TheFacebook’s:
The purpose of the Corporation is to engage in any lawful act or activity for which corporations
may be organized under the General Corporation Law of Delaware.
STOCK
The charter must provide three items of information about the company’s stock.
Par Value The concept of par value was designed to protect investors. Originally, par value
was supposed to be close to market price. A company could not issue stock at a price less than
par, which meant that it could not sell to insiders at a sweetheart price well belowmarket value.
(Once the stock was issued, it could be traded at any price.) Inmodern times, par value does not
relate to market value; it is usually some nominal figure such as 1¢ or $1 per share. Companies
may also issue stock with no par value. TheFacebook stock has a par value of $0.0001 per share.
Number of Shares Before stock can be sold, it must first be authorized in the charter.
The corporation can authorize as many shares as the incorporators choose, but the more
shares, the higher the filing fee. After incorporation, a company can add authorized shares
by simply amending its charter and paying the additional fee. TheFacebook charter
authorizes the creation of 10,000,000 shares.
Stock that has been authorized but not yet sold is called authorized and unissued. Stock
that has been sold is termed authorized and issued or outstanding. Stock that the company
has sold but later bought back is treasury stock.
Classes and Series Different shareholders often make different contributions to a
company. Some may be involved in management, whereas others may simply contribute
financially. Early investors may feel that they are entitled to more control than those who
come along later (and who perhaps take less risk). Corporate structure can be infinitely
flexible in defining the rights of these various shareholders. Stock can be divided into
categories called classes, and these classes can be further divided into subcategories called
series. All stock in a series has the same rights, and all series in a class are fundamentally the
same, except for minor distinctions. For example, in a class of preferred stock, all shareholders
may be entitled to a dividend, but the amount of the dividend may vary by series. Different
classes of stock, however, may have very different rights—a class of preferred stock is
different from a class of common stock. Exhibit 29.1 illustrates the concept of class and series.
Defining the rights of a class or series of stock is like baking a cake—the stock can
contain virtually any combination of the following ingredients (although the result may not
be to everyone’s taste):
• Dividend Rights. The charter establishes whether the shareholder is entitled to
dividends and, if so, in what amount.
• Voting Rights. Shareholders are usually entitled to elect directors and vote on charter
amendments, among other issues, but these rights can vary among different series
and classes of stock. When Ford Motor Co. went public in 1956, it issued Class B
Authorized and unissued
Stock that has been authorized,
but not yet sold.
Authorized and issued
Stock that has been authorized
and sold; another word for it is
outstanding.
Treasury stock
Stock that a company has sold,
but later bought back.
Classes of stock
Categories of stock with
different rights.
Series
Sub-categories of stock.
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common stock to members of the Ford family. This class of stock holds about
40 percent of the voting power and, thereby, effectively controls the company. Not
surprisingly, the chairman of the company has often been named “Ford.”TheFacebook
amended its charter to create two classes of stock with different voting rights, presumably
so that Zuckerberg could maintain control when the company went public.
• Liquidation Rights. The charter specifies the order in which classes of stockholders
will be paid upon dissolution of the company.
These are the ingredients for any class or series of stock. Some stock comes prepack-
aged like a cake mix. “Preferred” and “common” stock are two classic types. The Model
Act does not use these terms, but many states still do.
Owners of preferred stock have preference on dividends and also, typically, in liquidation.
If a class of preferred stock is entitled to dividends, then it must receive its dividends before
common stockholders are paid theirs. If holders of cumulative preferred stockmiss their dividend
one year, common shareholders cannot receive a dividend until the cumulative preferred share-
holders have been paid all that they are owed, no matter how long that takes. Alternatively,
holders of non-cumulative preferred stock lose an annual dividend for good if the company
cannot afford it in the year it is due. When a company dissolves, preferred stockholders typically
have the right to receive their share of corporate assets before common shareholders.
Common stock is last in line for any corporate payouts, including dividends and liquida-
tion payments. If the company is liquidated, creditors of the company and preferred shareholders
are paid before common shareholders. Exhibit 29.2 illustrates the order of payment for dividends.
Venture capitalists (professional investors who are in the business of financing compa-
nies) often choose a type of stock called participating preferred stock, which permits them to
have their cake and eat it too. Upon liquidation of the company, these shareholders are paid
first, receiving whatever they paid for the stock plus accrued dividends. Then they are
treated as if they had converted their preferred shares into common stock, so they also share
the rest of the proceeds with common shareholders.
Class B
Common
One
Class
Preferred
Stock
Class A
Common
Series
B1
Series
A1
Series
A2 Series
B3
es
1
Se
B
Series
B2
EXHIB IT 29.1 An Illustration of Classes and Series of Stock
Preferred stock
The owners of preferred stock
have preference on dividends
and also, typically, in liquidation.
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CHAPTER 29 Corporations 703
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29-3 AFTER INCORPORATION
29-3a Directors and Officers
Once the corporation is organized, the incorporators elect the first set of directors. There-
after, shareholders elect directors. Under the Model Act, a corporation is required to have at
least one director, unless (1) all the shareholders sign an agreement that eliminates the
board, or (2) the corporation has 50 or fewer shareholders. To elect directors, the share-
holders may hold a meeting, or, in the more typical case for a small company, they elect
directors by written consent. A typical written consent looks like this:
Once the incorporators or shareholders have chosen the directors, the directors must
elect the officers of the corporation. They can use a consent form if they wish. The Model
Act is flexible. It simply requires a corporation to have whatever officers are described in the
Dividend Is
Declared
Dividends Due in
Current Year to
Holders of Cumulative
and Non-cumulative
Preferred Stock
Are Paid First
Dividends Due in
Prior Years to
Holders of Cumulative
Preferred Stock
Are Paid Second
Remainder Is
Paid to Common
Shareholders
EXHIB IT 29.2 The Order in Which Dividends Are Paid
Classic American Novels, Inc.
Written Consent
The undersigned shareholders of Classic American Novels, Inc., a corporation organized and
existing under the General Corporation Law of the State of Wherever, hereby agree that the
following action shall be taken with full force and effect as if voted at a validly called and
held meeting of the shareholders of the corporation:
Agreed: That the following people are elected to serve as directors for one year, or
until their successors have been duly elected and qualified:
Herman Melville
Louisa May Alcott
Mark Twain
Dated: Signed:
Willa Cather
Dated: Signed:
Nathaniel Hawthorne
Dated: Signed:
Harriet Beecher Stowe©
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Written consent
Instead of holding a meeting,
participants may sign a
document approving certain
actions.
704 U N I T 4 Employment, Business Organizations and Property
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bylaws. The same person can hold more than one office. Exhibit 29.3 illustrates the election
process in corporations.
The written consents and any records of actual meetings are kept in a minute book,
which is the official record of the corporation. Entrepreneurs sometimes feel they are too busy
to bother with all these details, but if a corporation is ever sold, the lawyers for the buyers will
insist on a well-organized and complete minute book. In one case, a company that was seeking
a $100,000 bank loan could not find all its minutes. The company had to merge itself into a
newly created corporation so it could start fresh with a new set of corporate records. The
company spent $10,000 on this task, a large chunk out of the $100,000 loan.
29-3b Bylaws
The bylaws list all the “housekeeping” details for the corporation. For example, bylaws set
the date of the annual shareholders’ meeting, define what a quorum is (i.e., what percentage
of stock must be represented for a meeting to count), indicate how many directors there will
be, give titles to officers, and establish the fiscal (i.e., tax) year of the corporation.
29-3c Issuing Debt
Most startup companies begin with some combination of equity and debt. Equity (i.e.,
stock) is described in the charter; debt is not. Authorizing debt is often one of the first steps
a new company takes. There are several types of debt:
• Bonds are long-term debt secured by company assets. If the company is unable to pay
the debt, creditors have a right to specific assets, such as accounts receivable or
inventory.
• Debentures are long-term unsecured debt. If the company cannot meet its obligations,
the debenture holders are paid after bondholders but before stockholders.
• Notes are short-term debt, typically payable within five years. They may be either
secured or unsecured.
29-4 DEATH OF THE CORPORATION
Sometimes, business ideas are not successful and the corporation fails. This death can be
voluntary (the shareholders elect to terminate the corporation) or forced (by court order).
Sometimes, a court takes a step that is much more damaging to shareholders than simply
dissolving the corporation—it removes the shareholders’ limited liability.
Shareholders
tcelEtcelE
Directors Officers
EXHIB IT 29.3 The Election Process in Corporations
Minute book
The official record of a
corporation.
Bylaws
A document that specifies the
organizational rules of a
corporation or other
organization, such as the date
of the annual meeting and the
required number of directors.
Quorum
The percentage of stock that
must be represented for a
meeting to count.
Bonds
Long-term secured debt.
Debentures
Long-term unsecured debt.
Notes
When issued by a company,
short-term debt, typically
payable within five years.
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CHAPTER 29 Corporations 705
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29-4a Piercing the Corporate Veil
One of the major purposes of a corporation is to protect its owners—the shareholders—from
personal liability for the debts of the organization. Sometimes, however, a court will pierce
the corporate veil; that is, the court will hold shareholders personally liable for the debts of
the corporation. Courts generally pierce a corporate veil in four circumstances:
• Failure to Observe Formalities. If an organization does not act like a corporation, it will
not be treated like one. It must, for example, hold required shareholders’ and directors’
meetings (or sign consents), keep a minute book as a record of these meetings, andmake
all the required state filings. In addition, officers must be careful to sign all corporate
documents with a corporate title, not as an individual. An officer should sign like this:
Classic American Novels, Inc.
By:
Stephen Crane, President
• Commingling of Assets. Nothing makes a court more willing to pierce a corporate veil
than evidence that shareholders have mixed their assets with those of the corporation.
Sometimes, for example, shareholders may use corporate assets to pay their personal
debts. If shareholders commingle assets, it is genuinely difficult for creditors to
determine which assets belong to whom. This confusion is generally resolved in favor
of the creditors—all assets are deemed to belong to the corporation.
• Inadequate Capitalization. If the founders of a corporation do not raise enough capital
(either through debt or equity) to give the business a fighting chance of paying its debts,
courts may require shareholders to pay corporate obligations. Therefore, if the corporation
does not have sufficient capital, it needs to buy insurance, particularly to protect against
tort liability. Judges are likelier to hold shareholders liable if the alternative is to send an
injured tort victim away empty-handed. For example, Oriental Fireworks Co. had
hundreds of thousands of dollars in annual sales, but only $13,000 in assets. The company
did not bother to obtain any liability insurance, keep a minute book, or defend lawsuits.
There was no need because the company had no money. But then a court pierced the
corporate veil and found the owner of the company personally liable.1
• Fraud. If fraud is committed in the name of a corporation, victims can make a claim
against the personal assets of the shareholders who profited from the fraud.
The following case is a good example of when a court should pierce the corporate veil.
1Rice v. Oriental Fireworks Co., 75 Or. App. 627, 707 P.2d 1250, 1985 Ore. App. LEXIS 3928.
Pierce the corporate veil
A court holds shareholders
personally liable for the debts of
the corporation.
BROOKS V. BECKER
2005 VA. CIR. LEXIS 13
Circuit Court Of Fairfax County, Virginia, 2005
C A S E S U M M A R Y
Facts: Ronald Becker was the sole shareholder, officer,
and director of Becker Interiors. Becker and his compa-
nion, Robert LaPointe, used approximately $300,000 of
Becker Interiors’ funds to renovate their residence, pay
their personal credit card bills, and invest in another
company of which Becker was president. Becker sold a
corporate car for $73,700 and deposited those funds into
his personal account, along with the corporation’s income
tax refund check of $12,850. Becker Interiors supervised
the major renovation of a house in McLean, Virginia. The
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29-4b Termination
Terminating a corporation is a three-step process:
• Vote. The directors recommend to the shareholders that the corporation be dissolved,
and a majority of the shareholders agree.
• Filing. The corporation files “Articles of Dissolution” with the Secretary of State.
• Winding Up. The officers of the corporation pay its debts and distribute the
remaining property to shareholders. When the winding up is completed, the
corporation ceases to exist.
The Secretary of State may dissolve a corporation that violates state law by, for
example, failing to pay the required annual fees. Indeed, many corporations, particularly
small ones, do not bother with the formal dissolution process. They simply cease paying
their annual fees and let the Secretary of State act. A court may dissolve a corporation if it is
insolvent or if its directors and shareholders cannot resolve conflict over how the corporation
should be managed.
29-5 THE ROLE OF CORPORATE
MANAGEMENT
As business grows, entrepreneurs face new challenges. One of the most important is
attracting outside investors—people with money but without the knowledge or desire to
manage the enterprise. How can shareholders protect their interests in an organization
without being involved in management themselves? They elect directors to manage for
them. Directors set policy and then appoint officers to implement corporate goals. The
company hired Stephen Brooks as a subcontractor on the
project. When the company refused to pay Brooks, he
filed suit, winning a judgment against the company for
$54,597.09. But it turned out that Becker Interiors had no
assets.
Brooks then sued Ronald Becker in an attempt to
pierce the corporate veil and hold Becker personally liable
for the debts of the corporation.
Issues: Can Brooks pierce the corporate veil? Is Becker per-
sonally liable for the debts of the corporation?
Decision: The court allowed Brooks to pierce the corpo-
rate veil. Becker was held personally liable for the debts
of Becker Interiors, Inc.
Reasoning: Courts are extremely reluctant to pierce a
corporate veil and hold shareholders personally liable.
Indeed, courts will take this extraordinary step only when
necessary to promote justice, such as, for example, when a
shareholder uses the corporation to evade personal debts,
perpetrate fraud or a crime, commit an injustice, or gain an
unfair advantage. To hold a shareholder liable, the bound-
aries between the shareholder and the corporation must
be so confused that, in effect, the business does not exist
separately and to pretend that it does is unjust to the
plaintiff.
In this case, the extraordinary remedy of piercing
the corporate veil should be granted. Becker knowingly
violated his duties as an officer, director, and share-
holder of Becker Interiors by treating the corporation
as his personal piggy bank. He testified that renova-
tions to his personal residence were legitimate corporate
expenses because he used the house as a showcase for his
work. The court did not find this testimony credible. Nor did
the court believe that Becker acted on his accountant’s
advice when he commingled personal and corporation funds.
The court more easily believed his later testimony that his
accountant was “mystified” by this commingling of funds.
The court orders Becker to pay Brooks $54,597.09.
CHAPTER 29 Corporations 707
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Model Act describes the directors’ role thus: “All corporate powers shall be exercised by or
under the authority of, and the business and affairs of the corporation managed by or under
the direction of, its board of directors….”
As managers of the corporation, directors have important responsibilities to shareholders
and also to stakeholders, such as employees, customers, creditors, suppliers, and neighbors.
However, the interests of these various groups often conflict. In the first decade of the twenty-
first century, the world faced two financial crises that were caused, in part, by corporate
executives who engaged in high-risk activities that left them wealthy, but their shareholders
with nothing. Because of abuses by managers that, in some cases, included outright fraud,
Congress and other regulators tried to rebalance the power among managers and shareholders.
Part of their goal was to enhance shareholder oversight of the companies they own. The rest of
this chapter is about this balance of rights and responsibilities.
Managers have a fiduciary duty to act in the best interests of the corporation’s share-
holders. Because shareholders are primarily concerned about their return on investment,
managers must maximize shareholder value, which means providing shareholders with the
highest possible financial return from dividends and stock price. However, reality is more
complicated than this simple rule indicates. It is often difficult to determine which strategy
will best maximize shareholder value. And what about stakeholders? A number of states
have adopted statutes that permit directors to take into account the interests of stakeholders
as well as stockholders. The Indiana Code, for example, permits directors to consider “both
the short term and long term best interests of the corporation, taking into account, and
weighing as the directors deem appropriate, the effects thereof on the corporation’s share-
holders and the other corporate constituent groups….”2 The next section looks more closely
at directors’ responsibilities to their various constituencies.
29-6 THE BUSINESS JUDGMENT RULE
Officers and directors have a fiduciary duty to act in the best interests of their stockholders,
but under the business judgment rule, the courts allow managers great leeway in carrying
out this responsibility. The business judgment rule is a common law concept that has
achieved national acceptance. It is a fundamental principle of corporate law. To be pro-
tected by the business judgment rule, managers must act in good faith:
Duty of Loyalty 1. Without a conflict of interest
Duty of Care 2. With the care that an ordinarily prudent person would take in a
similar situation and
3. In a manner they reasonably believe to be in the best interests of the
corporation
The business judgment rule is two shields in one: It protects both the manager and her
decisions. If managers comply with the business judgment rule, a court will not hold them
personally liable for any harm their decisions cause the company, nor will the court rescind
their decisions.
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Business judgment rule
A legal rule that protects
managers from liability and
their decisions from court
interference.
2Indiana Code §23-1-35-1.
Stakeholders
Anyone who is affected by the
activities of a corporation, such
as a shareholder, employee,
customer, creditor, supplier,
or neighbor.
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The business judgment rule accomplishes three goals:
• It permits directors to do their job. If directors were afraid they would be liable for
every decision that led to a loss, they would never make a decision, or at least not a
risky one.
• It keeps judges out of corporate management. Without the business judgment rule,
judges would be tempted, if not required, to second-guess managers’ decisions.
• It encourages directors to serve. No one in his right mind would serve as a director if
he knew that every decision was open to attack in the courtroom.
Analysis of the business judgment rule is divided into two parts. The obligation of a
manager to act without a conflict of interest is called the duty of loyalty. The requirements
that a manager act with care and in the best interests of the corporation are referred to as the
duty of care.
29-6a Duty of Loyalty
The duty of loyalty prohibits managers from making a decision that benefits them at the
expense of the corporation.
SELF-DEALING
Self-dealing means that a manager makes a decision benefiting either himself or another
company with which he has a relationship. While working at the Blue Moon restaurant,
Zeke signs a contract on behalf of the restaurant to purchase bread from Rising Sun Bakery.
Unbeknownst to anyone at Blue Moon, he is a part owner of Rising Sun. Zeke has engaged
in self-dealing, which is a violation of the duty of loyalty.
Once a manager engages in self-dealing, the business judgment rule no longer applies.
This does not mean the manager is automatically liable to the corporation or that his
decision is automatically void. All it means is that the court will no longer presume that
the transaction was acceptable. Instead, the court will scrutinize the deal more carefully.
A self-dealing transaction is valid in any one of the following situations:
• The disinterested members of the board of directors approve the transaction.
Disinterested directors are those who do not themselves benefit from the transaction.
• The disinterested shareholders approve it. The transaction is valid if the shareholders
who do not benefit from it are willing to approve it.
• The transaction was entirely fair to the corporation. In determining fairness, the
courts will consider the impact of the transaction on the corporation and whether the
price was reasonable.
Although the business judgment rule did not protect Zeke, he would still not be liable
if he sought permission first, or if a court found that he was buying great bread at an
excellent price. Exhibit 29.4 illustrates the rules on self-dealing.
29-6b Corporate Opportunity
The self-dealing rules prevent managers from forcing their companies into unfair deals. The
corporate opportunity doctrine is the reverse—it prohibits managers from excluding their
company from favorable deals. Managers are in violation of the corporate opportunity
doctrine if they compete against the corporation without its consent.
Long ago, Charles Guth was president of Loft, Inc., which operated a chain of candy stores.
These stores sold Coca-Cola. Guth purchased the Pepsi-Cola Company personally, without
offering the opportunity to Loft. A Delaware court found that Guth had violated the corporate
Duty of loyalty
The obligation of a manager to
act without a conflict of
interest.
CHAPTER 29 Corporations 709
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opportunity doctrine and ordered him to transfer all his shares in Pepsi to Loft.3 That was in
1939, and Pepsi-Cola was bankrupt; today, PepsiCo, Inc. is worth more than $100 billion.
In the following case, the manager felt that he had a good reason for taking a corporate
opportunity. Unfortunately, the court disagreed.
Decision is entirely fair
to the corporation
Disinterested board
or shareholders
approve transaction
No liability;
decision stands
Disinterested board
or shareholders
do NOT approve
Decision is NOT
entirely fair to the corporation
Manager may be liable;
decision may be revoked
Manager engages
in self-dealing
EXHIB IT 29.4 The Rules on Self-Dealing
ANDERSON V. BELLINO
265 Neb. 577, 658 N.W.2d 645, 2003 LEXIS 49
Supreme Court Of Nebraska, 2003
C A S E S U M M A R Y
Facts: Richard Bellino and Robert Anderson formed
LaVista Lottery, Inc. to operate a restaurant, lounge,
and keno game in LaVista, Nevada.4 They each owned
50 percent of the stock of Lottery, and both were
officers and directors. During the next nine years, Lot-
tery grossed more than $100 million. Bellino and
Anderson each received over $4 million in salary and
dividends.
3Guth v. Loft, 5 A.2d 503, 23 Del. Ch. 255, 1939 Del. LEXIS 13 (Del. 1939).
4Keno is a game of chance similar to bingo except that in keno the players choose the numbers on
their ticket.
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EXAM Strategy
Question: Otto signed a lease with Landlord on a storefront in Georgetown, D.C.
He convinced his nephew Nick to start a furniture store in the space. Otto and Nick
formed a corporation to operate the store. Otto owned 51 percent and Nick 49 percent
of the company’s stock. Otto signed a lease between himself and the store at a price
that was 20 percent higher than the rent Otto was paying Landlord. Otto purchased a
warehouse and then rented it to the corporation at a fair-market rent. Nick sued,
alleging that the two leases were not valid. Were they?
Strategy: If the business judgment rule applies, the court will not second-guess a
corporate action. But here, the manager engaged in self-dealing, so the business
judgment rule is not applicable.
Result: Otto violated the duty of loyalty twice. The lease for the storefront was self-
dealing—it directly benefited him. When he purchased the warehouse, he took a
corporate opportunity that he should have offered first to the company. He is
personally liable for any damages to the corporation. The company also has the right
to cancel both leases and to purchase the warehouse from him.
Although Bellino and Anderson were both involved
in Lottery, Bellino spent more time, in part because of his
personal relationship with Lottery’s lounge manager. During
this period,Bellinodidnot complain toAnderson abouthis lack
of involvement in Lottery, and Anderson never refused to do
anything that Bellino asked him to do.
Resentful of Anderson’s work ethic, Bellino set up a
meeting with LaVista’s city administrator. Until that meet-
ing, the city had been satisfied with Lottery’s performance.
But after the meeting, the administrator recommended to
the city council that the keno contract be put up for compe-
titive bid. Bellino incorporated LaVista Keno, Inc., to bid on
the contract.
Bellino wrote to Anderson complaining that he (Bel-
lino) was doing too much work for Lottery at too little pay.
(Evidently, $4 million is not as much as it used to be.)
Therefore, Bellino intended to resign from Lottery and
bid on the city contract himself. Anderson offered to do
more work or whatever Bellino wanted, but Bellino
refused any effort at reconciliation. He then submitted a
bid on behalf of Keno. At the time he submitted the bid,
he was still an officer of Lottery, as well as a director and a
50 percent shareholder. Anderson also bid on the contract
on behalf of Lottery. The city awarded the new
contract to Keno.
Anderson and Lottery filed suit against Bellino and
Keno, alleging that they had usurped a corporate oppor-
tunity. The lower court found for Anderson and Lottery.
It ordered Bellino to pay $644,992.63 but provided that
Bellino could receive a credit of $172,514.63 against the
judgment if Bellino transferred the stock of Keno to
Lottery and persuaded the city to relicense the keno
contract from Keno to Lottery.
Issues: Did Bellino usurp a corporate opportunity? Is he
liable to Lottery?
Decision: Affirmed.Bellinousurpedacorporateopportunity.
Hemust comply with the lower court’s order to pay Lottery.
Reasoning: Bellino argued that the corporate opportu-
nity was simply the right to bid on the keno contract. But
that is not true—the opportunity was the keno contract
itself. The right to bid was simply a preliminary step
toward obtaining the opportunity.
Because an officer or director has a fiduciary obliga-
tion, he must always act in good faith in his dealings with
the corporation. He is liable if he causes harm to the
corporation or deprives it of business.
By winning the keno contract, Bellino deprived Lot-
tery of its only business. He should never have bid on the
contract himself.
CHAPTER 29 Corporations 711
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29-6c Duty of Care
In addition to the duty of loyalty, managers also owe a duty of care. The duty of care requires
officers and directors to act in the best interests of the corporation and to use the same care
that an ordinarily prudent person would take in a similar situation.
RATIONAL BUSINESS PURPOSE
Courts generally agree in principle that directors and officers are liable for decisions that
have no rational business purpose. In practice, however, these same courts have been
extremely supportive of managerial decisions, looking hard to find some justification. For
years, the Chicago Cubs baseball team was the only major American professional sports
team to play in a stadium without lights. A shareholder sued on the grounds that the Cubs’
revenues were peanuts and crackerjacks compared with those generated by teams that
played at night. In their defense, the Cubs argued that a large night crowd would cause
the neighborhood to deteriorate, depressing the value of Wrigley Field (which the Cubs did
not own). The court rooted for the home team and found that the Cubs’ excuse was a
“rational purpose” and a legitimate exercise of the business judgment rule.5
LEGALITY
Courts are generally unsympathetic to managers who engage in illegal behavior, even if
their goal is to help the company. For example, the managing director of an amusement
park in New York State used corporate funds to purchase the silence of people who
threatened to complain that the park was illegally operating on Sunday. The court ordered
the director to repay the money he had spent on bribes, even though the company had
earned large profits on Sundays.6
INFORMED DECISION
Generally, courts will protect managers who make an informed decision, even if the decision
ultimately harms the company. Making an informed decision means carefully investigating
the facts. However, even if the decision is uninformed, the directors will not be held liable if
the decision was entirely fair to the shareholders.
Exhibit 29.5 provides an overview of the duty of care.
EXAM Strategy
Question: You are the CEO of a software company. You will allow your engineers to
create software only for Apple computers, not for PCs, because you think Apple is
cooler. Some of your shareholders disagree with this policy. Is your decision protected
by the business judgment rule?
Strategy: Remember that you owe a duty of care to the corporation. This means that
you must have a rational business purpose for your decision.
Result: The courts are very generous in defining a rational business purpose. They
would probably uphold your decision so long as it was not in some way personally
benefiting you—for example, so long as you were not a major shareholder of Apple.
5Shlensky v. Wrigley, 95 Ill. App. 2d 173, 237 N.E.2d 776, 1968 Ill. App. LEXIS 1107 (Ill. App.
Ct. 1968).
6Roth v. Robertson, 64 Misc. 343, 118 N.Y.S. 351, 1909 N.Y. Misc. LEXIS 279 (N.Y. 1909).
Duty of care
The requirement that a
manager act with care and in
the best interests of the
corporation.
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29-7 THE ROLE OF SHAREHOLDERS
We have explored the duties and responsibilities of directors and managers. In this section, we
look at shareholders’ rights—what control do they exercise over the enterprises they own?
The topic of shareholder rights is contentious. As pointed out earlier, in this century, we
have already experienced two financial meltdowns—one at the beginning of the 2000s and
one at the end—that starkly revealed the different incentives faced by shareholders and
managers. Too often, managers earned exorbitant compensation from highly risky short-term
decisions that in the longer run left shareholders holding an empty bag. If CEOs made a risky
decision that paid off, they profited enormously. If the decision failed, they might be fired,
but they would still get to keep all the generous compensation they had received. On the way
out the door, many also got severance payments that left them wealthy beyond most people’s
dreams. For example, in the two years before the investment banks Bear Stearns Companies,
Inc., and Lehman Brothers Holdings, Inc., failed, their top five executives took home
$1.4 billion and $1 billion, respectively, even as their shareholders were left with nothing.
Even worse, investigations after the fact revealed that too many managers had gamed
compensation plans, stacked their boards with friends, and ignored shareholder interests.
Compliant boards had been little more than rubber stamps, approving whatever the officers
wanted. In anger and frustration, shareholders, Congress, the Securities and Exchange
Commission (SEC), and stock exchanges undertook an unprecedented effort to rebalance
corporate power. Yet these changes are little more than a shot in the dark, without compel-
ling evidence that they will enhance financial stability or improve shareholder results.
A note before we begin: At one time, corporate stock was primarily owned by indivi-
duals. But now institutional investors—pension plans, mutual funds, insurance companies,
No liability;
decision stands
Decision is NOT
entirely fair to shareholders
Manager may be liable;
decision may be revoked
Manager Makes a Decision
Decision meets
the duty of care
Uninformed
decision
Illegal
decision
No rational
business purpose
Decision is entirely
fair to shareholders
EXHIB IT 29.5 The Duty of Care
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CHAPTER 29 Corporations 713
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banks, foundations, and university endowments—own more than 50 percent of all shares
publicly traded in the United States. Institutional investors, with enormous sums to invest,
have little choice but to buy the stock of large companies. If they are unhappy with
management, it is difficult for them to do the “Wall Street walk”—that is, sell their
shares—because a sale of their large stock holdings would depress the market price. And
where would they invest the proceeds? Institutional investors cannot profit simply by
trading shares among themselves. For better or worse, the fate of fund managers hangs on
the success of these large companies.
29-7a Rights of Shareholders
Shareholders have neither the right nor the obligation to manage the day-to-day business of
the enterprise. If you own stock in Starbucks Corp., your share of stock plus $7.62 entitles
you to a cup of Grande Vanilla Latte, the same as everyone else. By the same token, if the
pipes freeze and the local Starbucks store floods, the manager has no right to call you, as a
shareholder, to help clean up the mess. What rights do shareholders have?
RIGHT TO INFORMATION
Shareholders have the right to obtain certain information about the company they own, but
the extent of this right depends on whether the organization is publicly or privately held.
(A private corporation’s stock is not publicly traded.) All corporations are regulated by state
law, but publicly traded enterprises must also meet SEC standards, which require much
more extensive information.
Under the Model Act, shareholders acting in good faith and with a proper purpose have
the right to inspect and copy the corporation’s minute book, accounting records, and
shareholder lists. A proper purpose is one that aids the shareholder in managing and
protecting her investment. If, for example, Celeste is convinced that the directors of Devil
Desserts, Inc., are mismanaging the company, she might demand a list of other shareholders
so that she can ask them to join her in a lawsuit. This purpose is proper—although the
company may not like it—and the company is required to give her the list. If, however,
Celeste wants to use the shareholder list as a potential source for her new online business
selling exercise equipment, the company could legitimately turn her down.
RIGHT TO VOTE
A corporation must have at least one class of stock with voting rights.
Shareholder Meetings Although not all states require public companies to hold an
annual meeting of shareholders, the New York Stock Exchange (NYSE) and NASDAQ
require companies listed with them to do so. Thus, annual shareholder meetings are the
norm for publicly traded companies.
Companies whose stock is not publicly traded can either hold an annual meeting or use
written consents from their shareholders. In addition, under the Model Act, shareholders
owning at least 10 percent of the company’s stock and the board of directors each have the
right to call a special meeting to vote on an emergency issue that cannot wait until the next
annual meeting—for example, to conclude a merger or sell off substantial assets.
Everyone who owns stock on the record date must be sent notice of a meeting, whether
it is an annual or special meeting. The record date can be any day that is no more than
70 days before the meeting. The votes taken at a shareholder meeting are not valid unless a
quorum is present, meaning that shareholders owning a certain percentage of the shares are
represented, either in person or by proxy.
Companies are permitted to hold shareholder meetings online rather than in person.
Many companies do both—conducting a live meeting with virtual access. In 2010, Symantec
Corporation became the first Fortune 500 company to eliminate the in-person meeting and
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hold a virtual-only version. Unfortunately, the company used this opportunity to limit rather
than expand access. It broadcast only in audio, not video, which meant that participants had
no opportunity to read body language or even realize that three directors were absent. In the
question-and-answer period, management read and answered only two questions from
shareholders and provided no opportunity for follow-up questions. Nor did they reveal
who had asked the questions, or even what questions they had chosen not to answer.
Ethics Symantec’s actions in holding a virtual shareholder meeting were legal. If you
had been a shareholder and had attended the meeting in cyberspace, would
you have been satisfied with the company’s virtual format? Did Symantec do the right thing?
Proxies Shareholders who do not wish to attend a shareholders’ meeting may appoint
someone else to vote for them. Confusingly, both this person and the document the
shareholder signs to appoint the substitute voter are called a proxy. Under SEC rules,
companies are not required to solicit proxies, but virtually all of them do because the NYSE
and NASDAQ require it, and in addition, that is the only practical way to obtain a quorum.
Along with the proxy, the company must also give shareholders a proxy statement and an
annual report. The proxy statement provides information on everything from management
compensation to a list of directors who miss too many meetings. The annual report contains
detailed financial data.
Shareholder Proposals Shareholders who oppose a particular company policy may
use the proxy process to challenge that policy. Under SEC rules, any shareholder who has
continuously owned for one year at least 1 percent of the company or $2,000 of stock can
require that one proposal be placed in the company’s proxy statement to be voted on at the
shareholder meeting. Most of these proposals involve issues of corporate governance (e.g.,
permitting secret ballots), executive compensation (e.g., “say on pay”), social issues (e.g.,
healthcare reform) or environmental policy (e.g., greenhouse gases). Prior to 1985, only two
proposals had been approved—ever. Recently, 37 percent of the corporate governance
proposals passed, but less than 5 percent of the others.
Note, however, that even if shareholders approve a proposal, the company may not
implement it. Resolutions are binding on a company only if they are within the narrow
realm of shareholder power. For example, because shareholders have the right to amend
company bylaws, such proposals are binding. But, a shareholder vote that requires the board
to take a specific action is not binding because shareholders have no legal right to manage
the company. Thus, even though the SEC requires companies to allow a vote on proposals
about succession planning, the board still does not have to develop a succession plan, even
if a majority of shareholders vote in favor. Most proposals are nonbinding, and companies
implement less than half of those that their shareholders approve.
Frustrated at this unresponsive behavior by boards, shareholders have begun to with-
hold their vote from any director who fails to support a successful shareholder proposal.
However, even this threat has not yet had a significant impact on board responsiveness to
shareholder proposals.
Ironically, companies sometimes implement shareholder proposals that have not
received support from a majority of the shareholders. The pressure of shareholder proposals
is credited with inducing many American companies to withdraw from South Africa in
protest against its apartheid regime. Other companies implement shareholder proposals
without even putting them up for a vote. Indeed, a substantial number of shareholder
proposals are now withdrawn before a vote because the company is willing to negotiate and
Proxy
The person whom a
shareholder appoints to vote
for her at a meeting of the
corporation. Also, the
document a shareholder signs
appointing this substitute voter.
Proxy statement
Before its annual meeting, a
public company provides a
document to shareholders that
contains information about the
corporation.
Annual report
A document that the SEC
requires public companies to
provide to their shareholders
each year. It contains financial
data.
CHAPTER 29 Corporations 715
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accommodate. For instance, Colgate-Palmolive Co. agreed to a proposal by institutional
investors to permit secret ballots at shareholder meetings.
ELECTION AND REMOVAL OF DIRECTORS
The process of electing directors to the board of a publicly traded company is different from
what most people think. Shareholders do not have the right to use the company’s proxy
statement to propose nominees for director. Instead, the nominating committee of the board
of directors produces a slate of directors, with one name per opening. Typically, the names
are approved by the CEO. This slate is then placed in the proxy statement and sent to
shareholders, whose only choice is to vote in favor of a nominee or to withhold their vote
(i.e., not vote at all). If shareholders want to vote for someone who was not selected by
the company, they have to nominate their own slate, prepare and distribute a proxy
statement to other shareholders, and then communicate why their slate is superior, all the
while fighting against the company’s almost unlimited financial resources. This process is
complex, expensive, and disruptive to the company. Not surprisingly, only a few share-
holder groups undertake this effort each year. Recent research does indicate, however,
that companies with a director elected through proxy contests outperform their peers over
both the short and long term.7
This traditional corporate voting method is called plurality voting. A successful candi-
date does not need to receive a majority vote—he must simply receive more than any
competitor. Since typically there are no competitors, one vote is sufficient (and that vote
could be his own). Even if a large number of shareholders withhold their votes, the nominee
may be embarrassed, but so long as he receives that one vote, he is elected. Thus, for
example, in the waning years of Michael Eisner’s rule at Disney Enterprises Inc., share-
holders withheld 43 percent of their votes from him. But that vote of no confidence did not
cause the board to fire him, nor did he immediately resign. Congress, other regulators, and
major shareholders are now reforming corporate democracy in an effort to rebalance the
relationship between managers and shareholders.
Majority Voting Systems Because of pressure from shareholder activists, 79 percent
of the S&P 500 (which consists of large companies) now refuse to seat a director if fewer
than half of the shares that vote tick off her name on the ballot. However, of smaller
companies—those in the Russell 3000 index—three-quarters still permit plurality voting,
where one vote is often sufficient to insure election.8
Independent Directors Congress began its reform effort by passing the Sarbanes-
Oxley Act (SOX), which applies to all publicly traded corporations in the United States, as
well as to all foreign companies listed on a U.S. stock exchange. Among other provisions,
SOX stipulates that all members of a board’s audit committee must be independent, and at
least one of these members must be a financial expert. Independent directors are those who
are not employees of the company and, therefore, presumably not in the pocket of the CEO.
Likewise, the NYSE and NASDAQ require that, for companies listed on these exchanges,
• Independent directors must comprise a majority of the board;
• They must meet regularly on their own, without inside directors;
7The Investor Responsibility Research Center Institute. See http://www.iminstitute.org/pdf/PR_5_25_09 .
8The S&P 500 is composed of 500 leading companies in the most important U.S. industries, while the
Russell 3000 is made up of the largest 3,000 companies in the United States, representing 98 percent
of the investable U.S. equity market.
Plurality voting
To be elected, a candidate only
needs to receive more votes
than her opponent, not a
majority of the votes cast.
716 U N I T 4 Employment, Business Organizations and Property
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• Only independent directors can serve on audit, compensation, or nominating
committees;
• Audit committees must have at least three directors who are financially literate.
The effectiveness of these reforms is uncertain. One study found that 45 percent of
directors who are technically “independent” have friendship ties to the CEO. And even
independent directors are often financially beholden to the CEO. At a minimum, the CEO
is more likely to fire them from their lucrative directorship than shareholders are, so their
incentives are often more aligned with the CEO. Some commentators even argue that
because independent directors do not work full time for the company, they know less about
what is really going on and have to rely more on company executives.
What happens to independent directors who fail to carry out their watchdog responsibilities?
Unless they personally committed fraud, the answer is: not much. After all, if the SEC were
aggressive about going after independent directors, few people would be willing to serve in that
role. Even if they are sued, the corporation or its insurance company usually pays the damages.
Shareholder Activists Proxy advisors, such as Institutional Shareholder Services, Inc.
(ISS), are a new development in corporate democracy. They advise institutional investors on
how to vote their shares. Proxy advisors and hedge funds (who often have substantial stock
holdings) wield significant power. ISS alone can affect up to 20 to 40 percent of the vote at a
company. Corporate managers argue that it is too much power because (1) activists may
well have an agenda that is contrary to that of other shareholders, and (2) they tend to
support corporate governance initiatives without proof of effectiveness.
In any event, boards have becomemore responsive to the demands of shareholder activists
and, as a result, are more likely to replace executives who perform badly, either in their
corporate or personal lives. For example, the board of Hewlett-Packard fired CEOMark Hurd
for a combination of reasons that included his fudging of expense reports to hide his relation-
ship with someone who accused him of sexual harassment, and, perhaps worst of all, bad press.
Proxy Access By a 3–2 vote of the commissioners, the SEC approved proxy access
rules that required companies to include in their proxy material the names of board
nominees selected by large shareholders (i.e., those who had owned 3 percent of the
company for three years). But when business groups sued the SEC to prevent implementa-
tion, a federal appeals court invalidated the proxy access rule on the grounds that the SEC
had not followed required procedures in adopting it. The SEC elected not to appeal this
decision.9 However, proxy access survives in a weakened form: The SEC permits share-
holders to make proposals that, if approved, would change company bylaws to require proxy
access. This two-step process is more complicated, and less likely to succeed, than the one-
step version the SEC originally proposed. Also, such proposals are binding on the company
only if state law permits. Such a proposal could be binding in Delaware.
The effectiveness of this rule change is uncertain. At this stage, it has not altered the
reality that for most companies, shareholders have little say on board nominations.
COMPENSATION FOR OFFICERS AND DIRECTORS—THE PROBLEM
As we have seen, a CEO has significant influence over the selection process for the company’s
board of directors. So directors have an incentive to keep the CEO happy. As a result,
between 2001 and 2003, public companies spent 9.8 percent of their net income on compen-
sation for top executives. In 1975, the top 100 CEOs earned 39 times as much as the average
worker. By 2005, that ratio was over 300. See Exhibit 29.6 for an illustration of this trend. Here
are some examples of executive compensation that particularly agitated shareholders:
9Business Roundtable v. SEC, 2011 U.S. App. LEXIS 14988 (D.C. Cir. 2011).
CHAPTER 29 Corporations 717
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• Michael Eisner was the head of Walt Disney Corporation for 20 years. At the
beginning of his tenure, the company did very well and few complained when he was
exceedingly well paid. But for the final 13 years, he earned $800 million while the
stock performed worse than government bonds (a low-risk, low-return investment).
• The CEO of Fannie Mae earned $90 million during a time when the company’s
accounting system was so flawed that it overstated its earnings by $11 billion.
• Executives whose companies survived the 2008 financial crisis only because of
taxpayer bailouts still received enormous bonuses. For example, taxpayers spent
$180 billion to save American International Group (AIG), Inc., even as the company
awarded bonuses of $165 million.
To many investors, sky-high executive salaries have become the symbol of all that is
wrong with corporate governance. In many companies, salaries are the least of the compen-
sation. Executives also received:
Stock Options Concerned about escalating executive salaries, shareholder activists
began advocating “pay-for-performance” plans. The theory was that if executives received
stock options instead of cash salaries, their incentives would be more closely aligned with
those of shareholders. It was a good theory, but in practice, it did not work as intended.
Stock options became a “heads, I win; tails, you lose” game. When stock prices soared
in a bull market, options became unexpectedly valuable. In some cases, managers were
600x
500x
400x
300x
200x
100x
0x
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
EXHIB IT 29.6 CEOs’ Pay as aMultiple of the AverageWorker’s Pay, 1960–2007
Source: Executive Excess 2008, the 15th Annual CEO Compensation Survey from
the Institute for Policy Studies and United for a Fair Economy.10
10Prepared by Professor G. William Miller, University of California at Santa Cruz, http:llsociology.ucsc.
edul whorulesamericalpowerlwealth.html.
718 U N I T 4 Employment, Business Organizations and Property
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richly rewarded even when their company had underperformed the (rising) market. How-
ever, when stock prices fell, boards lowered the price of the options.
Also, companies played games with options. After the 9/11 terrorist attack, the stock
market was closed for four days. When it reopened, stocks took a bigger plunge than they
had in any week since Nazi Germany invaded France at the beginning of World War II. In
what appeared to be an unseemly exploitation of a national tragedy, 186 companies granted
stock options to 511 executives during those few weeks. That is more than twice the
number of companies that usually issued stock options in September.11 These grants were
legal, at least; not so the backdated options that more than 2,000 companies appear to have
issued their executives. In granting these options, companies claimed that they had been issued
on an earlier date when the stock price was lower. This practice is fraud.
Termination, Retirement Plans, and Death Benefits Most public companies
provide their top executives with generous termination payments, no matter how they leave
their jobs. Indeed, many CEO employment contracts provide that the employee is entitled to
severance pay unless fired for committing a particular type of felony. Dying also pays. For
example, Nabor Industries Ltd. agreed to pay its 78-year-old CEO $263 million when he dies.
The CEO of the Shaw Group was entitled to $17 million if he does not compete with the
company after he dies. (Yes, you read that right—he was paid not to compete after his death.)
Lavish Perks Executives had long received perks such as country club memberships
and cars, but the roster of options expanded. One of the most popular perks is use of the
corporate jet. One study found a high correlation between the use of the company plane and
membership in far-flung golf clubs. Unfortunately, the correlation is inverse: The more
companies spend on private jets, the worse their stock performs.
Why has executive pay become so lavish?
Directors, not Shareholders, Set Executive Compensation Directors set the
CEO’s compensation, but shareholders are the ones who pay the money. People tend to
spend someone else’s money more generously than their own. Also, directors and the CEO
are often friends. Imagine if you got to decide how much your friend could spend dining
out, knowing that someone else, whom you had never met, would have to pay the bill. It
would be easy to be generous.
Shareholders Bear the Risk Once again, executive compensation is a “Heads I win,
tails you lose” game. As we discussed earlier in the chapter, if CEOs make a risky decision
that pays off, they typically profit enormously. But even if the decision turns out badly, they
are often well paid anyway. For example, Randall Stephenson, the CEO of AT&T,
proposed that his company buy T-Mobile USA. A clever idea, except that the purchase
violated the antitrust guidelines of the Justice Department. The risk that the government
would not approve the deal was well known. Nonetheless, Stephenson promised that
AT&T would pay T-Mobile $4.2 billion if the deal fell apart. The government did indeed
object, the deal was scuttled, and AT&T had to make the enormous payment to T-Mobile.
In response, the AT&T board imposed a punishment on Stephenson that was so harsh it
made headlines: His compensation was reduced by $2.08 million to only $18.7 million. That
was the penalty for losing $4.2 billion of shareholder money.
Benchmarking Games Compensation is rarely linked closely to individual perfor-
mance, but instead to overall industry or stock market performance, which is defined in a
way to favor executives. Two-thirds of the largest 1,000 U.S. companies report that they
11Charles Forelle, James Bandler, and Mark Maremont, “Executive Pay: The 9/11 Factor,” The Wall
Street Journal, July, 15, 2006, p. A1.
CHAPTER 29 Corporations 719
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performed better than their peers.12 That is, in part, because benchmarks can be manipu-
lated. For example, Tootsie Roll Industries Inc., with $500 million in sales, benchmarked
against Kraft Foods Inc., with $42.2 billion in earnings. Indeed, every company Tootsie Roll
benchmarked against had higher revenues.
Campbell Soup used one set of benchmark companies to determine executive com-
pensation, but another set to evaluate its total shareholder return. In all fairness, it seems
that Campbell’s ought to be consistent—presumably only one set of companies is the right
comparison group.
The CEO Gets All the Credit Compensation committees sometimes act as if the
CEO (and maybe a few other top executives) are solely responsible for a company’s success.
Although there is much talk about “pay for performance,” the reality is that luck can be as
important a determinant of executive compensation as good performance.13 After James
Kilts became CEO of Gillette Co., the stock price went up 61 percent. He had added
$20 billion in shareholder value, and therefore, to many it seemed only fair when he was
rewarded with a $153 million payout when Procter & Gamble bought the company. Or was
it? About half the increase in Gillette revenues during the time that Kilts was running the
show were attributable to currency fluctuations. A cheaper dollar increased revenue over-
seas. If the dollar had moved in the opposite direction, there might not have been any
increase in revenue.
The Busier the Directors, the Higher the Executive Pay Generally, executives
are more likely to be overpaid if directors serve onmany boards. These directors may be too busy
to pay attention to such details. Also, trophy directors may be afraid that if they offend a chief
executive at one company, word will get around, jeopardizing their position on other boards.
Most Executives Are Above Average Of course, not everyone can be above
average, but most directors believe that their executives are. No one wants to admit to
hiring incompetents. Suppose that you are on a company’s compensation committee and
have data about industry averages. If your executives are above average in performance, you
should pay them above-average salaries. If they are not above average, you should fire them,
which few boards want to do, except in the face of disaster. If you raise salaries, the industry
average also rises. The next company that sets compensation has an even higher bar to
jump. For example, Colgate-Palmolive awarded 2 million stock options to its CEO on the
understanding that he would receive no further grants for five years. Three years later,
however, when consultants found that the CEO’s compensation had fallen below the
median, the company immediately awarded him an additional 2.6 million options.
Compensation Consultants Often Have Conflicts of Interest Many compa-
nies hire compensation consultants to offer advice on executive pay. These same consultants
may also provide other services to the company—such as human resource management—for
which the fees can be substantial. The consultants have every incentive to suggest generous
packages. In any event, it is not their money.
To make matters even worse for shareholders, lavish compensation does not appear to
improve a business’s success. A study of the 58 companies that were most generous to their
CEOs found that, on average, these companies significantly underperformed both the
market generally and their industry in particular.14
12Kevin J. Murphy, “Politics, Economics and Executive Compensation,” reported in Lucian Bebchuk
and Jesse Fried, Pay Without Performance, Harvard University Press, 2004, p. 71.
13See, for example, Marianne Bertrand and Sendhil Mullainathan, “Are CEOs Rewarded for Luck?
The Ones Without Principals Are,” The Quarterly Journal of Economics, August 2001.
14Reed Abelson, “Who Profits If the Boss Is Overfed?” New York Times, June 20, 1999, Business
Section, p. 9.
720 U N I T 4 Employment, Business Organizations and Property
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Corporate executives are not the only people to earn fabulous salaries. Some athletes earn
more even than CEOs.What is the difference between athletes and executives (besides a hook
shot)? Athletes’ salaries are negotiated at arm’s length with the team owner who will actually be
paying the bill. This negotiation process means that (1) athletes’ pay is not camouflaged; (2)
they do not receive enormous severance packages on their way out the door; and (3) their
retirement pay is modest.15 Also, an athlete’s performance is transparent and easy to measure.
COMPENSATION FOR OFFICERS AND DIRECTORS—A SOLUTION?
The federal government has begun to respond to these compensation issues.
Proxy Rules The SEC began this process by amending its proxy rules to require more
information about executive compensation. A proxy statement must now include a summary
table setting out the full amount of compensation for the five highest-earning executives.
The company must explain, for example, why option grants were approved and how much
retirement benefits are worth. Companies must also disclose if the pay package increases
the risk of large losses. The goal of this provision is to discourage companies from offering
pay plans that reward executives for taking excessive risks.
Sarbanes-Oxley Under SOX:
• A company cannot make personal loans to its directors or officers.
• If a company has to restate its earnings, its CEO and CFO must reimburse the
company for any bonus or profits they received from selling company stock within a
year of the release of the flawed financials. This is a so-called claw-back provision.
Dodd-Frank In 2010, Congress passed the Dodd-Frank Wall Street Reform and Con-
sumer Protection Act. Dodd-Frank:
• Requires that compensation committees for all companies listed on a stock exchange
must be composed solely of independent directors.
• Strengthens the claw-back provisions of SOX and extends it to three years.
• Requires “say on pay.” At least once every three years, companies must take a
nonbinding shareholder vote on executive compensation (i.e., for executive officers,
but not for directors). In 2010, for the first time ever, shareholders voted against an
executive pay plan—54 percent of Motorola’s shareholders opposed CEO Sanjay
Jha’s compensation. The board had promised him 3 percent of the company if the
plan to split Motorola in two succeeded, or a guaranteed payment if it did not. This
vote was nonbinding, and the company made no concrete promises to respond.
• At least once every six years, companies must take a nonbinding shareholder vote on how
often to hold the say-on-pay vote—once a year, every two years, or every three years.
• In the event of a merger or sale of all company assets, shareholders have the right to a
nonbinding vote on so-called golden parachutes—special payments to executives that
result from the transaction.
• Companies must disclose the relationship between financial performance and the
executive compensation they actually paid.
• Companies must disclose the CEO’s compensation and the median compensation of
all other company employees, as well as the ratio of these two numbers.
15Some of the material in this section on executive compensation is drawn from Lucian Bebchuk and
Jesse Fried, Pay Without Performance, Harvard University Press, 2004.
CHAPTER 29 Corporations 721
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Even with these new protections in place, shareholder influence over executive com-
pensation is far from guaranteed. Note that the shareholder resolutions are nonbinding. And
there is little shareholders can do to challenge executive compensation in the courts. To be
successful, shareholders must prove that the board violated the business judgment rule,
either by making a decision that was grossly uninformed or by setting an amount so high that
it had no relation to the value of the services performed and was really a gift. As the following
case indicates, courts tend to be unsympathetic to this line of argument.
Emerging Growth Companies In an effort to encourage investment in growth
companies, Congress passed the Jumpstart Our Business Startups Act (the JOBS Act) in
2012. Under this statute, the Dodd-Frank rules about say-on-pay and the disclosure of
executive compensation do not apply to emerging growth companies (EGCs). An EGC is
one for which all the following statements are true:
• It has annual gross revenues of less than $1 billion (indexed for inflation).
• Its stock has been publicly traded for less than five years.
• It has issued less than $700 million in publicly traded stock.
• It has issued less than $1 billion in convertible debt in a three-year period.
FUNDAMENTAL CORPORATE CHANGES
A corporation must seek shareholder approval before undergoing any of the following
fundamental changes: a merger, a sale of major assets, dissolution of the corporation, or an
amendment to the charter.
BREHM V. EISNER
2006 Del. LEXIS 307
Supreme Court of Delaware, 2006
C A S E S U M M A R Y
Facts: Michael Ovitz founded Creative Artists Agency,
the premier talent agency in Hollywood. As a partner at
this firm, he earned between $20 and $25 million per year.
He was also a long-time friend of Michael Eisner, who
recommended that Disney hire him as president. Upon
the advice of Graef Crystal, a compensation consultant,
the board approved Ovitz’s contract.
After 14 months, all parties agreed that the experiment
had failed, so Ovitz left Disney—but not empty-handed.
Under his contract, he was entitled to $130 million in
severance pay.
Shareholders of Disney sued the board, alleging that
it had violated the business judgment rule by failing to
exercise due care.
Issues: DidDisney directors violate the business judgment rule?
Decision: No, the board complied with the business
judgment rule.
Reasoning: The board’s choice of Graef Crystal as a
compensation advisor was reasonable. He was well known
and highly regarded in this field. Once the board had
hired him, it was reasonable to rely on his advice. It is
true that the behavior of the board did not meet a “best
practices” standard—it could have done a more thorough
job of understanding the contract. But the business judg-
ment rule does not require best practices. Its purpose is to
protect directors who act in good faith and the board did
meet that standard. Moreover, the contract had a rational
business purpose: to induce Ovitz to leave Creative Artists
Agency and join Disney. For these two reasons, the board
did not breach its duty of care.
722 U N I T 4 Employment, Business Organizations and Property
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RIGHT TO DISSENT
Because a private corporation does not have publicly traded stock, its shareholders may not
have an easy way to sell their holdings. Therefore, if a private corporation decides to
undertake a fundamental change, the Model Act and many state laws require the company
to buy back the stock of any shareholders who object. This process is referred to as
dissenters’ rights, and the company must pay “fair value” for the stock. Fundamental
changes include a merger or a sale of most of the company’s assets.
RIGHT TO PROTECTION FROM OTHER SHAREHOLDERS
Anyone who owns enough stock to control a corporation has a fiduciary duty to minority
shareholders. (Minority shareholders are those with less than a controlling interest.) The
courts have long recognized that minority shareholders are entitled to extra protection
because it is easy (perhaps even natural) for controlling shareholders to take advantage of
them.
Although craigslist and eBay are both Internet companies, they have little in common
(other than a lowercase first letter). What obligations do they owe each other? You be the
judge.
You Be the Judge
Facts: craigslist, Inc.,
owned the most popular
website in the country
for classified ads. It had
just two shareholders—
Craig Newmark and Jim
Buckmaster—and only
34 employees. Rather than trying to maximize its profits
or expand its business, craigslist focused instead on
enhancing its user community (by, for example, offering
free ads). eBay, Inc. was a publicly traded company that
operated online auction sites worldwide. It employed over
16,000 people. Its primary focus was increasing profitabil-
ity and market share.
eBay decided to buy 28.4 percent of craigslist’s
shares, with the goal of ultimately acquiring the com-
pany or, failing that, learning the “secret sauce” of
craigslist’s success. Under the explicit terms of the
deal, it had the right to compete with craigslist. New-
mark and Buckmaster said that if eBay was able to offer
customers a better experience, then it should be
allowed to do so.
When eBay realized that the two men would never
sell craigslist to them, at least in this lifetime, it launched a
competing classifieds website at www.Kijiji.com. In this
process, it used nonpublic information about craigslist
that it garnered from its relationship with the company.
When the two men found
out about this “betrayal,”
they demanded that eBay
sell back its craigslist
stock. eBay refused.
Newmark and Buck-
master, in their role as
directors of craigslist, responded by prohibiting eBay from
buying more shares of craigslist or selling its existing
shares to anyone other than themselves. In response,
eBay filed suit, alleging that the two men had violated
the company’s fiduciary rights to eBay as a minority
shareholder.
You Be the Judge: Did Newmark and Buckmaster violate
their fiduciary duty to the minority shareholder?
Argument for Newmark and Buckmaster: eBay has
deliberately harmed craigslist by competing against it.
And it used confidential information to do so! eBay does
not deserve minority protection.
eBay has never grasped that craigslist’s success is
largely due to its unique corporate culture. The best
way to protect shareholders is to prevent eBay (or any
other shareholder, for that matter) from undermining all
that makes craigslist exceptional. The only way to
achieve this goal is to prohibit eBay from buying more
stock or selling what they already own to someone who
could be even worse.
Dissenters’ rights
A privately held company must
buy back the stock of any
shareholder who objects to a
fundamental change.
EBAY DOMESTIC HOLDINGS,
INC. V. NEWMARK
2010 Del. Ch. LEXIS 187
Court of Chancery of Delaware, 2010
CHAPTER 29 Corporations 723
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29-8 ENFORCING SHAREHOLDER RIGHTS
Shareholders in serious conflict with management have two different mechanisms for
enforcing their rights: a derivative lawsuit or a direct lawsuit.
29-8a Derivative Lawsuits
A derivative lawsuit is brought by shareholders to remedy a wrong that has been committed
against the corporation. The suit is brought in the name of the corporation, and all proceeds
of the litigation go to the corporation because it was the company that was harmed. Any
injury to the shareholders was indirect, affecting only the value of their stock. Thus, only
the corporation can bring suit in this situation.
Often in a derivative suit, the alleged wrong was committed by a corporate insider—
either an officer or director. But the board has to approve the litigation. How can share-
holders force the board to sue itself or some other insider? They have to make demand on
the board, meaning they have to ask the board to bring suit. Boards have the right to turn
down such a demand, and that is exactly what they generally do.
There is only one hope for shareholders: They have the right to file suit on behalf of the
corporation without first seeking the approval of the board if demand would be futile.
Demand is considered to be futile if the directors violated the duty of care or the duty of
loyalty that are required by the business judgment rule. Showing a violation of the business
judgment rule is, in essence, the only successful way to bring a derivative action.
In the Brehm v. Eisner case earlier in this chapter, shareholders of Disney wanted to sue
the board of directors over Michael Ovitz’s severance pay. But the shareholders had no right
to sue on their own behalf because it was the corporation that had been damaged. Any harm to
the shareholders was indirect, through the value of their shares in the company. As a result,
shareholders had to bring a derivative action, on behalf of the corporation. They made demand
on the board. But, of course, the board did not want to sue itself. And as you have seen, the
court decided that the decision to pay Michael Ovitz $130 million did not violate the
business judgment rule. Thus, the shareholders were denied their attempt to bring a
derivative lawsuit.
To take another example, shareholders wanted to sue directors of eBay, Inc. who had
personally received virtually guaranteed profits from initial public offerings run by invest-
ment bank Goldman Sachs even as they were hiring Goldman to do work for eBay. The
court held that the directors had had a conflict of interest that violated the business
judgment rule. Therefore, the shareholders could bring suit against them in the name of
the corporation without their permission.16
Argument for eBay: Controlling stockholders are fidu-
ciaries of the minority stockholders and must maximize
the value of their investment. Instead, Newmark and
Buckmaster have deliberately resisted making a profit.
They talk a lot about culture. Offering free ads may be
an essential component of a successful online classifieds
venture, but it is a sales tactic, not a culture.
Also, Newmark and Buckmaster are majority
shareholders. They can keep the company the way it
is for their entire lives, if they so desire, as long as
they hold onto their own shares. But their goal now
is to keep craigslist the same forever, even after their
deaths. Essentially, Newmark and Buckmaster regret
the deal they made with eBay, and have decided
that craigslist should be an eternal testament to their
greatness, unchanging forever. That may be their per-
sonal preference, but it is not a legitimate corporate
purpose.
16In re eBay, Inc. Shareholder Litigation, 2004 Del. Ch. LEXIS 4, (Del. 2004).
724 U N I T 4 Employment, Business Organizations and Property
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If shareholders are permitted to proceed with their derivative action, all damages go to
the corporation; the individual shareholders benefit only to the extent that the settlement
causes their stock to rise in value. Litigation is tremendously expensive. How can share-
holders afford to sue if they do not receive the damages? A corporation that loses a
derivative suit must pay the legal fees of the victorious shareholders. (Losing shareholders
are generally not required to pay the corporation’s legal fees.) Most derivative lawsuits are
brought by lawyers who seek out shareholders, persuade them to sue, and then collect a
good part of any settlement. Without this incentive, few shareholders would bring derivative
suits, and much corporate wrongdoing would go unchallenged. But this incentive system
also means that some meritless suits are brought.
29-8b Direct Lawsuits
Shareholders are permitted to sue the corporation directly only if their own rights have been
harmed. If, for example, the corporation denies shareholders the right to inspect its books
and records or to hold a shareholder meeting, they may sue in their own names and keep
any damages awarded. The corporation is not required to pay the shareholders’ legal fees;
winning shareholders can use part of any damage award for this purpose.
Chapter Conclusion
In corporations, shareholders without management skills complement managers without
capital. Although this separation between management and owners makes great economic
sense and has contributed significantly to the rise of the American economy, it also creates
complex legal issues. How can shareholders ensure that the corporation will operate in their
best interest? How can managers make tough decisions without being second-guessed by
shareholders? Balancing the interests of managers and shareholders is a complex problem
the law has struggled to resolve, without completely satisfying either side.
EXAM REVIEW
1. PROMOTERS Promoters are personally liable for contracts they sign before the
corporation is formed unless the corporation and the third party agree to a novation.
(p. 700)
Question: Ajouelo signed an employment contract with Wilkerson. The contract
stated: “Whatever company, partnership, or corporation that Wilkerson may form
for the purpose of manufacturing shall succeed Wilkerson and exercise the rights
and assume all of Wilkerson’s obligations as fixed by this contract.” Two months
later, Wilkerson formed Auto-Soler Co. Ajouelo entered into a new contract with
Auto-Soler providing that the company was liable for Wilkerson’s obligations
under the old contract. Neither Wilkerson nor the company ever paid Ajouelo. He
sued Wilkerson personally. Does Wilkerson have any obligations to Ajouelo?
Strategy: A promoter is not liable for a contract he signed on behalf of a yet-to-
be-formed corporation if the third party (in this case, Wilkinson) agrees to a
novation. (See the “Result” at the end of this section.)
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2. STATE OF INCORPORATION Companies generally incorporate in the state in
which they will be doing business. However, if they intend to operate in several
states, they may choose to incorporate in a jurisdiction known for its favorable
corporate laws, such as Delaware. (pp. 700–701)
3. THE CHARTER A corporate charter must generally include the company’s name,
address, registered agent, purpose, and a description of its stock. (pp. 701–703)
4. PIERCING THE CORPORATE VEIL A court may, under certain circumstances,
pierce the corporate veil and hold shareholders personally liable for the debts of the
corporation. (pp. 706–707)
5. TERMINATION Termination of a corporation is a three-step process requiring a
shareholder vote, the filing of “Articles of Dissolution,” and the winding up of the
enterprise’s business. (p. 707)
6. FIDUCIARY DUTY Officers and directors have a fiduciary duty to act in the best
interests of the shareholders of the corporation. Therefore, managers must maximize
shareholder value. (p. 708)
7. BUSINESS JUDGMENT RULE If managers comply with the business
judgment rule, a court will not hold them personally liable for any harm their
decisions cause the company, nor will the court rescind their decisions. The business
judgment rule has two parts: the duty of care and the duty of loyalty. (pp. 708–712)
8. DUTY OF LOYALTY Under the duty of loyalty, managers may not enter into an
agreement on behalf of their corporation that benefits them personally, unless the
disinterested directors or shareholders have first approved it. If the manager does not
seek the necessary approval, the business judgment rule no longer applies, and the
manager will be liable unless the transaction was entirely fair to the corporation.
(p. 709)
9. CORPORATE OPPORTUNITY Under the duty of loyalty, managers may not
take advantage of an opportunity that rightfully belongs to the corporation.
(pp. 709–711)
Question: Vern owned 32 percent of Coast Oyster Co. and served as president
and director. Coast was struggling to pay its debts, so Vern suggested that the
company sell some of its oyster beds to Keypoint Co. After the sale, officers at
Coast discovered that Vern owned 50 percent of Keypoint. They demanded that
he give the Keypoint stock to Coast. Did Vern violate his duty to Coast?
Strategy: Here, Vern has violated the duty of loyalty not once, but twice. (See
the “Result” at the end of this section.)
10. DUTY OF CARE Under the duty of care, managers must make honest, informed
decisions that have a rational business purpose. (p. 712)
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11. PROXIES Virtually all publicly held companies solicit proxies from their
shareholders. A proxy authorizes someone else to vote in place of the shareholder at
a company meeting. (p. 715)
12. SHAREHOLDER PROPOSALS Under certain circumstances, public
companies must include shareholder proposals in the proxy statement. (pp. 715–716)
13. INDEPENDENT DIRECTORS Under SOX, all members of a board’s audit
committee must be independent. For companies listed on the NYSE or NASDAQ,
independent directors must comprise a majority of the board, and only independent
directors can serve on audit, compensation, or nominating committees. (pp. 716–717)
14. EXECUTIVE COMPENSATION
• Under SOX, a company cannot make personal loans to its directors or officers. If
a company has to restate its earnings, its CEO and CFO must reimburse the
company for any bonus or profits they received from selling company stock within
a year of the release of the flawed financials.
• Dodd-Frank requires shareholder “say on pay.” In addition, companies must
disclose the CEO’s compensation and the median compensation of all other
company employees, as well as the ratio of these two numbers.
• Under the JOBS Act of 2012, the Dodd-Frank rules about say-on-pay and
disclosure of executive compensation do not apply to emerging growth
companies. (pp. 717–722)
15. DISSENTERS’ RIGHTS A shareholder of a privately held company who
objects to a fundamental change in the corporation can insist that her shares be
bought back at fair value. (p. 723)
16. MINORITY SHAREHOLDERS Controlling shareholders have a fiduciary duty
to minority shareholders. (pp. 723–724)
17. DERIVATIVE LAWSUITS A derivative lawsuit is brought by shareholders to
remedy a wrong to the corporation. The suit is brought in the name of the
corporation, and all proceeds of the litigation go to the corporation. (pp. 724–725)
18. DIRECT LAWSUITS Shareholders are permitted to sue the corporation directly
only if their own rights have been harmed. (p. 725)
Question: Daniel Cowin was a minority shareholder of a public company that
developed real estate in Washington, D.C. He alleged numerous instances of
corporate mismanagement, fraud, self-dealing, and breach of fiduciary duty by the
board of directors. He sought damages for the diminished value of his stock.
Could Cowin bring this suit as a direct action, or must it be a derivative suit?
Strategy: If the wrong was to the corporation, then Cowin must bring a derivative
lawsuit. He can only bring a direct action if the harm was to him personally. (See
the “Result” at the end of this section.)E
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1. Result: Wilkerson may have had an ethical obligation to Ajouelo, but not a legal
one. The court held that the second contract was a novation, which ended Wilk-
erson’s obligations under the first contract.
9. Result: If the shareholders and directors did not know of Vern’s interest in
Keypoint, they could not evaluate the contract properly. Vern should have told
them. Also, by purchasing stock in Keypoint, Vern took a corporate opportunity. He
had to turn over any profits he had earned on the transaction, as well as his stock in
Keypoint.
18. Result: The court ruled that the injury had fallen equally on all the share-
holders, and therefore Cowin could only bring a derivative suit.
MULTIPLE-CHOICE QUESTIONS
1. CPA QUESTION Generally, a corporation’s articles of incorporation must include
all of the following except:
(a) the name of the corporation’s registered agent.
(b) the name of each incorporator.
(c) the number of authorized shares.
(d) the quorum requirements.
2. CPA QUESTION A corporate stockholder is entitled to which of the following
rights?
(a) Elect officers.
(b) Receive annual dividends.
(c) Approve dissolution.
(d) Prevent corporate borrowing.
3. Participating preferred stockholders:
(a) only receive payment after other preferred shareholders have been paid.
(b) only receive payment after common shareholders have been paid.
(c) are treated like both a preferred shareholder and a common shareholder.
(d) receive all their payments before all other shareholders.
4. If a manager engages in self-dealing, which of the following answers will NOT protect
him from a finding that he violated the business judgment rule?
(a) The disinterested members of the board approved the transaction.
(b) The transaction was of minor importance to the company.
(c) The disinterested shareholders approved the transaction.
(d) The transaction was entirely fair to the corporation.
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5. The duty of care:
(a) is not a requirement of the business judgment rule.
(b) protects directors who make an uninformed decision if it was entirely fair to the
company.
(c) protects a decision that has a rational business purpose, even if the activity was
illegal.
(d) will not protect directors who make a decision that harms the company.
6. The president of R. Hoe & Co., Inc., refused to call a special meeting of the
shareholders although 55 percent of them requested it. One purpose of the meeting
was to reinstate the former president. Do shareholders have the right to make these
two requests?
(a) Yes to both.
(b) No to both.
(c) The shareholders have the right to call a meeting, but not to reinstate the
president.
(d) The shareholders have the right to reinstate the president, but not to call a
meeting.
7. Under SOX and Dodd-Frank:
(a) companies are prohibited from making personal loans to directors and officers.
(b) if a company restates its earnings, the five top executives must reimburse the
company for any income they have received during that period.
(c) all directors must be independent.
(d) shareholders have the right to strike down golden parachutes.
ESSAY QUESTIONS
1. Michael incorporated Erin Homes, Inc., to manufacture mobile homes. He issued
himself a stock certificate for 100 shares for which he made no payment. He and his
wife served as officers and directors of the organization, but, during the eight years of
its existence, the corporation held only one meeting. Erin always had its own
checking account, and all proceeds from the sales of mobile homes were deposited
there. It filed federal income tax returns each year, using its own federal identification
number. John and Thelma paid $17,500 to purchase a mobile home from Erin, but the
company never delivered it to them. John and Thelma sued Erin Homes and
Michael, individually. Should the court “pierce the corporate veil” and hold Michael
personally liable?
2. YOU BE THE JUDGE WRITING PROBLEM Asher Hyman and Stephen Stahl
formed a corporation named Ampersand to produce plays. Both men were employed
by the corporation. After producing one play, Stahl decided to write Phillys Beat,
focusing on the history of rock and roll in Philadelphia. As the play went into
production, however, the two men quarreled over Hyman’s repeated absences from
work and the company’s serious financial difficulties. Stahl resigned from Ampersand
and formed another corporation to produce the play. Did the opportunity to produce
CHAPTER 29 Corporations 729
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Phillys Beat belong to Ampersand? Argument for Stahl: Ampersand was formed for the
purpose of producing plays, not writing them. When Stahl wrote Phillys Beat, he was
not competing against Ampersand. Argument for Hyman: Ampersand was in the
business of producing plays, and it wanted Phillys Beat.
3. Angelica is planning to start a home security business in McGehee, Arkansas. She
plans to start modestly but hopes to expand her business within 5 years to
neighboring towns and, perhaps, within 10 years to neighboring states. Her inclination
is to incorporate her business in Delaware. Is her inclination correct?
4. Eve bought defective ball bearings from Saginaw Corp. Alfred was the sole
shareholder of the company and also its landlord. After Alfred sold all of Saginaw’s
assets, he withheld enough money to cover the rent that Saginaw owed him. As a
result, Saginaw had no money to pay Eve. Does Eve have a claim against Alfred?
5. Congressional Airlines was highly profitable operating flights between Washington,
D.C., and New York City. The directors approved a plan to offer flights from
Washington to Boston. This decision turned out to be a major mistake, and the airline
ultimately went bankrupt. Under what circumstances would shareholders be
successful in bringing suit against the directors?
DISCUSSION QUESTIONS
1. States compete for lucrative corporate filing fees
by passing statutes that favor management. One
proposed solution to this problem would be a
federal system of corporate registration. Is this a
good idea? What are the impediments to such
as system?
2. Ford Motor Co. and Facebook have both created
dual classes of stock so that the founders can
continue to control their company even after it
goes public. Should corporate laws permit this?
Should some shareholders be more equal than
others? If the founders want to control a company,
why shouldn’t they buy enough regular stock to do
so? It is one thing for Mark Zuckerberg to maintain
control of Facebook, but should his grandchildren
also have the right to control the company?
3. ETHICS Edgar Bronfman, Jr., dropped out of
high school to go to Hollywood and write songs
and produce movies. Eventually, he left
Hollywood to work in the family business—the
Bronfmans owned 36 percent of Seagram Co., a
liquor and beverage conglomerate. Promoted to
president of the company at the age of 32,
Bronfman seized a second chance to live his
dream. Seagram received 70 percent of its
earnings from its 24 percent ownership of DuPont
Co. Bronfman sold this stock at less than market
value to purchase (at an inflated price) 80 percent
of MCA, a movie and music company that had
been a financial disaster for its prior owners. Some
observers thought Bronfman had gone Hollywood;
others that he had gone crazy. After the deal was
announced, the price of Seagram shares fell 18
percent. Was there anything Seagram shareholders
could have done to prevent what to them was
not a dream but a nightmare? Apart from legal
issues, was Bronfman’s decision ethical? What
ethical obligations did he owe Seagram’s
shareholders?
4. Pfizer Inc. paid $2.3 billion to settle civil
and criminal charges alleging that it had
illegally marketed 13 of its most important
drugs. This settlement made history, but not
in a good way. It was both the largest criminal
fine and the largest settlement of civil health
care fraud charges ever paid. Shareholders filed
a derivative suit against the Pfizer board and top
executives. Defendants responded with a motion
to dismiss on the grounds that shareholders had not
made demand on the board. Is demand
necessary?
730 U N I T 4 Employment, Business Organizations and Property
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5. ETHICS After a recent annual meeting, Cisco
Systems reported the results of the votes on both
management and shareholder proposals. The
company reported the results of its own proposals
as a simple ratio of those in favor divided by the
total number of votes cast. But for shareholder
proposals, it reported the percentage as a ratio of
those in favor divided by all outstanding shares. As
a result, it reported the favorable vote for one
shareholder proposal as 19 percent when, in fact,
34 percent of the votes cast supported this
proposal. Is Cisco behaving ethically?
CHAPTER 29 Corporations 731
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CHAPTER30
GOVERNMENT
REGULATION:
SECURITIES AND
ANTITRUST
Sandy is a director of a public company. He tells
his girlfriend, Carly, that the company is about to
receive a takeover offer. Sandy does not buy any
stock himself, but Carly does. When the offer is
announced, the stock zooms up in price and Carly
makes a tidy profit.
Steve and Joe coach college wrestling teams that are
in the same conference, and have very tight budgets.
Both men are also about to hire an assistant coach. One
day at a meet, Steve suggests to Joe that they each agree
to limit their new coach’s salary to $52,000. That way,
neither of them will break their budget and they might
even have more money to give for athletic scholarships.
Joe thinks this is a great plan and agrees on the spot.
Each of these people is about to find out, in a very
unpleasant way, about government regulation. Sandy
and Carly have violated securities laws on insider trading. Steve and Joe have engaged in
price fixing that is illegal under antitrust laws.
The moral of the story? It is important to be familiar with the most crucial government
regulations. Ignorance can not only harm your business but also lead to fines and even
imprisonment. (Insider trading and price fixing are two common paths to prison for white-
collar workers.)
Each of these people is
about to find out, in a
very unpleasant way,
about government
regulation.
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30-1 SECURITIES LAWS
There are two major securities laws: the Securities Act of 1933 (the 1933 Act) and the
Securities Exchange Act of 1934 (the 1934 Act).
30-1a What Is a Security?
Both the 1933 and the 1934 Acts regulate securities. A security is any transaction in which
the buyer (1) invests money in a common enterprise and (2) expects to earn a profit
predominantly from the efforts of others.
This definition covers investments that are not necessarily called securities. Besides the
obvious stocks, bonds, or notes, the definition of security can even include items such as
orange trees. W. J. Howey Co. owned large citrus groves in Florida. It sold these trees to
investors, most of whom were from out of state and knew nothing about farming. Purchasers
were expected to hire someone to take care of their trees. Someone like Howey-in-the-
Hills, Inc., a related company that just happened to be in the service business. Customers
were free to hire any service company, but 85 percent of the acreage was covered by service
contracts with Howey-in-the-Hills. The court held that Howey was selling a security (no
matter how orange or tart), because the purchaser was investing in a common enterprise (the
orange grove) expecting to earn a profit from Howey’s farm work.
Other courts have interpreted the term security to include animal breeding arrangements
(chinchillas, silver foxes, or beavers, take your pick); condominium purchases in which the
developer promises the owner a certain level of income from rentals; and even investments
in whiskey.
30-1b Securities Act of 1933
The 1933 Act requires that, before offering or selling securities in a public offering, the
issuer must register the securities with the Securities and Exchange Commission (SEC). An
issuer is the company that sells the stock initially.
It is important to remember that when an issuer registers securities, the SEC does not
investigate the quality of the offering. Permission from the SEC to sell securities does not
mean that the company has a good product or will be successful. SEC approval simply
means that, on the surface, the company has provided all required information about itself
and its major products. For example, the Green Bay Packers football team sold an offering
of stock to finance stadium improvements. The prospectus admitted:
IT IS VIRTUALLY IMPOSSIBLE that any investor will ever make a profit on the stock
purchase. The company will pay no dividends, and the shares cannot be sold.
This does not sound like a stock you want in your retirement fund; on the other hand,
the SEC does not prevent Green Bay from selling it, or you from buying it, so long as the
company has revealed what the risks are.
LIABILITY
Under the 1933 Act, the seller of a security is liable for making any material misstatement or
omission, either oral or written, in connection with the offer or sale of a security. Anyone
who issues fraudulent securities is in violation of the 1933 Act, whether or not the securities are
registered. Both the SEC and any purchasers of the stock can sue the issuer. In addition, the
Justice Department can bring criminal charges against anyone who willfully violates this statute.
PUBLIC OFFERINGS
A company’s first public sale of securities is called an initial public offering or an IPO. Any
subsequent public sale is called a secondary offering.
Issuer
A company that sells its own
stock.
Initial public offering (IPO)
A company’s first public sale of
securities.
Secondary offering
Any public sale of securities by
a company after the initial
public offering.
CHAPTER 30 Government Regulation: Securities and Antitrust 733
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Registration Statement To make a public offering, the company must file a regis-
tration statement with the SEC. The registration statement has two purposes: to notify the
SEC that a sale of securities is pending and to disclose information of interest to prospective
purchasers. The registration statement must include detailed information about the issuer
and its business, a description of the stock, the proposed use of the proceeds from the
offering, and two years of audited balance sheets and income statements. Preparing a
registration statement is neither quick nor inexpensive—it can cost as much as $8 million
for an IPO.
Prospectus Typically, buyers never see the registration statement; they are given
the prospectus instead. (The prospectus is part of the registration statement that is sent
to the SEC.) The prospectus includes all of the important disclosures about the
company, while the registration statement includes additional information that is of
interest to the SEC but not to the typical investor, such as the names and addresses
of the lawyers for the issuer and underwriter. All investors must receive a copy of the
prospectus before purchasing stock.
Sales Effort Even before the final registration statement and prospectus are completed,
the investment bank representing the issuer begins its sales effort. It cannot actually make
sales during this period, but it can solicit offers. The SEC closely regulates an issuer’s sales
effort to ensure that it does not hype the stock by making public statements about the
company before the stock is sold. For example, the SEC delayed an offering of stock by
Google, Inc., after Playboy magazine published an interview with its founders.
Going Effective Once the SEC finishes its review of the registration statement, it sends
the issuer a comment letter, listing required changes. An issuer almost always has to amend
the registration statement at least once, and sometimes more than once. Remember that the
SEC does not assess the value of the stock or the merit of the investment. Its role is to ensure
that the company has disclosed enough information to enable investors to make an informed
decision. After the SEC has approved a final registration statement (which includes, of
course, the final prospectus), the issuer and underwriter agree on a price for the stock and
the date to go effective, that is, to begin the sale.
Registering securities with the SEC for a public offering is very time-consuming and
expensive, but the 1933 Act also permits issuers to sell stock in a private offering, which is
much simpler (and cheaper).
PRIVATE OFFERINGS
Regulation D Under the 1933 Act, an issuer is not required to register securities that are
sold in a private offering, that is, an offering with a relatively small number of investors or a
limited amount of money involved. Tens of thousands of these offerings take place each
year, compared with only about 130 IPOs.
The most common and important type of private offering is under Regulation D (often
referred to as “Reg D”). Half of all Reg D offerings take in less than $1 million but more than
twice as much capital is raised each year under this private method than in public offerings. Reg D
provides a number of different options, the most popular of which is Rule 506. Under Rule 506,
a company may sell an unlimited amount of stock, subject to the following restrictions:
• The issuer can sell to an unlimited number of accredited investors, but to only
35 unaccredited investors. Accredited investors are institutions (such as banks and
insurance companies) or wealthy individuals (with a net worth of more than $1
million, not counting their homes, or an annual income of more than $200,000).
• If the issuer sells to unaccredited investors, it may not advertise the stock publicly.
But if it limits sales to accredited investors, it may advertise publicly.
Registration statement
A document that notifies the
SEC that a sale of securities is
pending and discloses
information to prospective
purchasers.
Prospectus
A document that is part of the
registration statement. It must
be provided to all investors
before they purchase stock.
Comment letter
A document from the SEC
listing required changes in the
registration statement.
Go effective
The securities registration is
complete and the company may
begin the sale of its stock.
Private offering
A sale of securities that, under
the 1933 Act, is not
considered a public offering
because of the limited number
of investors or the small
amount of money raised.
Regulation D
The most common and
important type of private
offering.
Accredited investors
Institutions (such as banks and
insurance companies) or
wealthy individuals (with a net
worth of more than $1 million
or an annual income of more
than $200,000).
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• It need not provide information to accredited investors but must make disclosure to
unaccredited investors, including a certified balance sheet.
• Stock purchased under this rule is restricted (whichmeans that it cannot be sold for a year).
• One further wrinkle: If an unaccredited purchaser is unsophisticated, he must have a
purchaser representative to help him evaluate the investment.
Crowdfunding Congress recently passed the Jumpstart Our Business Startups (JOBS)
Act, which permits privately held companies to sell up to $1 million in securities in any
12-month period, provided that they do all of the following:
• Make a filing with the SEC and provide appropriate disclosure to the purchaser at the
time of purchase, and then annually;
• Limit investments as follows:
� Investors with income or net worth that is less than $100,000 can invest no more than
the maximum of $2,000 or 5 percent of their income or net worth.
� Investors with income or net worth that is equal to or greater than $100,000 can invest
no more than the maximum of $100,000 or 10 percent of their income or net worth.1
• Sell the securities through an approved intermediary, that is, a broker or a so-called
funding portal (e.g., a website) that is registered with the SEC;
• Take steps (as determined by the SEC) to reduce the risk of fraud; and
• Prohibit the stock from being resold for one year (except to accredited investors or
family members).
• Not advertise the offering (except to tell investors about the approved intermediary);
• Not offer investment advice or pay anyone to sell their securities.
30-1c Securities Exchange Act of 1934
REGISTRATION
Most buyers do not purchase new securities from the issuer in an IPO. Rather, they buy
stock that is publicly traded in the open market. This stock is, in a sense, secondhand
because other people—perhaps many others—have already owned it. The purpose of the
1934 Act is to provide investors with ongoing information about public companies (i.e.,
companies with publicly traded stock).
Under the 1934 Act, an issuer must register with the SEC if (1) it completes a public
offering under the 1933 Act, or (2) its securities are traded on a national exchange (such as
the New York Stock Exchange), or (3) it has at least 2,000 shareholders (with a maximum of
500 unaccredited investors) and total assets that exceed $10 million.
The 1934 Act requires public companies to file the following documents:
• Annual reports on Form 10-K, containing audited financial statements, a detailed
analysis of the company’s performance, and information about officers and directors.
A public company must also deliver its annual report to shareholders.
1Note that these provisions are inconsistent. An investor whose income is $50,000 but whose net
worth is $150,000 falls into both categories.
Purchaser representative
Someone who has enough
knowledge and experience in
financial matters to evaluate
the merits and risks of an
investment.
CHAPTER 30 Government Regulation: Securities and Antitrust 735
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• Quarterly reports on Form 10-Q, which are less detailed than 10-Ks and contain
unaudited financials.
• Form 8-K to report any significant developments, such as a change in control, the
resignation of a director over a policy dispute, or a change in auditing firms.
In response to corporate scandals, Congress passed the Sarbanes-Oxley Act of 2002.
This statute requires each company’s CEO and CFO to certify that:
• The information in the quarterly and annual reports is true,
• The company has effective internal controls, and
• The officers have informed the company’s audit committee and its auditors of any
concerns that they have about the internal control system.
LIABILITY
Section 10(b) (and Rule 10b-5) prohibit fraud in connection with the purchase and sale of
any security, whether or not the security is registered under the 1934 Act. Under these rules,
anyone who fails to disclose material information or makes incomplete or inaccurate dis-
closure is liable, so long as the statement or omission was made willfully, knowingly, or
recklessly. Material means that the information was important enough to affect an investor’s
decision. An example of fraud: An accounting firm that certified financials in a company’s
annual report, knowing that it had not in fact adequately audited the firm’s books, would be
liable under §10(b).
Both the 1933 Act and the 1934 Act specify that misstatements and omissions create
liability only if they are material. In the following case, a unanimous Supreme Court
provided guidance on what “material” means.
Material
Important enough to affect an
investor’s decision.
MATRIXX INITIATIVES, INC. V. SIRACUSANO
2011 U.S. LEXIS 2416
Supreme Court of the United States, 2011
C A S E S U M M A R Y
Facts: Zicam Cold Remedy was a nasal spray (or gel) that
accounted for 70 percent of Matrixx’s sales revenue. Its
active ingredient was zinc gluconate. Matrixx began
receiving reports that some Zicam users had developed
anosmia (i.e., they had lost their sense of smell). The
company learned for the first time that some studies had
linked the use of zinc sulfate to the loss of smell.
Matrixx then found out that two doctors were plan-
ning to make a presentation at a conference about patients
who had developed anosmia after Zicam use. Matrixx sent
them a letter warning them that they did not have permis-
sion to use the name of Matrixx or its products. The
doctors deleted references to Zicam.
Nine people filed suit against Matrixx, alleging that
Zicam had damaged their sense of smell. Matrixx then issued
statements that Zicam was poised for growth and that reve-
nues would increase by more than 80 percent. In its 10-Q
filing with the SEC, Matrixx warned of the potential “mate-
rial adverse effect” that could result from product liability
claims, “whether or not proven to be valid.” It did not
disclose, however, that plaintiffs had already sued Matrixx.
After the Food and Drug Administration (FDA)
announced that it was investigating Zicam, Matrixx’s
stock price fell. The company issued a press release stat-
ing that there are many causes for anosmia, including the
common cold, but Zicam was not one of them.
The day after this press release, Matrixx stock price
bounced back. Shortly thereafter, however, the TV show
Good Morning America reported that more than a dozen
patients had suffered from anosmia after using Zicam and
that some had filed lawsuits against Matrixx. The com-
pany’s stock price plummeted.
A group of shareholders filed suit, alleging that
Matrixx had violated §10(b) and Rule 10b-5. The trial
736 U N I T 4 Employment, Business Organizations and Property
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Ethics Matrixx learned that its products were potentially causing a loss of smell,
which is no minor matter. People with anosmia cannot properly taste food,
so they often lose interest in eating, which can lead to malnutrition and depression. Was it
ethical for the company to prohibit doctors from presenting information about Zicam at a
conference? Did the company have an ethical obligation to alert the public to this issue?
Which concern takes priority—shareholders or the public?
30-1d Short-Swing Trading—Section 16
Section 16 of the 1934 Act was designed to prevent corporate insiders—officers, directors,
and shareholders who own more than 10 percent of the company—from taking unfair
advantage of privileged information to manipulate the market.
Section 16 takes a two-pronged approach:
• First, insiders must report their trades within two business days.
• Second, insiders must turn over to the corporation any profits they make from the purchase
and sale or sale and purchase of company securities in a six-month period. Section 16 is a
strict liability provision. It applies even if the insider did not actually take advantage of
secret information or try to manipulate the market; if she bought and sold or sold and
bought stock in a six-month period, she is liable for any profits she earned.
Suppose that Manuela buys 20,000 shares of her company’s stock in June at $10 a share.
In September, her (uninsured) winter house in Florida is destroyed by a hurricane. To raise
money for rebuilding, she sells the stock at $12 per share, making a profit of $40,000. But
she has violated §16 and must turn over the profit to her company.
30-1e Insider Trading
Insider trading is immensely tempting. Anyone with reliable secret information can earn
millions of dollars overnight. The downside? Insider trading is a crime punishable by fines
and imprisonment. The guilty party may also be forced to turn over to the SEC three times
the profit made. For example, Raj Rajaratnam, the billionaire head of a hedge fund, was
recently sentenced to 11 years in prison and ordered to pay $63.8 million to the government.
court granted Matrixx’s motion to dismiss on the grounds
that, without a statistical correlation between the use of
Zicam and anosmia, the reported incidents were not mate-
rial. The Court of Appeals reversed. The Supreme Court
granted certiorari.
Issues: Did Matrixx violate §10(b) and Rule 10b-5?
Decision: Yes, Matrixx was in violation.
Reasoning: Information is material if a reasonable
investor would view it to be significant. The FDA some-
times takes action on a product even if the available
evidence merely suggests but does not prove that it causes
harm. The FDA does not require statistical correlation; it
considers other data as well. If this other information mat-
ters to the FDA, then it will also be important to investors.
However, reports of adverse events are common with
all pharmaceuticals, and companies are not required to
report each and every one of these events to investors.
Something more is needed, but that something is less
than statistical correlation.
In this case, the “total mix” of information reported by
the company was misleading. Matrixx told investors that
revenues were going to rise substantially even though it
had information that created a significant risk to its leading
product. That combination—knowledge of adverse events
and an upbeat revenue prediction—created an obligation to
report these potential concerns.
CHAPTER 30 Government Regulation: Securities and Antitrust 737
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These are the rules on insider trading:
• Fiduciaries. Any corporate insider who trades while in possession of nonpublic
material information in violation of his fiduciary duty to his company is liable under
Rule 10b-5. Corporate insiders include board members, major shareholders,
employees, and so-called temporary insiders, such as lawyers and investment bankers
who are doing deals for the company. Examples:
� If the director of research for MediSearch knows that the company will shortly
announce a major breakthrough in the treatment of AIDS and then buys stock in the
company before the information is public, she is guilty of insider trading.
� Suppose, however, that while looking in a Dumpster, Harry finds correspondence that
reveals MediSearch’s new discovery. He then buys MediSearch stock, which promptly
quadruples in value. Harry will be dining at the Ritz, not in the Dumpster nor in federal
prison, because he has no fiduciary duty to MediSearch.
• Misappropriation. So far we have been discussing fiduciaries with a direct relationship
to the company whose stock was traded. But people with a more remote connection
may also be liable. Anyone (1) with material, non-public information, (2) who
breaches a fiduciary duty to the source of the information (3) by revealing or trading on
it, is liable for insider trading. This rule applies even if the person does not work for
the company whose stock was traded. For example:
� James O’Hagan was a lawyer in a firm that represented a company attempting to take over
Pillsbury Co. Although O’Hagan did not work on the case, he heard about it and then
bought stock in Pillsbury. After the takeover attempt was publicly announced, O’Hagan
sold his stock in Pillsbury at a profit of more than $4.3 million.2Although Hagan’s firm did
not represent Pillsbury, the Supreme Court ruled that O’Hagan had violated insider trading
laws. While it was true that he had no fiduciary duty to Pillsbury, he did owe one to his law
firm, which was the source of the information. According to the court, what he had done
was the same thing as embezzlement.3
• Tippers. What about people who do not trade themselves but pass on information to
someone who does? Anyone who reveals material nonpublic information in violation
of his fiduciary duty is liable if (1) he knows the information was confidential and
(2) he expected some personal gain. Personal gain is loosely defined. Essentially, any
gift to a friend counts as personal gain. For example:
� W. Paul Thayer was a corporate director, deputy secretary of defense, and former fighter
pilot ace who gave stock tips to his girlfriend in lieu of paying her rent. That counted as
personal gain, and he spent a year and a half in prison.
• Tippees. Those who receive tips—tippees—are liable for trading on inside information,
even if they do not have a fiduciary relationship to the company, so long as (1) they know
the information is confidential; (2) they know it came from an insider who was violating
his fiduciary duty; and (3) the insider expected some personal gain. For example:
� Barry Switzer, then head football coach at the University of Oklahoma, went to a track meet
to see his son compete. While sunbathing on the bleachers, he overheard someone talking
about a company that was going to be acquired. Switzer bought the stock, but was acquitted
of insider trading charges because the insider had not breached his fiduciary duty. He had
not tipped anyone on purpose—he had simply been careless. Also, Switzer did not know
2O’Hagan used the profits that he gained through this trading to conceal his previous embezzlement
of client funds. There is a moral here.
3521 U.S. 642, 117 S. Ct. 2199, 1997 U.S. LEXIS 4033.
738 U N I T 4 Employment, Business Organizations and Property
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that the insider was breaching a fiduciary duty, and the insider expected no personal gain
from releasing the information.4
• Takeovers. Rule 14e-3 prohibits trading on inside information during a tender offer if
the trader knows the information was obtained from either the bidder or the target
company. The trader or tipper need not have violated a fiduciary duty.
• Advanced Planning. Under Rule 10b5-1, an insider can avoid insider trading charges if
she commits in advance to a plan to sell securities. Thus, if an insider knows that she will
want to sell stock to pay a child’s college tuition, she can establish such a sales plan in
advance. She will then not be liable for the sales, no matter what inside information she
knows. But, she must sell according to the plan, despite any change in circumstances.
In the following case, two employees were not told specific information, but they made
an educated guess. Have they violated insider trading rules?
SECURITIES AND EXCHANGE COMMISSION V. STEFFES
2011 U.S. Dist. LEXIS 85496
United States District Court for the Northern District of Illinois
C A S E S U M M A R Y
Facts: Florida East Coast Industries, Inc. (East Coast),
was a publicly traded company that operated a freight
railroad between Jacksonville and Miami. As a vice presi-
dent, Gary Griffiths’s job was to oversee maintenance of
the railcars. He was married to the sister of his high school
friend, Rex Steffes. He had helped Rex’s son Cliff obtain
a job driving trains for East Coast.
The CFO of East Coast asked Griffiths to prepare an
inventory of all the rolling stock the company owned and
to arrange trips among its rail yards in a special railroad car
reserved for visitors. Griffiths also heard that a large num-
ber of men in suits had been touring the company’s rail
yards. Yard employees began asking Griffiths whether
East Coast would be sold and whether they would lose
their jobs. Indeed, it turned out that East Coast’s Board of
Directors had secretly hired an investment bank to sell
the company.
During this period, Griffiths, Rex and Cliff called
each other repeatedly. After the calls, Rex made various
purchases of East Coast stock, although his broker advised
against buying so many shares of one company. Rex
ultimately spent a total of $1.14 million on East Coast
stock. Also, Cliff purchased the first call options of his life,
spending $15,015 on East Coast.5 After the company was
sold, both Rex and Cliff made substantial profits.
The SEC filed suit, alleging that Griffiths, Rex, and
Cliff had violated §10(b) and Rule 10b-5. The men filed a
motion to dismiss.
Issue: Did the defendants engage in illegal insider trading?
Decision: Yes, Griffiths, Rex and Cliff were liable for
insider trading.
Reasoning: This case is atypical in that Griffiths was not
told directly about the merger but instead figured it out
himself. Although no one particular piece of information—
such as the fact that men in suits were touring rail yards—was
itself crucial, his ultimate conclusion that a sale was about to
take place was material, nonpublic information.
Although phone calls among family member are not
themselves illegal or even suspicious, the fact that Rex
bought stock shortly after each of these calls created a reason-
able inference that Griffiths tipped Rex. The SEC was
entitled to prove its case through circumstantial evidence.
Although Griffiths himself did not buy East Coast stock,
he was nonetheless liable, too. He violated his fiduciary duty
by passing on this material nonpublic information. He may
not have directly benefited from the trades but it is well
established that the concept of gain is a broad one and in-
cludes a gift of confidential information to a relative or friend.
4SEC v. Switzer, 590 F. Supp. 756, 1984 U.S. Dist. LEXIS 15303 (W.D. Okla. 1984).
5Call options are the right to purchase stock of a company at a specific price for a specific period of
time. A buyer purchases a call option in the expectation that the stock price will go up.
CHAPTER 30 Government Regulation: Securities and Antitrust 739
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EXAM STRATEGY
Question: Paul was an investment banker who sometimes bragged about deals he
was working on. One night, he told a bartender, Ryanne, about an upcoming deal.
Ryanne bought stock in the company Paul had mentioned. Both were prosecuted for
insider trading. Ryanne was acquitted but Paul was convicted, even though Ryanne
was the one who made money. How is that possible?
Strategy: Note that there are different standards for tippers and tippees.
Result: Paul is liable if he knew the information was confidential and he expected some
personal gain. A gift counts as personal gain. (The courts have an expansive definition of
gifts—practically anything counts. Here, the information could be interpreted as a tip to
the bartender.) Ryanne would not be liable unless she knew the information was
confidential and had come from an insider who was violating his fiduciary duty.
Why is insider trading a crime? Who is harmed? Insider trading is illegal because:
• It offends our fundamental sense of fairness. No one wants to be in a poker game
with marked cards.
• Investors will lose confidence in the market if they feel that insiders have an unfair
advantage.
• Investment banks typically “make a market” in stocks, meaning that they hold extra
shares so that orders can be filled smoothly. These marketmakers expect to earn a certain
profit, but inside traders skim some of it off. Somarketmakers simply raise the commission
they charge. As a result, everyone who buys and sells stock pays a slightly higher price.
30-1f Blue Sky Laws
Currently, all states and the District of Columbia also regulate the sale of securities. These
state statutes are called blue sky laws (because crooks were willing to sell naive investors a
“piece of the great blue sky”). However, under the National Securities Markets Improve-
ment Act (NSMIA) of 1996, states may not regulate offerings of securities that are:
• Traded on a national exchange,
• Exempt under Rule 506, or
• Sold to a qualified purchaser.6
Any securities offerings not covered by the NSMIAmust comply with state securities laws.
30-2 ANTITRUST LAW
Congress passed the Sherman Act in 1890 to prevent extreme concentrations of economic
power and promote competition. Because this statute was aimed at the Standard Oil Trust,
which then controlled the oil industry throughout the country, it was termed antitrust
legislation.
6The SEC was supposed to define this term in 1996, but has not yet done so.
Blue sky laws
State securities laws.
Antitrust legislation
Laws aimed at preventing
extreme concentrations of
economic power and promoting
competition.
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Violations of the antitrust laws are divided into two categories: per se and rule of reason.
Per se violations are automatic. Defendants charged with this type of violation cannot defend
themselves by saying, “But the impact wasn’t so bad” or “No one was hurt.” The court will
not listen to excuses, and violators may be sent to prison.
Rule of reason violations, on the other hand, are illegal only if they have an anticompetitive
impact on the market. For example, mergers are illegal only if they harm competition in their
industry. Those who commit rule of reason violations are not sent to prison.
Both the Justice Department and the Federal Trade Commission (FTC) have authority
to enforce the antitrust laws. In addition to the government, anyone injured by an antitrust
violation has the right to sue for damages. The United States is unusual in this regard—in
most other countries, only the government is able to sue antitrust violators. A successful
plaintiff can recover treble (i.e., triple) damages from the defendant.
30-2a The Sherman Act
PRICE-FIXING
Section 1 of the Sherman Act prohibits all agreements “in restraint of trade.” The most
common—and one of the most serious—violations of this provision involves horizontal
price-fixing. When competitors agree on the prices at which they will buy or sell products,
their price-fixing is a per se violation of §1 of the Sherman Act.
In the following Landmark Case, the defendants argued that price-fixing was wrong
only if the prices were unfair. Did the Supreme Court agree?
Landmark Case
Facts: This case in-
volved dirty doings in the
bathroom fixture business.
The federal government
alleged that 23 of the
corporations that manufac-
tured these fixtures had
agreed on the prices they
would charge their custo-
mers. The defendants
argued that they had not violated the law because their
prices had been reasonable.
They were found guilty at trial, but the appeals court
overturned their convictions. The Supreme Court granted
certiorari.
Issue: Is price-fixing legal so long as the prices are reasonable?
Decision: Price-fixing is a per se violation, even if the
prices are reasonable.
Reasoning: The goal of
the Sherman Act is to pro-
mote competition, but
price-fixing automatically
eliminates one form of it.
Indeed, the power to fix
prices is thepower tocontrol
a market, an outcome that
the Sherman Act prohibits.
Moreover, even if the
prices were fair when set, the reasonable price today may,
through economic and business changes, become the
unreasonable price of tomorrow. And it would be wrong
to require the government to prove that prices are unrea-
sonable, especially because economists may not be able to
agree.
For these reasons, the judgment of the appeals court
was reversed.
UNITED STATES V. TRENTON
POTTERIES COMPANY
273 U.S. 392; 1927 U.S. LEXIS 975
Supreme Court of the United States, 1927
C A S E S U M M A R Y
Per se
An automatic breach of
antitrust laws.
Rule of reason
An action that breaches
antitrust laws only if it has an
anticompetitive impact.
CHAPTER 30 Government Regulation: Securities and Antitrust 741
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The Supreme Court has referred to this type of collusion as “the supreme evil of
antitrust,” and it has been illegal for the better part of a century.7 But it never seems to go
away. Samsung Electronics Co. paid a $300 million fine for having conspired to fix prices of
computer chips. Other companies engaged in this conspiracy paid $346 million in fines. These
penalties were topped by F. Hoffmann-La Roche, which paid $500 million for conspiring to fix
the prices of vitamins. Executives went to prison for their roles in these conspiracies.
RESALE PRICE MAINTENANCE
Resale price maintenance (RPM), also called vertical price fixing, means the manufacturer
sets the minimum prices that retailers may charge. In other words, it prevents retailers from
discounting. Why does the manufacturer even care? After all, once the retailer purchases the
item, the manufacturer has made its profit. The only way the manufacturer makes more
money is to raise its wholesale price, not the retail price. RPM guarantees a profit margin for
the retailer.
Manufacturers care about retail prices because pricing affects the product’s image with
consumers. Armani men’s suits sell for around $2,000. What conclusion do you draw about
the quality of those suits? Would your opinion change if you saw Armani suits being sold for
less? You can understand that Armani might want to prohibit retailers from lowering the
prices on its suits. Consumer advocates contend, however, that manufacturers such as
Armani are simply protecting dealers from competition. Discounting may or may not harm
products, but, they insist, RPM certainly hurts consumers.
In 1911, the Supreme Court ruled that RPM was a per se violation of §1 of the Sherman
Act.8 However, what the Supreme Court giveth, it can also taketh away. In 2007, the
Supreme Court overruled itself and held that RPM is a rule of reason violation. The
following case explains why.
LEEGIN CREATIVE LEATHER PRODUCTS,
INC. V. PSKS, INC.
551 U.S. 877, 127 S. Ct. 2705, 2007 U.S. LEXIS 8668
Supreme Court of the United States,2007
C A S E S U M M A R Y
Facts: Leegin manufactured belts and other women’s
fashion accessories under the brand name “Brighton.” It
sold these products only to small boutiques and specialty
stores. Sales of the Brighton brand accounted for about half
the profits at Kay’s Kloset, a boutique in Lewisville, Texas.
Leegin decided it would no longer sell to retailers
who discounted Brighton prices. It wanted to ensure that
stores could afford to offer excellent service. It was also
concerned that discounting harmed Brighton’s image.
Despite warnings from Leegin, Kay’s Kloset persisted in
marking down Brighton products by 20 percent. So Lee-
gin cut the store off.
Kay’s sued Leegin, alleging that RPM was a per se
rule violation of the law. The trial court found for Kay’s
and entered judgment against Leegin for almost
$4 million. The Court of Appeals affirmed. The Supreme
Court granted certiorari. On appeal, Leegin did not dis-
pute that it had entered into RPM agreements with retail-
ers. Rather, it contended that the rule of reason should
apply to those agreements.
Issue: Is resale price maintenance a per se or rule of reason
violation of the Sherman Act?
Decision: RPM is a rule of reason violation.
7Verizon Communs., Inc. v. Trinko, LLP, 540 U.S. 398 (S. Ct. 2004).
8Dr. Miles Medical Co. v. John D. Park & Sons, 220 U.S. 373 (1911).
742 U N I T 4 Employment, Business Organizations and Property
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VERTICAL MAXIMUM PRICE FIXING
In the case of resale price maintenance, the manufacturer sets the minimum prices its
distributors can charge. Vertical maximum price fixing (when a manufacturer sets maximum
prices), is also a rule of reason violation of §1 of the Sherman Act. The defendant is liable
only if the price fixing harms competition. (You remember that, by contrast, all horizontal
price fixing is a per se violation.)
When State Oil Co. leased a gas station to
Barkat Khan, it set a maximum price that Khan
could charge for gas. Khan sued State Oil, but the
Supreme Court ruled in favor of the oil company
on the grounds that cutting prices to increase
business is the very essence of competition and,
furthermore, low prices benefit consumers.9
MONOPOLIZATION
Under §2 of the Sherman Act, it is illegal to
monopolize or attempt to monopolize a market.
To monopolize means to acquire control over a
market in the wrong way. Having a monopoly is
legal unless it is gained or maintained by using wrongful tactics.
To determine if a defendant has illegally monopolized, we must ask three questions:
• What is the market? If buyers view twoproducts as close substitutes, then the items are in
the same market. For example, imagine that your company sells soft drinks in Smallville.
These drinks have unusual food flavors—steak and cheese, among others. For some
reason, you are the only company in that area who sells food-flavored soft drinks, so, by
definition, you control 100 percent of the market. But is that the relevantmarket? Perhaps
the relevant market is flavored drinks or soft drinks or all beverages. The question
economists ask is: How high can your prices rise before your buyers will switch to a
different product? (This concept is called cross-elasticity of demand.) If a price increase from
$2 to $2.20 a bottle causes many of your customers to buy Coke instead, it is clear you are
part of a larger market. However, if you could raise your price to $5 per bottle and still hold
on to many of your customers, then you might well be in your own market.
Reasoning: To be a per se violation, an activity must
not only be anticompetitive, it must also lack any
redeeming virtue. Recent research indicates that resale
price maintenance may offer some benefits:
• Retailers can provide better service. Without RPM,
consumers might go look at a product at the
retailer who hires experienced sales help or
offers product demonstrations, but then go buy
the item from a discounter who provides none of
these services. In short order, the upscale retailer
will either go out of business or cut back on
service and consumers will have fewer options.
• If retailers do not have to compete with others who
sell the same brand, they can focus instead on
competing against other brands. For example,
retailers selling the same brand may pool their
marketing dollars to have greater impact.
It is worth noting, though, that RPM can have an
anticompetitive effect. A manufacturer with market
power could, for example, use resale price mainte-
nance to give retailers an incentive not to sell the
products of smaller rivals. Courts must be diligent in
recognizing and preventing any RPM that has an
anticompetitive impact.
Possessing a monopoly is
not necessarily illegal;
using “bad acts” to
acquire or maintain one
is.
9State Oil Co. v. Khan, 522 U.S. 3, 1997 U.S. LEXIS 6705 (1997).
CHAPTER 30 Government Regulation: Securities and Antitrust 743
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• Does the company control the market? No matter what its market share, a company
does not have a monopoly unless it can exclude competitors or control prices.
For example, the Justice Department sued a movie theater chain that possessed a
93 percent share of the box office in Las Vegas. But the court ruled against the Justice
Department because the chain’s market share decreased to 75 percent within three
years. This decline indicated that the company did not control the market and that
barriers to entry were low.10
• How did the company acquire or maintain its control? If the law prohibited the mere
possession of a monopoly, it might discourage companies from producing excellent
products or offering low prices. So possessing a monopoly is not necessarily illegal;
using “bad acts” to acquire or maintain one is. For example, Microsoft insisted that
computer manufacturers who wanted to install the Windows operating system on
any computer had to purchase a license for every machine they made. This requirement
meant that a manufacturer would not even consider offering consumers another operating
system because it had already paid for Microsoft’s on all of its machines. The Justice
Department ordered Microsoft to halt this arrangement.
Predatory pricing is another example of a bad act.
PREDATORY PRICING
Predatory pricing occurs when a company lowers its prices below cost to drive competitors
out of business. Once the predator has the market to itself, it raises prices to make up lost
profits—and more besides. Typically, the goal of a predatory pricing scheme is either to win
control of a market or to maintain it. Therefore, it is illegal under §2 of the Sherman Act. To
win a predatory pricing case, the plaintiff must prove three elements:
• The defendant is selling its products below cost.
• The defendant intends that the plaintiff go out of business.
• If the plaintiff does go out of business, the defendant will be able to earn sufficient
profits to recover its prior losses.
The classic example of predatory pricing is a large grocery store that comes into a small
town offering exceptionally low prices that are subsidized by profits from its other branches.
Once all the “Ma and Pa” corner groceries go out of business, MegaGrocery raises its prices
to much higher levels.
Predatory pricing cases can be difficult to win. For example, it is hard for Ma and Pa to
prove that MegaGrocery intended for them to go out of business. It is also difficult for Ma
and Pa to show that MegaGrocery will be able to make up all its lost profits once the corner
grocery is out of the way. They need to prove, for example, that no other grocery chain will
come to town. It is difficult to prove a negative proposition like that, especially in the
grocery business, where barriers to entry are low.
In recent times, plaintiffs have not had much success with predatory pricing suits. For
example, Liggett began selling generic cigarettes 30 percent below the price of branded
cigarettes. Brown & Williamson retaliated by introducing its own generics at an even lower
price. Liggett sued, claiming that Brown’s prices were below cost. The Supreme Court
agreed that Brown was not only selling below cost, but also intended to harm Liggett.
Brown still won the case, however, because there was no evidence that it would be able to
recover its losses from the below-cost pricing. If Brown raised its prices, other competitors
would come back into the market.11
10United States v. Syufy Enterprises, 903 F.2d 659, 1990 U.S. App. LEXIS 7396, (9th Cir., 1990).
11Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209, 1993 U.S. LEXIS 4245 (1993).
744 U N I T 4 Employment, Business Organizations and Property
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30-2b The Clayton Act
MERGERS
The Clayton Act prohibits mergers that are anticompetitive. Companies with substantial
assets must notify the Federal Trade Commission (FTC) before undertaking a merger. This
notification gives the government an opportunity to prevent a merger ahead of time, rather
than trying to untangle one after the fact.12
Horizontal Mergers. A horizontal merger involves companies that compete in the
same market. In determining whether to permit a merger, the government and the courts
consider how the merger will affect competition and consumers. Thus the government
cleared a merger between aircraft giants Boeing and McDonnell Douglas, which together
had a virtual monopoly on the American aircraft business. But the aircraft market is global,
and American companies faced severe competition from Europe’s Airbus consortium.
Therefore, the government believed that the merger would not harm competition.
Conversely, the FTC blocked the merger of office supply giants Staples, Inc., and
Office Depot. Nationally, these two retailers controlled only 4 percent of the market for
office supplies. But rather than focusing on national market share, the FTC looked instead
on the ability to control prices locally. The agency found that, when both stores operated in
the same market, prices were significantly lower than when only one store was present.
Thus, a box of file folders cost $1.72 in Orlando, Florida (where both stores competed), and
$4.17 in nearby Leesburg (where Office Depot had a monopoly). In the FTC’s view, if the
two stores combined, they would have had enough power in local markets to raise prices and
harm consumers.
The following landmark case illustrates how the courts analyze merger cases.
Landmark Case
Facts: Waste Manage-
ment, Inc. (WMI) acquired
Texas Industrial Disposal,
Inc. (TIDI). Both compa-
nieswere in the trashcollec-
tion business. In Dallas,
their combined market
share was 48.8 percent.
The trial court held
that the merger was
illegal and ordered WMI to divest itself of TIDI.
Issue: Did WMI violate the Clayton Act by acquiring TIDI?
Decision: No, this merger was not an antitrust
violation.
Reasoning: A large mar-
ket share creates a pre-
sumption of monopoly
power but the parties can
rebut that presumption by
showing that the merger
does not have an anticom-
petitive impact.
Although WMI’s
acquisition of TIDI led
to a nearly 50 percent market share, WMI nonetheless
made a compelling argument that it was not able to exer-
cise monopoly power. In Dallas, competitors could easily
enter the waste hauling business. Thus, if WMI raised
12Under a statutory amendment called Hart-Scott-Rodino, a transaction must be reported if it involves
assets of $70.9 million or higher, or if one party has assets or net revenues of $141.8 million or higher
and the other party has at least $14.2 million in assets or net revenues. The FTC adjusts these figures
annually for inflation.
UNITED STATES V. WASTE
MANAGEMENT, INC.
743 F.2d 976, 1984 U.S. App. LEXIS 18843
United States Court of Appeals for the Second Circuit, 1984
C A S E S U M M A R Y
CHAPTER 30 Government Regulation: Securities and Antitrust 745
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In short, traditionally market share was the most important factor in evaluating mergers. As
Waste Management indicates, however, courts are now more concerned about market power.
Vertical Mergers A vertical merger involves companies at different stages of the
production process—for example, when a producer of a final good acquires a supplier, or
vice versa. If Staples bought a paper manufacturer, that would be a vertical merger. This
type of merger can also be anticompetitive, especially if it reduces entry into a market by
locking up an important supplier or a top distributor. However, the Justice Department’s
guidelines provide that it will challenge vertical mergers only if they are likely to increase
entry barriers in a concentrated market.
TYING ARRANGEMENTS
A tying arrangement is an agreement to sell a product on the condition that the buyer also
purchases a different (or tied) product. A tying arrangement is illegal under the Clayton Act if:
• The two products are clearly separate,
• The seller requires the buyer to purchase the two products together,
• The seller has significant power in the market for the tying product, and
• The seller is shutting out a significant part of the market for the tied product.
Six movie distributors refused to sell individual films to television stations. Instead,
they insisted that a station buy an entire package of movies. To obtain classics such as
Treasure of the Sierra Madre and Casablanca (the tying product), the station also had to
purchase such forgettable films as Gorilla Man and Tugboat Annie Sails Again (the tied
product).13 The distributors engaged in an illegal tying arrangement. These are the ques-
tions that the court asked:
• Are the two products clearly separate? A left and right shoe are not separate products, and
a seller can legally require that they be purchased together. Gorilla Man, on the other
hand, is a separate product from Casablanca.
• Is the seller requiring the buyer to purchase the two products together? Yes, that is the whole
point of these “package deals.”
• Does the seller have significant power in the market for the tying product? In this case, the
tying products are the classic movies. Since they are copyrighted, no one else can
show them without the distributor’s permission. The six distributors controlled a
great many classic movies. So, yes, they do have significant market power.
prices, new firms could enter the market, driving prices
down. Indeed, over the previous 10 years, a number
of companies had started in the commercial trash
collection business. A person could simply acquire
a truck, a few containers, drive the truck himself,
and operate out of his home. This individual’s
success would depend on his personal initiative,
and whether he had the desire and energy to provide
a high level of service.
Because barriers to entry were low, WMI’s 48.8
percent market share did not accurately reflect future
market power. Thus, the merger did not substantially
lessen competition in the relevant market and was
not a violation of the Clayton Act.
13United States v. Loew’s Inc., 371 U.S. 38, 1962 U.S. LEXIS 2332 (1962).
Tying product
In a tying arrangement, the
product offered for sale on the
condition that another product
be purchased as well.
Tied product
In a tying arrangement, the
product that a buyer must
purchase as the condition for
being allowed to buy another
product.
746 U N I T 4 Employment, Business Organizations and Property
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• Is the seller shutting out a significant part of the market for the tied product? In this case, the
tied products are the undesirable films like Tugboat Annie Sails Again. Television
stations forced to take the unwanted films did not buy “B” movies from other
distributors. These other distributors were effectively foreclosed from a substantial
part of the market.
EXAM Strategy
Question: Two medical supply companies in the San Francisco area provide oxygen
to homes of patients. The companies are owned by the doctors who prescribe the
oxygen. These doctors make up 60 percent of the lung specialists in the area. Does
this arrangement create an antitrust problem?
Strategy: Does the seller have significant power in the market for the tying product
(lung patients)? Is it shutting out a significant part of the market for the tied product
(oxygen)?
Result: The FTC charged the doctors with an illegal tying arrangement. Because
the doctors effectively controlled such a high percentage of the patients needing the
service, other oxygen companies could not enter the market.
30-2c The Robinson-Patman Act
Under the Robinson-Patman Act (RPA), it is illegal to charge different prices to different
purchasers if:
• The items are the same, and
• The price discrimination lessens competition.
However, it is legal to charge a lower price to a particular buyer if:
• The costs of serving this buyer are lower, or
• The seller is simply meeting competition.
Congress passed the RPA in 1936 to prevent large chains from driving small, local stores
out of business. Owners of these Ma and Pa stores complained that the large chains could
sell goods cheaper because suppliers charged them lower prices. As a result of the RPA,
managers who would otherwise like to develop different pricing strategies for specific
customers or regions may hesitate to do so for fear of violating this statute. In reality,
however, they have little to fear.
Under the RPA, a plaintiff must prove both that price discrimination occurred and that
it lessened competition. It is perfectly permissible, for example, for a supplier to sell at a
different price to its Texas and California distributors, or to its health care and educational
distributors, so long as the distributors are not in competition with each other.
The RPA also permits price variations that are based on differences in cost. Thus,
Kosmo’s Kitchen would be perfectly within its legal rights to sell its frozen cheese enchi-
ladas to Giant at a lower price than to Corner Grocery if Kosmo’s costs are lower to do so.
Giant often buys shipments the size of railroad containers, which cost less to deliver than
smaller boxes.
CHAPTER 30 Government Regulation: Securities and Antitrust 747
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Chapter Conclusion
In this chapter, you have learned about some of the important government regulations that
affect business. They can have a profound impact on your business—and on your life.
EXAM REVIEW
1. SECURITY A security is any transaction in which the buyer (1) invests money in
a common enterprise and (2) expects to earn a profit predominantly from the efforts
of others. (p. 733)
Question: As a pitcher for the Cleveland Indians farm team, Randy Newsom had
dreams of glory, but a paycheck that was a nightmare—$8,000 for the season.
Newsom came up with a clever solution: He set up a website that offered fans the
opportunity to buy a share of his future. For only $20, the buyer was entitled to
.002 percent of his career pay. Any problems with this plan?
Strategy: Remember that even orange trees can be securities. (See the“Result”
at the end of this section.)
2. THE 1933 ACT The 1933 Act requires that, before offering or selling securities
in a public offering, the issuer must register the securities with the Securities and
Exchange Commission (SEC). (pp. 733–735)
3. PROSPECTUS All investors must receive a copy of the prospectus before
purchasing stock in a public offering. (p. 734)
4. PRIVATE OFFERING Under the 1933 Act, an issuer is not required to register
securities that are sold in a private offering, but the issuer may have to meet certain
disclosure requirements. (pp. 734–735)
5. REGULATION D The most common and important type of private offering is
under Regulation D. It permits issuers to sell stock to a small number of investors and
for a limited amount of money. (pp. 734–735)
6. THE 1934 ACT The 1934 Act requires public companies to make regular filings
with the SEC, including annual reports, quarterly reports, and Form 8-Ks. (pp. 735–737)
7. REGISTRATION Under the 1934 Act, an issuer must register with the SEC if
(1) it completes a public offering under the 1933 Act, or (2) its securities are traded
on a national exchange (such as the New York Stock Exchange), or (3) it has at least
2,000 shareholders (with a maximum of 500 unaccredited investors) and total assets
that exceed $10 million. (pp. 735–736)
8. SARBANES-OXLEY Sarbanes-Oxley requires each company’s CEO and CFO to
certify that the information in the quarterly and annual reports is true. (p. 736)
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9. SECTION 16 Insiders must report their trades in company stock within two
business days. They must turn over to the corporation any profits they make from the
purchase and sale or sale and purchase of company securities in a six-month period.
(p. 737)
Question: You are the president of Turbocharge, Inc., a publicly traded
company. You have been buying stock recently because you think the company’s
product—a more efficient hybrid engine—is very promising. One day, you show
up at work and find your desk in the hallway. The CEO has fired you. In a huff,
you sell all your company stock. The only silver lining to your cloud is that you
make a large profit. Or is this a silver lining?
Strategy: You can be in violation of Section 16 even if you did not have any
inside information when you trade. (See the“Result” at the end of this section.)
10. INSIDER TRADING:
• Any corporate insider who trades while in possession of nonpublic material
information in violation of his fiduciary duty to his company is liable.
• Anyone (1) with material, non-public information, (2) who breaches a fiduciary
duty to the source of the information (3) by revealing or trading on it, is liable.
• Anyone who reveals material nonpublic information in violation of his fiduciary
duty is liable if (1) he knows the information was confidential and (2) he
expected some personal gain.
• Those who receive tips—tippees—are liable for trading on inside information,
even if they do not have a fiduciary relationship to the company, so long as (1)
they know the information is confidential; (2) they know it came from an
insider who was violating his fiduciary duty; and (3) the insider expected
some personal gain.
• Rule 14e-3 prohibits trading on inside information during a tender offer if the trader
knows the information was obtained from either the bidder or the target company.
11. THE NSMIA The National Securities Markets Improvement Act prohibits states
from regulating securities offerings that are:
• traded on a national exchange,
• exempt under Rule 506, or
• sold to “qualified purchasers.” (p. 740)
12. BLUE SKY LAWS State securities statutes are called blue sky laws. (p. 740)
13. PRICE-FIXING When competitors agree on the prices at which they will buy or
sell products, their price-fixing is a per se violation of Section 1 of the Sherman Act.
(pp. 741–742)
14. RPM Resale price maintenance means the manufacturer sets minimum prices that
retailers may charge. It is a rule of reason violation of Section 1 of the Sherman Act.
(pp. 742–743)
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CHAPTER 30 Government Regulation: Securities and Antitrust 749
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15. VERTICAL MAXIMUM PRICE FIXING An arrangement whereby a
manufacturer sets maximum prices is a rule of reason violation of §1 of the Sherman
Act and, therefore, illegal only if it has an anticompetitive effect. (p.743)
16. MONOPOLIZATION Under §2 of the Sherman Act, it is illegal to monopolize or
attempt to monopolize a market. Having a monopoly is legal unless it is gained or
maintained by using wrongful tactics. To determine if a company is guilty of
monopolization, ask three questions:
• What is the market?
• Does the company control the market?
• How did the company acquire or maintain its control? (pp. 743–744)
Question: BAR/BRI was the largest bar review company in the country, with
branches in 45 states. Barpassers was a much smaller company located only in
Arizona and California. BAR/BRI distributed pamphlets on campuses that falsely
suggested Barpassers was near bankruptcy. Enrollments in Barpassers’ courses
dropped, and the company was forced to postpone plans for expansion. Did
Barpassers have an antitrust claim against BAR/BRI?
Strategy: It did not matter if BAR/BRI had a monopoly. These “bad acts” could
have helped the company acquire one. (See the“Result” at the end of this section.)
17. PREDATORY PRICING Predatory pricing occurs when a company lowers its
prices below cost to drive competitors out of business. (p. 744)
18. THE CLAYTON ACT The Clayton Act prohibits mergers that are
anticompetitive. (pp. 745–747)
19. TYING ARRANGEMENTS A tying arrangement is an agreement to sell a
product on the condition that the buyer also purchases a different (or tied) product.
Certain tying arrangements are illegal under the Clayton Act. (pp. 746–747)
20. RPA Under the Robinson-Patman Act, it is illegal to charge different prices to
different purchasers if the items are the same and the price discrimination lessens
competition. (p. 747)
1. Result: Newsom was selling securities: Buyers were investing in him, hoping
that they could earn a profit from his efforts. He needed to comply with the
provisions of the 1933 Act.
9. Result: You are in violation of §16. Even though you acted without any bad
intent, you must turn over all your profits to the company.
16. Result: A jury found that BAR/BRI had violated §2 of the Sherman Act by
attempting to create an illegal monopoly. The jury ordered BAR/BRI to pay
Barpassers more than $3 million, plus attorney’s fees.
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MULTIPLE-CHOICE QUESTIONS
1. Under Regulation D, an issuer:
(a) May not sell to 1,000 accredited investors
(b) May not sell to 27 unaccredited investors
(c) Must make disclosure to accredited investors
(d) Must make disclosure to unaccredited investors
(e) May only sell $1 million worth of stock
2. Which of the following statements is not true about a public offering?
(a) The issuer files a registration statement with the SEC.
(b) The issuer files a prospectus with the SEC.
(c) Company officers may make public statements about the offering before the
stock is sold.
(d) Company officersmaymake public statements about the offering after the stock is sold.
(e) The issuer may solicit offers for the stock before the effective date.
3. To have an illegal monopoly, a company must: (I) Control the market (II) Maintain its
control improperly (III) Have a market share greater than 50 percent
(a) I, II, and III
(b) I and II
(c) II and III
(d) I and III
(e) Neither I, II, nor III
4. Lloyd sold car floor mats to Mercedes dealerships. Then Mercedes began to include floor
mats as standard equipment. Mercedes has a 10 percent share of the luxury car market.
(a) Mercedes has created an illegal tying arrangement because floor mats and cars are
separate products.
(b) Mercedes has not created an illegal tying arrangement because it does not have
significant power in the luxury car market.
(c) Mercedes has not created an illegal tying arrangement because it is not tying the
two products together.
(d) Mercedes has created an illegal tying arrangement because it controls the market
in floor mats for its cars.
5. Mike is director of sales for his company. He negotiates prices with Paige and Lauren,
who work for two of his biggest customers. Paige tells him that she can buy the same
product cheaper elsewhere. He cuts the price for her, but not for his other customers.
At the same time, he develops a crush on Lauren, so offers to sell her the product at a
lower price. In subsequent months, these two customers come to dominate the
market. Which statement is correct?
(a) Mike can charge whatever price he wants to any customer.
(b) Mike must charge all his customers the same price.
(c) The price cut to Paige, but not Lauren, is legal.
(d) The price cut to Lauren, but not Paige, is legal.
(e) Mike is not required to charge all his customers the same price, but neither of
these price cuts is legal.
CHAPTER 30 Government Regulation: Securities and Antitrust 751
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ESSAY QUESTIONS
1. Jonah bought 12 paintings from Theo’s Art Gallery, at a total cost of $1 million. Theo
told Jonah that the paintings were a safe investment that could only go up in value.
The gallery permitted any purchaser to trade in a painting for any other artwork the
gallery owned. In the trade-in, the purchaser would get credit for the amount of the
original painting and then pay the difference if the new painting was worth more.
When Jonah’s paintings did not increase in value, he sued Theo for a violation of the
securities laws. Were these paintings securities?
2. You are in line at the movie theater when you overhear a stranger say: “The FDA has
just approved Hernstrom’s new painkiller. When the announcement is made on
Monday, Hernstrom stock will take off.” Have you violated the law if you buy stock
in the company before the announcement on Monday?
3. In New York City, 50 bakeries agreed to raise the retail price of bread. All the
association’s members printed the new price on their bread sleeves. Are the bakeries
in violation of the antitrust laws?
4. Suppose that Disney insists that retailers cannot sell DVDs of Brave for less than
$16.99. The company threatens to cut off any retailers who discount that price. But
stores would like to use these movies as a loss leader, selling them at a very low price
to lure customers. Is it legal for Disney to cut off retailers who discount prices?
5. Reserve Supply Corp., a cooperative of 379 lumber dealers, charged that Owens-
Corning Fiberglass Corp. violated the Robinson-Patman Act by selling at lower prices
to Reserve’s competitors. Owens-Corning had granted lower prices to a number of
Reserve’s competitors to meet, but not beat, the prices of other insulation
manufacturers. Is Owens-Corning in violation of the Robinson-Patman Act?
DISCUSSION QUESTIONS
1. Federal security laws are based on the assumption
that investors are knowledgeable enough to assess
the quality of a stock, so long as the issuer provides
adequate disclosure. Is this assumption reasonable,
or should securities laws provide greater protection
to investors?
2. ETHICS David Sokol worked at Berkshire
Hathaway for legendary investor Warren Buffett,
who is renowned not only for his investment skills
but also his ethics. Bankers suggested to both Sokol
and the CEO of Lubrizol that the company might
be a good buy for Berkshire. Sokol then found out
that the CEO of Lubrizol planned to ask his board
for permission to approach Berkshire about a
possible acquisition. Sokol purchased $10 million
worth of Lubrizol stock before recommending
Lubrizol to Buffett. Sokol mentioned to Buffett “in
passing” that he owned shares of Lubrizol. Buffett
did not ask any questions about the timing or
amount of Sokol’s purchases. Sokol made a $3
million profit when Berkshire acquired Lubrizol.
Did Sokol violate insider trading laws? Did he
behave ethically? What about Buffett?
3. The SEC believes that anyone in possession of
nonpublic material information about a company
should be required to disclose it before trading
on the stock of that enterprise. Instead, the
courts have developed a more complex set of
rules. Do you agree with the SEC or the courts
on this issue?
752 U N I T 4 Employment, Business Organizations and Property
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4. Resale price maintenance used to be a per se
violation of the antitrust laws, but now it is a rule of
reason violation. Will this change in the law lead to
higher or lower prices for consumers? Will it
provide other benefits for consumers? Do you
agree with the Supreme Court’s decision?
5. ETHICS Clarice, a young woman with a mental
disability, brought a malpractice suit against a
doctor at the Medical Center. As a result, the
Medical Center refused to treat her on a
nonemergency basis. Clarice then went to another
local clinic, which was later acquired by the
Medical Center. Because the new clinic also
refused to treat her, Clarice had to seek medical
treatment in another town 40 miles away. Has the
Medical Center violated the antitrust laws? Was is
it ethical to deny treatment to a patient?
CHAPTER 30 Government Regulation: Securities and Antitrust 753
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CHAPTER31
CONSUMER
PROTECTION
Three women signed up for a lesson at the
Arthur Murray dance studio in Washington,
D.C. Expecting a session of quiet fun, they
instead found themselves in a nightmare of
humiliation and coercion:
• “First of all, I did not want the [additional]
lesson, and I think it was unpleasant
because I had three, maybe four, people, as
I say, pressuring me to buy something by a
certain time, and I do recall asking that I be let to
think, let me think it over, and I was told that the
contest would end at 6 o’clock or something to that
effect and if I did not sign by a certain time, it
would be too late. I think we got under the
deadline by maybe a minute or two. If I had been
given time to think, I would not have signed that
contract.”
• “I tried to say no and get out of it and I got very,
very upset because I got frightened at paying out
all that money and having nothing to fall back on. I remember I started crying and
couldn’t stop crying. All I thought of was getting out of there. So finally after I don’t
know how much time, Mr. Mara said, well, I could sign up for 250 hours, which was
half the 500 Club, which would amount to $4,300. So I finally signed it. After that, I
tried to raise the money from the bank and found I couldn’t get a loan for that amount
and I didn’t have any savings and I had to get a bank loan to pay for it. That was when
I went back and asked him to cancel that contract. But Mr. Mara said that he couldn’t
cancel it.”
• “I did not wish to join the carnival, and while it was only an additional $55, I had no
desire to join. [My instructor] asked everyone in the room to sit down in a circle
around me and he stood me up in that circle, in the middle of the circle, and said,
‘Everybody, I want you to look at this woman here who is too cheap to join the
carnival. I just want you to look at a woman like that. Isn’t it awful?’ ”
I remember I started
crying and couldn’t
stop crying. All I thought
of was getting out of there.
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Because of abuses such as these, the Federal Trade Commission (FTC) ordered the
Arthur Murray dance studio to halt its high-pressure sales techniques, limit each contract
to no more than $1,500 in dance lessons, and permit all contracts to be canceled within
seven days.1
31-1 INTRODUCTION
Years ago, consumers typically dealt with merchants they knew well. A dance instructor
in a small town would not stay in business long if he tormented his elderly, vulnerable
clients. As the population grew and cities expanded, however, merchants became less
and less subject to community pressure. The law has supplemented, if not replaced,
these informal policing mechanisms. Both Congress and the states have passed statutes
that protect consumers from the unscrupulous. But the legal system is generally
too slow and expensive to handle small cases. The women who fell into the web of
Arthur Murray had neither the wealth nor the energy to sue the studio themselves.
To aid consumers such as these, Congress empowered federal agencies to enforce
consumer laws.
31-1a Federal Trade Commission
Congress created the FTC in 1915 to regulate business. Although its original focus was on
antitrust law, it now regulates a wide range of business activities that affect consumers—
everything from advertising to consumer loans to warranties to debt collection practices.
The FTC has several options for enforcing the law:
• Voluntary Compliance. When the FTC determines that a business has violated the
law, it first asks the offender to sign a voluntary compliance affidavit promising to stop
the prohibited activity.
• Administrative Hearings and Appeals. If the company refuses to stop voluntarily, the
FTC takes the case to an administrative law judge (ALJ) within the agency. The
violator may settle the case at this point by signing a consent order. If the case
proceeds to a hearing, the ALJ has the right to issue a cease and desist order,
commanding the violator to stop the offending activity. The FTC issued a cease
and desist order against the Arthur Murray dance studio. A defendant can appeal such
an order to the five Commissioners of the FTC, from there to a federal appeals court, and
ultimately to the United States Supreme Court. Both the Commissioners and the Fifth
Circuit Court of Appeals confirmed the cease and desist order against Arthur Murray.
The case never reached the Supreme Court.
• Penalties. The FTC can impose a fine for each violation of a voluntary compliance
affidavit, a consent order, a cease and desist order, an FTC rule, or a cease and desist
order issued against someone else. For example, the Arthur Murray studio could be
liable for violating an FTC cease and desist order prohibiting high-pressure sales by
the Fred Astaire studio. In addition, the FTC can file suit in federal court asking for
damages on behalf of an injured consumer if (1) the defendant has violated FTC
rules and (2) a reasonable person would have known under the circumstances that
the conduct was dishonest or fraudulent.
1ln re Arthur Murray Studio of Washington, Inc., 78 F.T.C. 401, 1971 FTC LEXIS 75 (1971).
CHAPTER 31 Consumer Protection 755
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31-1b Consumer Financial Protection Bureau
In 2010, Congress created the Consumer Financial Protection Bureau (CFPB) to regulate
consumer financial products and services, including mortgages, credit cards, and private
student loans. (It does not have the authority to regulate car loans.) Among its goals is to clarify
and simplify the terms of credit cards, checking accounts, and mortgage disclosure forms.
Already, the CFPB has proposed rules that would require banks to clearly reveal
overdraft fees on checking accounts, announced its intent to closely supervise credit
reporting agencies, and obtained a $210 million settlement from Capital One for deceptive
marketing of credit cards.
31-2 SALES
Section 5 of the Federal Trade Commission Act (FTC Act) prohibits “unfair and deceptive
acts or practices.”
31-2a Deceptive Acts or Practices
Many deceptive acts or practices involve advertisements. Under the FTC Act, an adver-
tisement is deceptive if it contains an important misrepresentation or omission that is likely
to mislead a reasonable consumer. A company advertised that a pain-relief ointment called
“Aspercreme” provided “the strong relief of aspirin right where you hurt.” From this ad and
the name of the product, do you assume that the ointment contains aspirin? Are you a
reasonable consumer? Consumers surveyed in a shopping mall believed the product con-
tained aspirin. In fact, it does not. The FTC required the company to disclose that there is
no aspirin in Aspercreme.2
In another example, Nestlé sold a drink called Boost Kid Essentials, which contained
probiotics, good bacteria that aid digestion and fight bad germs. But Nestlé went further
than that in its ads, claiming that Boost would prevent children from getting sick or missing
school. How could any parent resist that drink? Only Nestlé had no evidence for these
claims. In a settlement with the FTC, Nestlé agreed not to make any claims for which it did
not have scientific evidence.
In the following case, the court discussed the type of scientific evidence required to
support health claims.
2In re Thompson Medical Co., Inc., 104 F.T.C. 648, 1984 FTC LEXIS 6 (1984).
FEDERAL TRADE COMMISSION V. DIRECT MARKETING
CONCEPTS, INC.
624 F.3d 1; 2010 U.S. App. LEXIS 21743
United States Court of Appeals for the First Circuit, 2010
C A S E S U M M A R Y
Facts: Direct Marketing Concepts, Inc., broadcast an
infomercial for Coral Calcium that featured a spokes-
person named Robert Barefoot. In the ad, his claims
were as bare as his feet. He asserted that these pills
could cure virtually all diseases, including heart
disease, cancer, lupus, multiple sclerosis, and
Parkinson’s. To bolster these claims, Barefoot cited
unspecified articles from prominent medical journals.
During an 18-month period, this infomercial generated
$54 million in sales.
756 U N I T 4 Employment, Business Organizations and Property
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31-2b Unfair Practices
The FTC Act also prohibits unfair acts or practices. The Commission considers a practice to
be unfair if it meets all of the following three tests:
• It causes a substantial consumer injury. This can mean physical or financial injury.
A furnace repair company that dismantled home furnaces for “inspection” and
then refused to reassemble them until the consumers agreed to buy services
or replacement parts had caused a substantial consumer injury.
• The harm of the injury outweighs any countervailing benefit. A pharmaceutical
company sold a sunburn remedy without conducting adequate tests to ensure
that it worked. The expense of these tests would have forced the company
to raise the product’s price. The company had demonstrated that the product
was safe, and there was evidence in the medical literature that the ingredients
when used in other products were effective. The FTC determined that,
although the company was technically in violation of its rules, the benefit
to consumers of a cheaper product more than outweighed the risk of injury
to them.
• The consumer could not reasonably avoid the injury. The FTC is particularly vigilant
in protecting susceptible consumers—such as the elderly or the ill—who are
less able to avoid injury. For instance, the Commission looks especially
carefully at those who offer a cure for cancer, as the defendants did in the
Direct Marketing case.
In addition, the FTC may decide that a practice is unfair simply because it violates
public policy, even if it does not meet these three tests. The Commission refused to allow a
mailorder company to file collection suits in states far from where the defendants lived
because the practice was unfair, whether or not it met the three tests.
The FTC filed suit against the company and
Barefoot, alleging that the infomercials were deceptive.
The trial court granted the FTC’s motion for summary
judgment, ruling that the infomercials were misleading as
a matter of law and, therefore, there was no need for a
trial. The defendants appealed.
Issue: Were the infomercials misleading as a matter of law?
Decision: Yes, the infomercials were misleading and no
trial was needed.
Reasoning: To make claims such as these, the defend-
ants needed to have had some scientific evidence. But
medical experts for the FTC testified that there was no
evidence that calcium cures any of the diseases listed in
the infomercial. Nor have there ever been any articles in
serious medical journals that would support such claims.
The only evidence for these infomercials was
excerpts from Barefoot’s books, his deposition testimony,
and some popular science and pseudoscientific articles,
which included references to magazines such as Reader’s
Digest. But none of these sources (other than his own
writings) supported Barefoot’s claims. Therefore, the
defendants engaged in deceptive advertising as a matter
of law.
In their defense, Barefoot and the company claimed
that the statements were nothing but puffery and that the
disclaimers in the ads were sufficient to defeat an action
for deceptive advertising. However, specific and measur-
able claims are not puffery. And the only disclaimer was
the notice that the ads were paid advertising. Disclaimers
are not effective unless they leave consumers with an
accurate impression of the product being advertised. That
was not the case here.
CHAPTER 31 Consumer Protection 757
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31-2c Additional Sales Rules
BAIT-AND-SWITCH
FTC rules prohibit bait-and-switch advertisements: A merchant may not advertise a product
and then disparage it to consumers in an effort to sell a different (more expensive) item.
Seven websites based in Brooklyn, New York, such as Best Price Photo and 86th
Street Photo, engaged in a classic bait-and-switch operation. They advertised products
at a much lower price than competitors. That was the bait—an alluring offer that sounds
almost too good to be true. Of course, it is. Once a customer placed an order, the
company tried to sell an upgraded product at a much higher price. That is the switch.
The real purpose of the advertisement was simply to find customers who were inter-
ested in buying. If customers refused the new item, they would be told that the original
product was backordered, and the sale was cancelled. If customers agreed to buy the
more expensive product, it would turn out to be of poor quality. But the company
would not allow returns—either the return fees would be high or the “customer
service” department would refuse to answer the phone.
MERCHANDISE BOUGHT BY MAIL, BY TELEPHONE, OR ONLINE
Many consumers buy virtually everything—food, clothing, furnishings—online. The FTC
has established the following rules for this type of merchandise:
• Sellers must ship an item within the time stated or, if no time is given, within 30 days
after receipt of the order.
• If a company cannot ship the product when promised, it must send the customer a
notice with the new shipping date and an opportunity to cancel. If the new shipping
date is within 30 days of the one originally promised and the customer does not
cancel, the order is still valid.
• If the company cannot ship by the second shipment date, it must send the customer
another notice. This time, however, the company must cancel the order unless the
customer returns the notice, indicating that he still wants the item.
Staples, Inc., violated these FTC rules when it told customers that they were viewing
“real-time” inventory and that products would be delivered in one day, even on weekends.
In fact, the website was not updated in real time, one-day delivery only applied to
customers who lived within 20 miles of a Staples store, and it never happened on weekends.
The company paid a fine of $850,000 to settle these charges.
TELEMARKETING
It used to be that telemarketers would practically ruin dinner hour in the United States with
their relentless phone calls. But now, FTC rules prohibit telemarketers from calling any
telephone number listed on its do-not-call registry. You can register your home and cell
phone numbers with the FTC online at http://www.donotcall.gov or by telephone at (888)
382-1222. FTC rules also prohibit telemarketers from blocking their names and telephone
numbers on Caller ID systems.
What is even more annoying than telemarketing calls from a live person? Robocalls
(prerecorded commercial telemarketing calls) from a machine. Such calls are illegal unless
the telemarketer obtains written permission from the person being called. You can file a
complaint by calling (877) FTC-HELP or by going to the ftc.gov website. Exempted from
this ban are informational calls (cancellations of a flight or a school day), debt collection calls
(as long as they are not trying to sell anything), political messages, charitable outreach, and
health care messages.
Bait-and-switch
A practice where sellers
advertise products that are not
generally available but are being
used to draw interested parties
in so that they will buy other
products.
758 U N I T 4 Employment, Business Organizations and Property
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UNORDERED MERCHANDISE
Under §5 of the FTC Act, anyone who receives unordered merchandise in the mail can treat
it as a gift. She can use it, throw it away, or do whatever else she wants with it.
There you are, watching an infomercial for Anushka products, guaranteed to fight that
scourge of modern life—cellulite! Rushing to your phone, you place an order. The Anushka
cosmetics arrive, but for some odd reason, the cellulite remains. A month later, another bottle
arrives, like magic, in the mail. The magic spell is broken, however, when you get your credit
card bill and see that, without your authorization, the company has charged you for the new
supply of Anushka. Is this a hot new marketing technique? Not exactly. The FTC ordered
the company to cease and desist this unfair and deceptive practice. The company improperly
billed its customers, said the FTC, and should have notified them that they were free to treat
the unauthorized products as a gift, to use or throw out as they wished.3
DOOR-TO-DOOR SALES
Consumers at home need special protection from unscrupulous salespeople. In a store,
customers can simply walk out, but at home, they may feel trapped. Under the FTC door-
to-door rules, a salesperson is required to notify the buyer that she has the right to cancel the
transaction prior to midnight of the third business day thereafter. This notice must be given
both orally and in writing; the actual cancellation must be in writing. The seller must return
the buyer’s money within 10 days.
EXAM Strategy
Question: Mantra Films sold “Girls Gone Wild” DVDs on the Internet. When
customers ordered one DVD, the company would enroll them automatically in a
“continuity program” and send them unordered DVDs each month on a “negative-
option” basis, charging consumers’ credit cards for each DVD until consumers took
action to stop the shipments. Is Mantra’s marketing plan legal?
Strategy: Review the various sales regulations—more than one is involved in this case.
Result: This marketing plan was deceptive because customers were not told that
they would be enrolled in the continuity program. Also, Mantra could not legally bill
for the unordered DVDs. Under the unordered merchandise rule, consumers had the
right to treat them as gifts.
31-3 CONSUMER CREDIT
Historically, the practice of charging interest on loans was banned by most countries and by
three of the most prominent religions—Christianity, Islam, and Judaism. As the European
economy developed, however, moneylending became essential. To compromise, govern-
ments began to permit interest charges but limited the maximum rate.
Even in modern times, many states limit the maximum interest rate a lender may
charge consumers. (Although, usury laws typically do not apply to credit card debt, mort-
gages, consumer leases, or commercial loans.) The penalty for violating usury statutes varies
among the states. Depending upon the jurisdiction, the lender may forfeit (1) the interest
above the usury limit, (2) all of the interest, or (3) all of the loan and the interest.
3In the Matter of Synchronal Corp., 116 F.T.C. 1189, 1993 FTC LEXIS 280 (1993).
CHAPTER 31 Consumer Protection 759
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31-3a Truth in Lending Act—General Provisions
To avoid the penalties of usury laws, lenders found many creative methods to disguise the
real interest rate from the authorities. In the process, they also hid it from borrowers. Many
consumers had no idea what interest rate they were really paying. Congress passed the Truth
in Lending Act (TILA) with the simple goal of ensuring that when consumers borrowed
money, they understood the terms and costs of the loan. Note that TILA does not regulate the
actual interest rates or the terms of a loan; that responsibility is left to the states. TILA simply
requires lenders to disclose the terms of a loan in an understandable and complete manner.
APPLICABILITY
TILA applies to a transaction only if all of the following tests are met:
• It is a consumer loan. That means a loan to an individual for personal, family, or
household purposes, not a loan to a business.
• The loan has a finance charge or will be repaid in more than four installments. Sometimes
finance charges masquerade as installment plans. Boris can pay for his 3D TV in six
monthly installments of $400 each, or he can pay $1,800 cash up front. If he chooses
the installment plan, he is effectively paying a finance charge of $600. That is why
TILA applies to loans with more than four installments.
• The loan is for less than $53,000, is secured by a mortgage on real estate, or is a private
education loan.4
• The loan is made by someone in the business of offering credit. If Boris borrows from his
friend to buy the TV, TILA does not apply.
DISCLOSURE
In all loans regulated by TILA:
• The disclosure must be clear and in meaningful sequence. For example, a finance company
made all the necessary disclosures, but it violated TILA nonetheless because it
scattered the required terms throughout the loan document, intermixed with
confusing provisions that were not required by TILA.5 A loan document should not
be a scavenger hunt.
• The lender must disclose the finance charge. The finance charge is the amount, in dollars,
the consumer will pay in interest and fees over the life of the loan. It is important
for consumers to know this amount because otherwise, they may not understand the
real cost of the loan. Of course, the longer the loan, the higher the finance charge.
Someone who borrows $5,000 for 10 years at 10 percent annual interest will pay
$500 each year for 10 years, for a total finance charge of $5,000—equal to the
principal borrowed. In 30-year mortgages, the finance charge will typically exceed
the amount of the principal.
• The creditor must also disclose the annual percentage rate (APR). This number is the actual rate
of interest the consumer pays on an annual basis. Without this disclosure, it would be
easy in a short-term loan to disguise a very high APR because the finance charge is low.
Boris borrows $5 for lunch from his employer’s credit union. Under the terms of the loan,
he must repay $6 the following week. His finance charge is only $1, but his APR is
astronomical—20 percent per week—which is over 1,000 percent for a year.
4This amount adjusts every December 31, to reflect inflation.
5Allen v. Beneficial Fin. Co. of Gary, 531 F.2d 797, 1976 U.S. App. LEXIS 12935 (7th Cir. 1976).
760 U N I T 4 Employment, Business Organizations and Property
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All TILA loans must meet these three requirements. TILA requires additional
disclosure for two types of loans: open-end credit (discussed later in the chapter) and
closed-end credit.
Closed-end Credit In a closed-end transaction, the loan is a fixed amount and the
borrower knows the payment schedule in advance. Boris enters into a closed-end transaction
when he buys a $30,000 car and agrees to make specified monthly payments over five years.
Before a consumer enters into a closed-end transaction, the lender must disclose:
• The cash price;
• The total down payment;
• The amount financed;
• An itemized list of all other charges;
• The number, amount, and due dates of payments;
• The total amount of payments;
• Late payment charges;
• Penalties for prepaying the loan; and
• The lender’s security interest in the item purchased.
Enforcement The FTC generally has the right to enforce TILA. In addition, consumers
who have been injured by any violation (except for the advertising provisions) have the right
to file suit.
31-3b Home Loans
MORTGAGE LOANS
TILA prohibits unfair, abusive, or deceptive home mortgage lending practices. In what
seems like an exercise in stating the obvious, TILA (as amended by the Dodd-Frank Wall
Street Reform and Consumer Protection Act):
• Requires lenders to make a good-faith effort to determine whether a borrower can
afford to repay the loan,
• Prohibits lenders from coercing or bribing an appraiser into misstating a home’s
value, and
• Bans prepayment penalties on adjustable rate mortgages.
TILA also regulates so-called subprime loans (also known as higher-priced mortgage
loans). These are loans that have an above-market interest rate because they involve
high-risk borrowers.6 For subprime loans, a lender:
• Must collect property taxes and homeowners insurance for all first mortgages.
• May not make loans that have balloon payments (very large payments at the end).
• May not charge excessive late fees.
6In the official definition, subprime loans (also referred to as higher-priced loans) are first mortgages
that have an APR 1.5 percentage points or more above the average prime offer rate or second
mortgages that have an APR 3.5 percentage points or more above that index.
Subprime loans
A loan that has an above-
market interest rate because
the borrower is high-risk.
CHAPTER 31 Consumer Protection 761
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HOME EQUITY LOANS
Scam artists sometimes prey upon the elderly, who are vulnerable to pressure, and upon the
poor, who may not have access to conventional financing. These swindlers offer home
equity loans, secured by a second mortgage, to finance fraudulent repairs. (There are, of
course, many legitimate lenders in the home equity business.) The following news report
shows scam artists at work:
Mack and Jacqueline Moon of East Baltimore hired a home improvement contractor to install a
dropped ceiling, paneling, and cabinets in the unfinished basement of their rowhouse. The
couple was determined not to put a second mortgage on their house, anticipating they would
need backup money to pay medical expenses for their 10-year-old daughter, who had lupus.
They signed the contract a few days later after a second salesman assured them, “We were able to
work it out, and you don’t have to worry about a mortgage.” The Moons were never given copies
of the loan documents nor told of the 17 percent interest rate. A year later, when they tried to use
their home’s equity to pay medical bills for their daughter, who had since died, they discovered
they had given a second mortgage to the lender without knowing it.7
In response to such scams, Congress amended TILA to provide additional
consumer safeguards for certain home equity installment loans. If a home equity
installment loan:
• Has an APR (interest rate) that is more than 10 percentage points higher than
Treasury securities, or
• The consumer must pay fees and points at closing that are higher than 8 percent of
the total loan amount, then,
• At least three business days before the loan closing, the lender must notify the
consumer that (1) he does not have to go through with the loan (even if he has
signed the loan agreement) and (2) he could lose his house if he fails to make
payments, and
• Loans that are for less than five years may not contain balloon payments (that is, a
payment at the end that is more than twice the regular monthly payment).
RESCISSION
This change in the law came too late to help the Moons, but they found relief in a different
TILA provision. Under TILA, consumers have the right to rescind a mortgage for up to
three business days after the signing (including Saturdays). However, if the lender does not
comply with the disclosure provisions of TILA, the consumer can rescind for up to three
years from the date of the mortgage.
The Moons were able to rescind the loan because the lender had not made adequate
disclosure. This right of rescission does not apply to a first mortgage used to finance a house
purchase or to any refinancing with the consumer’s existing lender. (Note that some states
have passed, and others are considering, predatory lending laws that more strictly regulate
loans with high fees or interest rates.)
The table below summarizes the major provisions of TILA that we have discussed
so far.
7Lorraine Mirabella, “With Hopes of Improving Their Homes, Many Owners Fall Prey to Loan
Scams.” Copyright 1994 by Baltimore Sun Company. Reproduced by permission of Baltimore Sun
Company via Copyright Clearance Center.
762 U N I T 4 Employment, Business Organizations and Property
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TILA applies to a transaction only if: It is a consumer loan.
The loan has a finance charge or will be repaid in more
than four installments.
The loan is for less than $53,000, is secured by a
mortgage on real estate, or is a private education loan.
The loan is made by someone in the business of offering
credit.
In all loans regulated by TILA: The disclosure must be clear and in meaningful sequence.
The lender must disclose the finance charge and the APR.
For regular mortgage loans: Lenders must verify the borrowers’ ability to repay the
loan. Lenders may not coerce or bribe an appraiser into
misstating a home’s value. Lenders cannot charge
prepayment penalties on adjustable rate mortgages.
For subprime mortgage loans: Loans with balloon payments are prohibited.
Late fees are limited.
31-3c Credit Cards
Credit and debit cards are extremely important to most consumers, so lately they have come
under increased scrutiny from Congress and the regulatory agencies.
DISCLOSURE
TILA establishes disclosure rules for credit cards, which it calls open-end credit. This is a
credit transaction in which the lender makes a series of loans that the consumer can repay at
once or in installments. These rules apply to all consumer credit cards, such as VISA or
MasterCard, which permit installment payments, and even to those, such as American
Express, that require the full balance to be paid each month.
In any advertisement or solicitation, the lender must disclose:
• Credit terms.
• In the case of a teaser rate, it must clearly disclose that the rate is introductory, when it
expires, and the permanent rate that will replace it.
Before establishing an open-end credit account, the lender must disclose to the consumer:
• When a finance charge will be imposed, and
• How the finance charge will be calculated (for example, whether it will be based on the
account balance at the beginning of the billing cycle, the end, or somewhere in between).
In each monthly statement, the lender must disclose:
• The amount owed at the beginning of the billing cycle (the previous balance);
• Amounts and dates of all purchases, credits, and payments;
• Finance charges and late fees;
• The date by which a bill must be paid to avoid these charges; and
• Either the consequences of making the monthly minimum payment or a toll-free
number that can be used to obtain such information.
©
C
en
g
ag
e
Le
ar
n
in
g
Open-end credit
A lender makes a series of
loans that the consumer can
repay at once or in
installments.
CHAPTER 31 Consumer Protection 763
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REGULATION OF CREDIT CARD DEBT
Credit Card Act of 2009 During the economic crisis that began in 2008, many
consumers struggled to pay their credit card bills. In response, Congress increased oversight
of credit card companies by passing the Credit Card Act of 2009. Under the new rules, these
companies:
• Cannot increase the interest rate, fees, or charges on balances a consumer has already
run up unless she is more than 60 days late in making the minimum payment.
• Must give 45 days’ notice before increasing a card’s annual percentage rate (APR)
or making any other significant change in credit terms (which gives the consumer
a chance to pay off the bill ahead of the increase).
• Must re-evaluate any rate increase every six months, and then, if a decrease is
warranted, it must occur within 45 days after the evaluation.
• Must give notice of the consumer’s right to cancel a card and pay off the debt once
the APR is changed.
• Cannot charge interest on fees or on a bill that is paid on time or during a grace period.
• Cannot charge late payment fees of more than $25 (unless one of the consumer’s last
six payments was late, in which case the fee may be up to $35 or the company can
show that its costs justify a higher fee).
• Cannot charge late fees that are greater than the minimum payment owed.
• Cannot charge more than one fee per event, such as a single late payment.
• Must mail the bill at least 21 days before the due date, disclose what the due date is,
and set the same due date each month.
• Cannot set due dates on weekends or in the middle of the day. If the payment arrives
by 5 p.m. on the day it is due, or if it arrives on the weekend after a Friday due date,
it is on time.
• Must warn consumers about the impact of making minimum-only payments.
• Must apply any payments to whichever debt on the card has the highest interest rate
(say, a cash advance rather than a new purchase).
• Must offer consumers the right to set a fixed credit limit. Consumers cannot be
charged a fee if the company accepts charges above that limit unless the consumer
has agreed to the fee.
• Cannot issue credit cards to people under 21 unless the young person has income
or the application is co-signed by someone who can afford to pay the bills, such as
a parent or spouse. The co-signer must also approve any increase in the credit
limit.
Ethics Each of the rules in the previous section was aimed at eliminating existing
practices. Looking at this list, would you judge any of these practices to be
unethical? Banks argue that they will have to replace this lost income by charging other fees
for, say, maintaining a basic checking account. What Life Principles should bankers apply
when they set fees?
764 U N I T 4 Employment, Business Organizations and Property
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LIABILITY
Stolen Cards Your wallet is missing, and with it your cash, your driver’s license, a photo
of your dog, a Groupon, and—oh, no!—all your credit cards! It is a disaster, to be sure. But it
could have been worse. There was a time when you would have been responsible for every
charge a thief rang up. Now, under TILA, you are liable only for the first $50 in charges the
thief makes before you notify the credit card company. If you call the company before any
charges are made, you have no liability at all. But if, by the time you contact the company, a
speedy robber has completely furnished her apartment on your card, you are still liable only
for $50. Of course, if you carry a wallet full of cards, $50 for each one can add up to a sizable
total. If the thief steals just your credit card number, but not the card itself, you are not
liable for any unauthorized charges.
Disputes with Merchants You use your credit card to buy a new tablet computer at
ShadyComputers, but when you take it out of the box, it will not even turn on. You have a
major $600 problem. But all is not lost. In the event of a dispute between a customer and a
merchant, the credit card company cannot bill the customer if (1) she makes a good faith
effort to resolve the dispute, (2) the dispute is for more than $50, and (3) the merchant is in
the same state where she lives or is within 100 miles of her house.
What happens if the merchant and the consumer cannot resolve their dispute, or if the
merchant is not in the same state as the consumer? Clearly, credit card companies do not want
to be caught in the middle between consumer and merchant. In practice, they now require all
merchants to sign a contract specifying that, in the event of a dispute between the merchant
and a customer, the credit card company has the right to charge back the merchant’s account.
If a customer seems to have a reasonable claim against a merchant, the credit card company
will typically transfer the credit it has given the merchant back to the customer’s account. Of
course, the merchant can try to sue the customer for any money owed.
Disputes with the Credit Card Company The Fair Credit Billing Act (FCBA)
provides additional protection for credit card holders (and for holders of so-called revolving
charge accounts—such as those from stores). Is there anyone in America who has not
sometime or other discovered an error in a credit card bill? Before Congress passed the
FCBA in 1975, a dispute with a credit card company often deteriorated into an avalanche of
threatening form letters that ignored any response from the hapless cardholder.
Under the FCBA:
• If, within 60 days of receipt of a bill, a consumer writes to a credit card company to
complain about the bill, the company must acknowledge receipt of the complaint
within 30 days.
• Within two billing cycles (but no more than 90 days), the credit card company must
investigate the complaint and respond:
� In the case of an error, by correcting the mistake and notifying the consumer
� If there is no error, by writing to the consumer with an explanation
• Whether or not there was a mistake, if the consumer requests it, the credit card
company must supply documentary evidence to support its position—for example,
copies of the bill signed by the consumer or evidence that the package actually arrived.
• The credit card company cannot try to collect the disputed debt or close or suspend
the account until it has responded to the consumer complaint.
• The credit card company cannot report to credit agencies that the consumer has an
unpaid bill until 10 days after the response. If the consumer still disputes the charge,
the credit card company may report the amount to a credit agency but must disclose
that it is disputed.
CHAPTER 31 Consumer Protection 765
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In the following case, American Express made a big mistake picking on a law professor.
The court’s opinion was written by Abner J. Mikva, a highly regarded judge on the federal
appeals court. He was clearly exasperated by American Express’s arguments and used
strong language to reprimand the company—and the lower court. Since Judge Mikva had
served in Congress, he could speak with some authority about Congress’s approach to
consumer legislation.
31-3d Debit Cards
LIABILITY
So your wallet is missing, and with it your debit card. No problem, right—it is just like a
credit card? Wrong. Debit cards look and feel like credit cards, but legally they are a
different plastic altogether. Debit cards work like checks (which is why they are also called
check cards). When you use your debit card, the bank deducts money directly from your
account, which means there is no bill to pay at the end of the month (and no interest charges
on unpaid bills). That is the good news.
GRAY V. AMERICAN EXPRESS CO.
743 F.2d 10, 240 U.S. App. D.C. 10, 1984 U.S. App. LEXIS 19033
United States Court of Appeals for the District of Columbia Circuit, 1984
C A S E S U M M A R Y
Facts: In December, Oscar Gray used his American
Express credit card to buy airline tickets costing $9,312.
American Express agreed that Gray could pay for the
tickets in 12 monthly installments. In January, Gray paid
$3,500 and then in February, an additional $1,156. In
March, American Express billed Gray by mistake for the
entire remaining balance, which he did not pay. In April,
Gray and his wife went out for dinner to celebrate their
wedding anniversary. When he tried to pay with his
American Express card, the restaurant told him that the
credit card company had not only refused to accept the
charges for the meal but had instructed the restaurant to
confiscate and destroy the card. While still at the restau-
rant, Gray spoke on the telephone to an American
Express employee, who informed him, “Your account is
canceled as of now.”
Gray wrote to American Express, pointing out the
error. For more than a year, the company failed to respond
to Gray or to investigate his claim. It then turned the bill
over to a collection agency. Gray sued American Express
for violating the Fair Credit Billing Act. The trial court
granted summary judgment to American Express and
dismissed the complaint on the grounds that Gray had
waived his rights under the Act.
Issue: Was American Express liable to Gray for violating the
FCBA?
Decision: Yes, American Express violated the FCBA.
Reasoning: The FCBA provides that, during an on-going
dispute between a credit card company and a consumer,
the company cannot close the consumer’s account simply
for failure to pay the disputed amount. American Express
argued, however, that the statute did not apply in this case
because its standard credit card contract, which Gray
signed, gave the company the right to revoke his card at
any time without cause and without notice.
It is true that Gray signed this lopsided contract.
However, the whole point of consumer law is to even
out bargaining power between companies and con-
sumers. To allow a consumer to waive his rights in this
way would make the statute meaningless. A court should
not assume that Congress has passed a nonsensical
statute.
Check cards
Another name for a debit card.
766 U N I T 4 Employment, Business Organizations and Property
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The bad news is that your liability for a stolen debit card is much greater. If you report
the loss before anyone uses your card, you are not liable for any unauthorized withdrawals. If
you report the theft within two days of discovering it, the bank will make good on all losses
above $50. If you wait until after two days, your bank will only replace stolen funds above
$500. After 60 days of receipt of your bank statement, all losses are yours: The bank will not
repay any stolen funds. If an unauthorized transfer takes place using just your number, not
your card, then you are not liable at all as long as you report the loss within 60 days of
receiving the bank statement showing the loss. After 60 days, however, you are liable for the
full amount.
FEES
Many people like to use debit cards to help keep track
of their spending and to avoid paying the interest rates
on credit cards. However, traditionally there was a large
downside to debit cards: Banks would charge a flat fee
of $20 to $30 each time cardholders overdrew their bank
account, no matter how small the overdraft. A customer
could easily be charged $150 in overdraft fees on $50
worth of overdrafts. Suppose that someone makes a $20
overdraft that he repays in two weeks, but in the meantime,
he incurs a $27 fee. In that case, he has paid an interest rate
of 3,520 percent.
Under new rules, though, banks are not allowed to
overdraw an account and charge the fee unless the
consumer signs up for an overdraft plan. Of course,
this rule means that consumers who do not “opt in”
to the overdraft plan will not be allowed to overdraw their account, no matter how
desperate they are. (The same rule applies to ATM withdrawals.)
31-3e Credit Reports
ACCURACY OF CREDIT REPORTS
Gossip and rumor can cause great harm. Bad enough when whispered behind one’s back,
worse yet when placed in files and distributed to potential creditors. Most adults rely on
credit—to acquire a house, credit cards, overdraft privileges at the bank, or even obtain a job
or rent an apartment. A sullied credit report makes life immensely more difficult. A number
of statutes, including the Fair Credit Reporting Act (FCRA), the Fair and Accurate Credit
Transactions Act (FACTA), and Dodd-Frank regulate credit reports.
Consumer reporting agencies are businesses that supply consumer reports to third
parties. A consumer report is any communication about a consumer’s creditworthiness,
character, general reputation, or lifestyle that is considered as a factor in establishing credit,
obtaining insurance, securing a job, acquiring a government license, or for any other
legitimate business need. Under the FCRA:
• A consumer reporting agency cannot report obsolete information. Ordinary credit
information is obsolete after seven years, bankruptcies after 10 years. (But if a
consumer is applying for more than $150,000 of credit or life insurance, or for a job
that pays more than $75,000 a year, then there is no time limit.)
• Investigative reports that discuss character, reputation, or lifestyle become obsolete in
three months. An investigative report cannot be ordered without first informing the
consumer.
Debit cards look and feel
like credit cards, but
legally they are a
different plastic
altogether.
Investigative reports
Reports that discuss
character, reputation, or
lifestyle. They become obsolete
in three months.
Consumer reporting
agency
A business that supplies
consumer reports to third
parties.
CHAPTER 31 Consumer Protection 767
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• A consumer reporting agency cannot report medical information without the
consumer’s permission.
• An employer cannot request a consumer report on any current or potential employee
without the employee’s permission. An employer cannot take action because of
information in the consumer report without first giving the current or potential employee
a copy of the report and a description of the employee’s rights under this statute.
• Anyone who makes an adverse decision against a consumer because of a credit report
must reveal the name and address of the reporting agency that supplied the
information. An “adverse decision” includes denying credit or charging higher rates.
• Upon request from a consumer, a reporting agency must disclose all information in his
file, the source of the information (except for investigative reports), the name of
anyone to whom a report has been sent in the prior year (two years for employment
purposes), and the name of anyone who has requested a report in the prior year.
• If a consumer tells an agency that some of the information in his file is incorrect,
the agency must both investigate and forward the data to the information
provider. The information provider must investigate and report the results to
the agency. If the data are inaccurate, the information provider must so notify
all national credit agencies. The consumer also has the right to give the agency
a short report telling his side of the story. The agency must then include the
consumer’s statement with any credit reports it supplies and also, at the consumer’s
request, send the statement to anyone who has received a report within six months
(or two years for employment purposes).
EXAM Strategy
Question: Edo applied for insurance with Geico. In calculating his premium, Geico
looked at his credit history and his financial circumstances. It did not offer him the
best possible premium, but this was because of his current finances, not his credit
history. Was this an “adverse decision” under the FCRA, and was Geico required to
notify him?
Strategy: Review the requirements of the FCRA. An adverse decision means that
Edo was worse off because of a bad credit report.
Result: Edo’s premium was based on his current situation, not his credit history.
Therefore, Geico did not have to notify Edo of an adverse decision because his
premium would have been the same even if his credit report had been neutral.
ACCESS TO CREDIT REPORTS AND CREDIT SCORES
Under FACTA, consumers are entitled by law to one free credit report every year from each
of the three major reporting agencies: Equifax, Experian, and TransUnion. You can order
these reports at https://www.annualcreditreport.com. Consumer advocates recommend that
you check your credit reports every year to make sure they are accurate and that no one else
has been obtaining credit in your name. If you find any errors, notify the agency in writing and
warn it that failing to make corrections is a violation of the law. (Note, though, that many
websites with similar names pretend to offer a free credit report but instead enroll customers in
paid programs to monitor their credit reports. Be sure to go to the right website.)
768 U N I T 4 Employment, Business Organizations and Property
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Although your credit report is valuable information, you do not know how creditors will
evaluate it. For that, you need to know your credit score (usually called a FICO score).8 This
number (which ranges between 300 and 850) is based on your credit report and is supposed
to predict your ability to pay your bills. However, it is not automatically included as part of
your credit report. But now, under Dodd-Frank, anyone who penalizes you because of your
score has to give it to you for free, as well as information about how your score compares
with others.
IDENTITY THEFT
In identity theft, a fraudster steals the victim’s personal information, such as social security
number, credit card information, or mother’s maiden name, and uses it to obtain credit or
goods in the victim’s name and otherwise wreak havoc in the victim’s life. One goal of
FACTA was to reduce identity theft. Therefore, in addition to your right to a free credit
report each year, FACTA also created the National Fraud Alert System, which permits
consumers who fear they may be the victim of identity theft to place an alert in their credit
files, warning financial institutions to investigate carefully before issuing any new credit. It
also requires credit bureaus to share information about identity theft.
A fraud alert does not prevent identity theft—culprits may still be able to open a new
account or obtain a credit card. Therefore, many states permit a “security freeze,” which
prohibits any access to a consumer’s credit report. Once an account is frozen, no one,
including the consumer, can obtain a new line of credit. The downside is that to obtain
new credit, the consumer must pay a fee to thaw the account.
Also, under the Gramm-Leach-Bliley Privacy Act of 1999, banks, other financial institu-
tions, and consumer reporting agencies must notify a consumer (1) before disclosing any
personal information to a third party or (2) if there has been unauthorized access to the
consumer’s sensitive personal information.9 The company cannot disclose private informa-
tion if the consumer opts out (that is, denies permission).
31-3f Debt Collection
Have you ever fallen behind on your car payments? That is hardly a crime—but in the past,
debt collectors might have treated you as a criminal. They might have threatened to arrest
you. Or they might have changed the password on your cell phone account and obtained
your cell phone records so that they could pose as a police officer and call your friends,
relatives, and past employers to tell them there was an arrest warrant out for you, even if this
was not true.
It is bad enough to be hassled over a debt that one does, in fact, owe, but many times,
consumers are threatened and harangued for debts that are not legitimate. Indeed, this
author has had such an experience: A hospital billed the wrong insurance company and
then notified her (at the wrong address) when the insurance company did not pay. When
she failed to pay a bill she had never received and did not owe, the hospital turned it over
to a collector who, in violation of state law, called her to yell, harangue, and threaten. In
the end, all was resolved (she is, after all, a lawyer aware of her rights), but the experience
was terribly unpleasant. Typically, companies sell their consumer debts for pennies on the
dollar to collection agencies that are not overly scrupulous in ascertaining whether the
debt is legitimate. Hoping for a little help from Washington? In a recent year, the FTC
received 66,000 complaints about debt collectors, yet it brought enforcement action
against only 10 companies.
8It is called a FICO score because it was developed by the Fair Isaac Corporation.
915 U.S.C. §6801.
CHAPTER 31 Consumer Protection 769
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The Fair Debt Collection Practices Act (FDCPA) is designed to protect consumers
from abusive debt collection efforts. This statute provides that a collector must, within five
days of contacting a debtor, send the debtor a written notice containing the amount of the
debt, the name of the creditor to whom the debt is owed, and a statement that if the debtor
disputes the debt (in writing), the collector will cease all collection efforts until it has sent
evidence of the debt. Also, under the FDCPA, collectors may not:
• Call or write a debtor who has notified the collector in writing that he wishes no
further contact,
• Call or write a debtor who is represented by an attorney,
• Call a debtor before 8:00 a.m. or after 9:00 p.m.,
• Threaten a debtor or use obscene or abusive language,
• Call or visit the debtor at work if the debtor’s employer prohibits such contact,
• Imply that they are attorneys or government representatives when they are not, or use
a false name,
• Threaten to arrest consumers who do not pay their debts,
• Make other false or deceptive threats—that is, threats that would be illegal if carried
out or which the collector has no intention of doing—such as suing the debtor or
seizing property,
• Contact acquaintances of the debtor for any reason other than to locate the debtor
(and then only once), or
• Tell acquaintances that the consumer is in debt.
Of course, these rules do not prevent the collector from filing suit against the debtor.
In the event of a violation of the FDCPA, the debtor is entitled to damages, court costs,
and attorney’s fees. The FTC also has authority to enforce the Act.
In the following case, a collection agency skates close to the edge. Does it go too far?
You Be the Judge
Facts: Card Service Cen-
ter (CSC) sent Elizabeth
Brown a collection letter
demanding payment of a
delinquent credit card
balance of $1,874. The
letter said:
“You are requested to contact the Recovery Unit of the
Card Service Center…to discuss your account. Refusal to
cooperate could result in a legal suit being filed for collec-
tion of the account.
You now have five (5) days to make arrangements for
payment of this account. Failure on your part to cooperate
could result in our forwarding this account to our attorney
with directions to continue collection efforts.”
Brown did not con-
tact CSC within five days,
and CSC did nothing
other than send her more
collection letters.
Brown filed suit,
alleging that CSC had
violated the FDCPA. She alleged that the letter was
deceptive because the company never had any intention
of carrying out its threats. The district court granted
CSC’s motion to dismiss. Brown appealed.
Issue: Did CSC’s letter violate the FDCPA?
Argument for Brown: CSC’s letter indicated that
there were two options: a lawsuit or referral to an
attorney. Neither happened, and CSC knew when it
BROWN V. CARD SERVICE
CENTER
464 F.3d 450; 2006 U.S. App. LEXIS 24579
United States Court of Appeals for the Third Circuit, 2006
770 U N I T 4 Employment, Business Organizations and Property
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31-3g Equal Credit Opportunity Act
The Equal Credit Opportunity Act (ECOA) prohibits any creditor from discriminating
against a borrower because of race, color, religion, national origin, sex, marital status, age
(as long as the borrower is old enough to enter into a legal contract), or because the
borrower is receiving welfare. A lender must respond to a credit application within 30 days.
If a lender rejects an application, it must either tell the applicant why or notify him that he
has the right to a written explanation of the reasons for this adverse action.
As an example of the types of abuses that the ECOA is designed to prevent, consider
the plight of this African American couple. Florence and Joe made an offer to buy a new
home at the Meadowood housing development near Tampa. The developer accepted their
offer, contingent upon their obtaining a mortgage. When the couple filed an application
with Rancho Mortgage and Investment Corp., they were surprised by the hostility of
Rancho’s loan processor. She requested information they had already supplied and repeat-
edly questioned them about whether they intended to occupy the house, which was about
80 miles from their jobs. Florence and Joe insisted they wanted to live near their son and
daughter-in-law and escape city crime. Rancho turned down their mortgage, refusing to give
either an oral or a written explanation. The house was sold to another buyer.
Joe and Florence didn’t get mad, they got even. They sued under the ECOA. Rancho
was ordered to pay damages to the couple.10
As the following case illustrates, the ECOA protects against a broad range of wrongdoing.
sent the letter that neither would happen. This letter
was an empty threat, plain and simple—exactly the
type of behavior the FDCPA prohibits. It is deceptive
for CSC to assert that it could take an action that it had
no intention of taking and has never or very rarely
taken before.
It is possible that a sophisticated debtor would realize
that CSC had no intention of filing suit against Brown, but
the point of the FCDPA is to protect all consumers, even
those who are unsophisticated. As Supreme Court Justice
Hugo Black observed, our laws “are made to protect the
trusting as well as the suspicious.”
Argument for CSC: The letter said “could,” not “will.”
It did not imply that legal action was imminent, only that
it was possible. This was not a threat, it was a statement of
fact—CSC could file suit if it wanted. That was an option
available to CSC, whether or not the company elected to
pursue it.
TREADWAY V. GATEWAY CHEVROLET
OLDSMOBILE INC.
362 F.3d 971; 2004 U.S. App. LEXIS 6325
United States Court of Appeals for the Seventh Circuit, 2004
C A S E S U M M A R Y
Facts: Gateway Chevrolet Oldsmobile, a car dealership,
sent an unsolicited letter to Tonja Treadway notifying her
that she was “pre-approved” for the financing to purchase
a car. Gateway did not provide financing itself; instead, it
arranged loans through banks or finance companies.
Treadway called the dealer to say that she was
interested in purchasing a used car. With her permission,
Gateway obtained her credit report. Based on this report,
the dealer determined that Treadway was not eligible for
financing. This was not surprising, given that Gateway
10Robert J. Bruss, “Home Buyers Sue Mortgage Lender for Racial Discrimination,” Tampa Tribune,
November 5, 1994, p. 3.
CHAPTER 31 Consumer Protection 771
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31-3h Consumer Leasing Act
If you, like many other consumers, lease a car rather than buy it, you are protected under the
Consumer Leasing Act (CLA). The CLA does not apply to any lease for more than $50,000
or to the rental of real property—that is, to house or apartment leases.
Before a lease is signed, a lessor must disclose the following in writing:
• All required payments, including deposits, down payments, taxes, and license fees,
• The number and amount of each monthly payment and how payments are calculated,
• Balloon payments (that is, payments due at the end of the lease),
• Required insurance payments,
• Annual mileage allowance,
• The total amount the consumer will have paid by the end of the lease,
• Available warranties,
• Maintenance requirements and a description of the lessor’s wear and use standards,
• Penalties for late payments,
• The consumer’s right to purchase the leased property, and at what price,
• The consumer’s right to terminate a lease early, and
• Any penalties for early termination.
had purchased Treadway’s name from a list of people
who had recently filed for bankruptcy.
Instead of applying for a loan on behalf of Treadway,
Gateway told her that it had found a bank that would
finance her transaction, but only if she purchased a new
car and provided a co-signer. Treadway agreed to pur-
chase a new car and came up with Pearlie Smith, her
godmother, to serve as a co-signer.
Concerned as it was with customer convenience,
Gateway had an agent deliver papers directly to Smith’s
house to be signed immediately. If Smith had read the
papers before she signed them (which of course you
would always do), she might have realized that she had
committed herself to be the sole purchaser and owner of
the car. But she had no idea that she was the owner until
she began receiving bills on the car loan. After Treadway
made the first payment on behalf of Smith, both women
refused to pay more—Smith, because she did not want a
new car; Treadway, because the car was not hers. The car
was repossessed, but the financing company continued to
demand payment.
It turned out that Gateway was running a scam. The
dealership would lure desperate prospects off the bank-
ruptcy rolls and into the showroom with promises of
financing for a used car, and then sell a new car to their
“co-signer” (who was, in fact, the sole signer). Instead of
selling a used car to Tonja Treadway, Gateway sold a new
car to Pearlie Smith.
Treadway filed suit against Gateway, alleging that it
had violated the ECOA by not notifying her that it had
rejected her application.
Issue: Did Gateway violate the ECOA?
Decision: Yes, Gateway was in violation because it did
not tell Treadway that it had rejected her application.
Reasoning: The ECOA requires any lender who rejects
a loan application to tell the applicant the reason or notify
her that she has the right to a written explanation.
By deciding not to send Treadway’s application to
any lender, Gateway effectively rejected it. But because
Gateway did not tell customers that it had done the
rejecting, they naturally assumed that a bank or other
lender had turned them down. If the dealership’s role is
secret, it has no accountability—it can discriminate against
any and all without getting caught. Gateway could simply
throw the credit report of every minority applicant in the
“circular file” and none would be the wiser.
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EXAM Strategy
Question: Clyde goes into a Tesla dealership to investigate buying an electric sports
car. He does not look as if he can afford a six-figure purchase, so the sales staff orders
a credit report on him. After all, no point in wasting their time. Do they have the right
to order a report on Clyde? Which consumer statute applies?
Strategy: The FCRA regulates the issuance of consumer reports. These reports can
be used only for a legitimate business need.
Result: A car dealership cannot obtain a consumer report on someone who simply
asks general questions about prices and financing or who wants to test-drive a car; nor
can the dealer order a report to use in negotiations. However, a dealer has the right to
a report that is needed to arrange financing requested by the consumer or to verify a
buyer’s creditworthiness when he presents a personal check to pay for the vehicle.
31-4 MAGNUSON-MOSS WARRANTY ACT
When Senator Frank E. Moss sponsored the Magnuson-Moss Warranty Act, this is how he
explained the need for such a statute:
[W]arranties have for many years confused, misled, and frequently angered American consum-
ers…. Consumer anger is expected when purchasers of consumer products discover that their
warranty may cover a 25-cent part but not the $100 labor charge, or that there is full coverage on a
piano so long as it is shipped at the purchaser’s expense to the factory…. There is a growing need
to generate consumer understanding by clearly and conspicuously disclosing the terms and
conditions of the warranty and by telling the consumer what to do if his guaranteed product
becomes defective or malfunctions.11
The Magnuson-Moss Warranty Act does not require manufacturers or sellers to provide
a warranty on their products. The Act does require any supplier that offers a written warranty
on a consumer product that costs more than $15 to disclose the terms of the warranty in
simple, understandable language before the sale. This statute applies only to written warran-
ties on goods (not services) sold to consumers. It does cover sales by catalog or on the
Internet. Required disclosure includes the following:
• The name and address of the person the consumer should contact to obtain warranty
service,
• The parts that are covered and those that are not,
• What services the warrantor will provide, at whose expense, and for what period of
time, and
• A statement of what the consumer must do and what expenses he must pay.
Although suppliers are not required to offer a warranty, if they do offer one, they must
indicate whether it is full or limited. Under a full warranty, the warrantor must promise to fix
a defective product for a reasonable time without charge. If, after a reasonable number of
efforts to fix the defective product, it still does not work, the consumer must have the right
to a refund or a replacement without charge; but the warrantor is not required to cover
damage caused by the consumer’s unreasonable use.
11Quoted in David G. Epstein and Steve H. Nickles, Consumer Law (Eagan, Minn.: West, 1981).
CHAPTER 31 Consumer Protection 773
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31-5 CONSUMER PRODUCT SAFETY
In 1969, the federal government estimated that consumer products caused 30,000 deaths,
110,000 disabling injuries, and 20 million trips to the doctor. Toys were among the worst
offenders, injuring 700,000 children a year. Children were cut by Etch-a-Sketch glass
panels, choked by Zulu gun darts, and burned by Little Lady toy ovens. Although injured
consumers had the right to seek damages under tort law, the goal of the Consumer Product
Safety Act of 1972 (CPSA) was to prevent injuries in the first place. This act created the
Consumer Product Safety Commission (CPSC) to evaluate consumer products and develop
safety standards. Manufacturers must report all potentially hazardous product defects within
24 hours of discovery. The Commission can impose civil and criminal penalties on those
who violate its standards. Individuals have the right to sue under the CPSA for damages,
including attorney’s fees, from anyone who knowingly violates a consumer product safety
rule. You can find out about product recalls or file a report on an unsafe product at the
Commission’s website (http://www.cpsc.gov) or at saferproducts.gov.
Ethics Imagine that you are Robert Eckert, chairman and CEO of Mattel, Inc. Your
company has sold millions of JeepWrangler Power Wheels. These toys are
designed for children as young as two years old. You have just been notified that 150 of the
cars have caught on fire, while thousands of others have overheated. In some cases, these
toys have burned so fiercely that they have caught their garages on fire, endangering all of
the home’s occupants. You know that under CPSC rules, you are required to report toy
defects within 24 hours. You also know that making the required report could have a
significant impact on Mattel’s profitability. What would you do?
Mattel decided to figure out what the problem was before reporting anything to the
CPSC. In the end, it delayed months. Eckert was quoted as saying that the law was
unreasonable and the company would not follow it.12
Is Mattel’s stance ethical? What would Mill and Kant think? What Life Principle is the CEO
applying?
Chapter Conclusion
Virtually no one will go through life without reading an advertisement, ordering online,
borrowing money, acquiring a credit report, or using a consumer product. It is important to
know your rights.
EXAM REVIEW
1. UNFAIR PRACTICES The Federal Trade Commission (FTC) prohibits
“unfair and deceptive acts or practices.” A practice is unfair if it violates public policy
or if it meets the following three tests:
12Based on an article by Nicholas Casey and Andy Pasztor, “Safety Agency, Mattel Clash Over
Disclosures,” The Wall Street Journal, September 4, 2007, p. A1.
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• It causes a substantial consumer injury.
• The harm of the injury outweighs any countervailing benefit.
• The consumer could not reasonably avoid the injury. (p. 757)
2. DECEPTIVE ADVERTISEMENTS The FTC considers an advertisement to
be deceptive if it contains an important misrepresentation or omission that is likely
to mislead a reasonable consumer. (pp. 756–757)
3. BAIT-AND-SWITCH FTC rules prohibit bait-and-switch advertisements. A
merchant may not advertise a product and then disparage it to consumers in an effort
to sell a different item. (p. 758)
4. MERCHANDISE BOUGHT BY MAIL, BY TELEPHONE, OR
ONLINE Under FTC rules for this type of merchandise, sellers must ship an item
within the time stated or, if no time is given, within 30 days after receipt of the order.
(p. 758)
5. DO-NOT-CALL REGISTRY The FTC prohibits telemarketers from calling
telephone numbers listed on its do-not-call registry. Telemarketers may not
make robocalls unless they have obtained written permission from the person
being called. (p. 758)
6. UNORDERED MERCHANDISE Consumers may keep as a gift any
unordered merchandise that they receive in the mail. (p. 759)
7. DOOR-TO-DOOR RULES Under the FTC door-to-door rules, a salesperson is
required to notify the buyer that she has the right to cancel the transaction prior to
midnight of the third business day thereafter. (p. 759)
8. TILA DISCLOSURE In all loans regulated by the Truth in Lending Act, the
disclosure must be clear and in meaningful sequence. The lender must disclose the
finance charge and the annual percentage rate. (pp. 760–761)
9. MORTGAGES Lenders must make a good faith effort to determine whether a
borrower can afford to repay the loan. They may not coerce or bribe an appraiser into
misstating a home’s value. Nor may they charge prepayment penalties on adjustable
rate mortgages. (p. 761)
10. SUBPRIME LOANS For subprime loans, a lender:
• May not make loans with balloon payments.
• Is limited in the late fees it may charge. (p. 761)
11. HOME EQUITY LOANS In the case of a high-rate home equity loan, the
lender must notify the consumer at least three business days before the closing
that he does not have to go through with the loan (even if he has signed the
loan agreement) and (2) he could lose his house if he fails to make payments. If
the duration of a high-rate home equity loan is less than five years, it may not
contain balloon payments. (p. 762)
CHAPTER 31 Consumer Protection 775
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12. RESCINDING A MORTGAGE Under TILA, consumers have the right to
rescind a mortgage (other than a first mortgage) for three business days after the
signing if the lender is not the same as for the first mortgage. If the lender does not
comply with the disclosure provisions of TILA, the consumer may rescind for up to
three years from the date of the mortgage. (pp. 762–763)
Question: In August, Ethel went to First American Mortgage and Loan
Association of Virginia (the Bank) to sign a second mortgage on her home. Her
first mortgage was with a different bank. She left the closing without a copy of the
required TILA disclosure forms. Ethel defaulted on her loan payments, and, the
following May, the Bank began foreclosure proceedings on her house. In June,
she notified the Bank that she wished to rescind the loan. Does Ethel have a right
to rescind the loan 10 months after it was made?
Strategy: In questions about mortgages, it is important to notice if the
question involves a first or subsequent mortgage because the rules are different.
Also, it matters whether the bank is the same for both mortgages. (See the
“Result” at the end of this section.)
13. CREDIT V. DEBIT CARDS Under TILA, a credit card holder is liable only for
the first $50 in unauthorized charges made before the credit card company is notified
that the card was stolen. If, however, you wait more than two days to report the loss of
a debit card, your bank will reimburse you only for losses in excess of $500. If you fail
to report the lost debit card within 60 days of receipt of your bank statement, the bank
is not liable at all. (pp. 765–767)
14. CREDIT CARD DEBT Credit card companies cannot increase the interest rate,
fees, or charges on balances unless the consumer is more than 60 days late in making
the minimum payment, nor can they charge interest or fees on a bill that is paid on
time or during the grace period. Credit card companies must give 45 days’ notice
before increasing a card’s APR. (p. 764)
15. CREDIT CARD DISPUTE In the event of a dispute between a customer and a
merchant, the credit card company cannot bill the customer if:
• She makes a good faith effort to resolve the dispute,
• The dispute is for more than $50, and
• The merchant is in the same state where she lives or is within 100 miles of her
house. (p. 765)
16. MORE CREDIT CARD DISPUTES Under the Fair Credit Billing Act, a credit
card company must promptly investigate and respond to any consumer complaints
about a credit card bill. (pp. 765–766)
17. DEBIT CARD FEES Banks may not overdraw an account and charge an
overdraft fee unless the consumer signs up for an overdraft plan. (p. 767)
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18. CREDIT REPORTS Under the Fair Credit Reporting Act:
• A consumer report can be used only for a legitimate business need,
• A consumer reporting agency cannot report obsolete information,
• An employer cannot request a consumer report on any current or potential
employee without the employee’s permission, and
• Anyone who makes an adverse decision against a consumer because of a credit
report must reveal the name and address of the reporting agency that supplied the
negative information. (pp. 767–769)
19. ACCESS TO CREDIT REPORTS AND CREDIT SCORES The Fair and
Accurate Credit Transactions Act permits consumers to obtain one free credit report
every year from each of the three major reporting agencies. Also, anyone who penalizes
a consumer because of her credit score must give it to her at no charge. (pp. 768–769)
20. DEBT COLLECTION Under the Fair Debt Collection Practices Act, a debt
collector may not harass or abuse debtors. (pp. 769–771)
21. ECOA The Equal Credit Opportunity Act prohibits any creditor from
discriminating against a borrower on the basis of race, color, religion, national origin,
sex, marital status, age, or because the borrower is receiving welfare. (pp. 771–772)
Question: Kathleen, a single woman, applied for an Exxon credit card. Exxon
rejected her application without giving any specific reason and without providing
the name of the credit bureau it had used. When Kathleen asked for a reason for
the rejection, she was told that the credit bureau did not have enough information
about her to establish creditworthiness. In fact, Exxon had denied her credit
application because she did not have a major credit card or a savings account, she
had been employed for only one year, and she had no dependents. Did Exxon
violate the law?
Strategy: Exxon violated two laws. Review the statutes in the “Consumer
Credit” section of the chapter. (See the “Result” at the end of this section.)
22. CONSUMER LEASING ACT This statute applies to any lease up to $50,000
(except for real property). The lessor is required to make certain disclosures before
the lease is signed. (p. 772)
23. WARRANTIES The Magnuson-Moss Warranty Act requires any supplier that
offers a written warranty on a consumer product costing more than $15 to disclose the
terms of the warranty in simple and readily understandable language before the sale.
(p. 773)
24. CONSUMER PRODUCT SAFETY The Consumer Product Safety Commission
evaluates consumer products and develops safety standards. (p. 774)
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Question: Joel was two years old and his brother, Joshua, was three when
their father left both children asleep in the rear seat of his automobile while
visiting a friend. A cigarette lighter was on the dashboard of the car. After
awaking, Joshua began playing with the lighter and set fire to Joel’s diaper. Do
the parents have a claim against the manufacturer of the lighter under the
Consumer Product Safety Act?
Strategy: The CPSA regulates unsafe products. Was the cigarette lighter unsafe?
(See the “Result” at the end of this section.)
12. Result: Ethel entered into a second mortgage that was not from the same bank
as her first mortgage. Therefore, under TILA, Ethel had an automatic right to
rescind for three business days. However, because the lender did not give the
required forms to her at the closing, she could rescind for up to three years.
21. Result: The court held that Exxon violated both the Fair Credit Reporting Act
(FCRA) and the Equal Credit Opportunity Act (ECOA). The FCRA requires
Exxon to tell Kathleen the name of the credit bureau that it used. Under the
ECOA, Exxon was required to tell Kathleen the real reasons for the credit denial.
24. Result: The court held that the plaintiff did not have a claim because there was
no evidence that the manufacturer had knowingly violated a consumer product
safety rule.
MULTIPLE-CHOICE QUESTIONS
1. Dell advertised that a computer came with particular software. In fact, the software
was not available for several months. Instead, Dell sent customers a coupon for the
software “when available.” What did Dell do wrong?
I. Failed to offer buyers the opportunity to cancel their orders
II. Did not automatically cancel the orders
III. Did not ship the software within 30 days
(a) I and II
(b) I, II, and III
(c) I and III
(d) II and III
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

2.
When customers called the number provided, New Rapids Carpet Center, Inc., sent
salespeople to visit them at home to sell them carpet that was not as advertised—it
was not continuous filament nylon pile broadloom, and the price was not $77. What
set of rules has New Rapids violated?
(a) Unordered merchandise
(b) Consumer Product Safety Act
(c) Bait-and-switch
(d) Fair Credit Reporting Act
3. Which of the following laws set limits on interest rates?
(a) State usury laws
(b) TILA and state usury laws
(c) TILA
(d) None; there are no limits on interest rates
4. Companies must obtain permission from a consumer before charging for overdrafts on:
(a) debit cards
(b) credit cards
(c) neither
(d) both
5. You notice a charge on your credit card bill of $149.99 for a kayak. This seems very
strange to you because you have not purchased a kayak. What do you need to do to
avoid having to pay this charge?
(a) Call the store
(b) Call the credit card company
(c) Write the store
(d) Write the credit card company
ESSAY QUESTIONS
1. YOU BE THE JUDGE WRITING PROBLEM Process cheese food slices must
contain at least 51 percent natural cheese. Imitation cheese slices, by contrast, contain
little or no natural cheese and consist primarily of water, vegetable oil, flavoring, and
fortifying agents. Kraft, Inc., makes Kraft Singles, which are individually wrapped
process cheese food slices. When Kraft began losing market share to imitation slices
GET ENOUGH BROADLOOM TO CARPET ANY AREA OF YOUR
HOME OR APARTMENT UP TO 150 SQUARE FEET CUT,
MEASURED, AND READY FOR INSTALLATION FOR ONLY $77.
GET 100% DUPONT CONTINUOUS FILAMENT NYLON PILE
BROADLOOM.
CALL COLLECT
CHAPTER 31 Consumer Protection 779
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that were advertised as both less expensive and equally nutritious as Singles, Kraft
responded with a series of advertisements informing consumers that Kraft Singles cost
more than imitation slices because they are made from 5 ounces of milk. Kraft does
use 5 ounces of milk in making each Kraft Single, but 30 percent of the calcium
contained in the milk is lost during processing. Imitation slices contain the same
amount of calcium as Kraft Singles. Are the Kraft advertisements deceptive?
Argument for Kraft: This statement is completely true—Kraft does use 5 ounces of
milk in each Kraft Single. The FTC is assuming that the only value of milk is the
calcium. In fact, people might prefer having milk rather than vegetable oil, regardless
of the calcium. Argument for the FTC: It is deceptive to advertise more milk if the
calcium is the same after all the processing.
2. Josephine was a 60-year-old widow who suffered from high blood pressure and
epilepsy. A bill collector from Collections Accounts Terminal, Inc., called her and
demanded that she pay $56 she owed to Cabrini Hospital. She told him that Medicare
was supposed to pay the bill. Shortly thereafter, Josephine received a letter from
Collections that stated:
You have shown that you are unwilling to work out a friendly settlement with us to clear the
above debt. Our field investigator has now been instructed to make an investigation in your
neighborhood and to personally call on your employer. The immediate payment of the full
amount, or a personal visit to this office, will spare you this embarrassment.
Has Collections violated the law?
3. Thomas worked at a Sherwin-Williams paint store that James managed. Thomas and
James had a falling out when, according to Thomas, “a relationship began to bloom
between Thomas and one of the young female employees, the one James was
obsessed with.” After Thomas quit, James claimed that Thomas owed the store $121.
Sherwin-Williams reported this information to the Chilton credit reporting agency.
Thomas sent a letter to Chilton disputing the accuracy of the Sherwin-Williams
charges. Chilton contacted James who confirmed that Thomas still owed the money.
Chilton failed to note in Thomas’s file that a dispute was pending. Thereafter, two of
Thomas’s requests for credit cards were denied. Have James and Chilton violated the
Fair Credit Reporting Act?
4. In October, Renie Guimond discovered that her credit report at TransUnion
incorrectly stated that she was married, used the name “Ruth Guimond,” and had
a credit card from Saks Fifth Avenue. After she reported the errors, TransUnion
wrote her in November to say that it had removed this information. However, in
March, TransUnion again published the erroneous information. The following October,
TransUnion finally removed the incorrect information from her file. Guimond was
never denied credit because of these mistakes. Is TransUnion liable for violating the
Fair Credit Reporting Act?
5. Thomas Waldock purchased a used BMW 320i from Universal Motors, Inc. It was
warranted “to be free of defects in materials or workmanship for a period of three years
or 36,000 miles, whichever occurs first.” Within the warranty period, the car’s engine
failed, and upon examination, it was found to be extensively damaged. Universal
denied warranty coverage because it concluded that Waldock damaged the engine by
over-revving it. Waldock vehemently disputed BMW’s contention. He claimed that,
while the car was being driven at a low speed, the engine emitted a gear-crunching
noise, ceased operation, and would not restart. Is Universal in violation of the law?
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6. ETHICS After TNT Motor Express hired Joseph Bruce Drury as a truck driver, it
ordered a background check from Robert Arden & Associates. TNT provided Drury’s
social security number and date of birth, but not his middle name. Arden discovered
that a Joseph Thomas Drury, who coincidentally had the same birth date as Joseph
Bruce Drury, had served a prison sentence for drunk driving. Not knowing that it had
the wrong Drury, Arden reported this information to TNT, which promptly fired
Drury. When he asked why, the TNT executive refused to tell him. Did TNT violate
the law? Whether or not TNT was in violation, did its executives behave ethically?
Who would have been harmed or helped if TNT managers had informed Drury of the
Arden report?
DISCUSSION QUESTIONS
1. Should employers use credit checks as part of the
hiring process? On one hand, each year employers
suffer losses of $55 million because of workplace
violence, while retailers lose $30 billion a year from
employee theft. Those who commit fraud are often
living above their means. On the other hand, there
is no evidence that workers with poor credit reports
are more likely to be violent, steal from their
employers, or quit their jobs. And refusing to hire
someone with a low credit score may simply be
kicking him when he is down. What would you do
if you were an employer?
2. The fee on a debit card overdraft can be as high or
higher than the amount taken out. Instead of
overdrawing their accounts, consumers would be
much better off either not spending the money,
using a credit card, or paying cash. Typically, the
people most likely to sign up for overdraft
“protection” are those who can least afford it—
they have maxed out their credit cards and used up
any home equity. Is it ethical for a bank to offer an
overdraft plan?
3. Look at the section entitled “Credit Card Act of
2009” on p. 764. All of these activities used to be
legal. Which ones were unethical?
4. Go to youtube.com and search for “free credit
reports.” Watch the advertisements for
freecreditreport.com. Although the characters
repeat the word, “free” over and over, in fact the
reports are not free unless the consumer signs up
for the paid credit monitoring service. At the end
of the ad, a voice quickly says, “Offer applies with
enrollment in Triple Advantage.” Are these ads
deceptive under FTC rules? Are they ethical
according to your Life Principles?
5. Advertisements for Listerine mouthwash claimed
that it was as effective as flossing in preventing
tooth plaque and gum disease. This statement was
true, but only if the flossing was done incorrectly.
In fact, many consumers do floss incorrectly.
However, if flossing is done right, it is more
effective against plaque and gum disease than
Listerine. Is this advertisement deceptive?
CHAPTER 31 Consumer Protection 781
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CHAPTER32
CYBERLAW
Garrett always said that his computer was
his best friend. He was online all the time,
g-chatting with his friends, listening to music,
doing research for his courses, and, okay, maybe
playing a few games now and again. Occasion-
ally, the computer could be annoying. It would
crash once in a while, trashing part of a paper
before he saved it. And there was the time that a
copy of an email he sent Lizzie complaining
about Caroline somehow ended up in Caroline’s
inbox. He was pretty irritated when the White
Sox tickets he bought in an online auction
turned out to be for a Little League team. And he was
tired of all the spam advertising pornographic websites.
But these things happen and, despite the petty annoy-
ances, his computer was an important part of his life.
Then one day, Garrett received a panicked text
message from a teammate on his college wrestling squad
telling him to click on a certain website pronto to see
someone they knew. Garrett eagerly clicked on the
website and discovered, to his horror, that he was
featured—in the nude. The website was selling DVDs
showing him and other members of the wrestling team in the locker room in various states
of undress. Other DVDs, from other locker and shower rooms, were for sale, too, showing
football players and wrestlers from dozens of universities. The DVDs had titles like
“Straight Off the Mat” and “Voyeur Time.” No longer trusting technology, Garrett pulled
on his running shoes and dashed over to the office of his business law professor for help
figuring out what his rights were.
Garrett eagerly clicked
on the website and
discovered, to his horror,
that he was featured—in
the nude.
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Computers and the Internet—cyberspace—together comprise one of the great technolo-
gical developments of modern times.1 And its importance and impact continue to grow.
Beginning in December 2010, the world watched the “Arab Spring”—popular uprisings
throughout the Middle East that brought down governments in Tunisia, Egypt, and
Libya, and challenged leaders throughout the area. These movements were organized
and fueled by the Internet. In response, threatened governments fought back by trying to
limit access to the Internet generally and social media sites in particular. In Syria, police
demanded the Facebook passwords of suspected protest organizers. Meanwhile, in
England, a different type of protest challenged a court ruling. A married soccer player
obtained an injunction prohibiting newspapers from revealing his alleged affair, and even
the existence of the injunction. Within days, Ryan Giggs and his affair was one of the top
topics on Twitter.
Cyberspace is a disruptive technology which can both fight repression and undermine
legitimate laws. It has brought change to every aspect of our lives—how we make friends,
buy things, obtain news, campaign for election, start revolutions, challenge the status quo.
Inevitably, new technologies create the need for new law. In the thirteenth century,
England was one of the first countries to develop passable roads. Like the Internet, these
roadways greatly enhanced communication, creating social and business opportunities, but
also enabled new crimes. Good roads meant that bad guys could sneak out of town without
paying their bills. Parliament responded with laws to facilitate the collection of out-of-town
debts. Similarly, while the Internet has opened up enormous opportunities in both our
business and personal lives, it has also created the need for new laws, both to pave the way
for these opportunities and to limit their dangers.
The process of lawmaking never stops. Judges sit and legislatures meet—all in an effort
to create better rules and a better society. However, in an established area of law, such as
contracts, the basic structure changes little. Cyberlaw is different because it is still very
much in its infancy. Not only are new laws being created almost daily, but whole areas of
regulation are, as yet, unpaved roads. Although the process of rule making has progressed
well, much debate still surrounds cyberspace law, and much work remains to be done. This
chapter focuses on the existing rules and also discusses the areas of regulation that are still
incomplete and being debated.
Cyberlaw affects many areas of our lives. This chapter, however, deals with issues that
are unique to the cyberworld, such as online privacy, spam, and cybercrimes.
Before beginning the chapter in earnest, let’s return briefly to Garrett, the wrestler.
What recourse does Garrett have for his Internet injuries? The nude video incident happened
at Illinois State University and seven other colleges. Approximately 30 athletes filed suit
against GTE and PSINet for selling the films online, but the two web hosts were found not to
be liable under the Communications Decency Act because they had not produced the films
themselves—they had simply permitted the sale of someone else’s content. What about
Garrett’s other computer injuries? Lizzie was not being a good friend, but it was perfectly
legal for her to forward Garrett’s email to Caroline. The seller of the White Sox tickets
violated both federal and state fraud statutes. The federal CAN-SPAM Act regulates spam—
unsolicited commercial email—but a lawsuit is a slow and awkward tool for killing such a
flourishing weed.
1The term “Internet” means “the international computer network of both Federal and non-Federal
interoperable packet switched data networks,” according to 47 U.S. §230 (f)(1). It began in the 1960s
as a project to link military contractors and universities. Now, it is a giant network that connects
smaller groups of linked computer networks. The World Wide Web was created in 1991 by Tim
Berners-Lee as a subnetwork of the Internet. It is a decentralized collection of documents containing
text, pictures, and sound. Users can move from document to document using links that form a “web”
of information.
CHAPTER 32 Cyberlaw 783
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32-1 PRIVACY
The Internet has vastly increased our ability to communicate quickly and widely. In the
pre-Internet era, setting up a meeting required days of phone tag. Intraoffice memos were
typed, photocopied, and then hand-delivered by messengers. Catalog orders were sent via
regular mail, a slow, inefficient, and costly method. As wonderful as cybercommunication
can be, though, it is not without its dangers.
32-1a Tracking Tools
Consumers enter the most personal data—credit card numbers, bank account information,
lists of friends, medical data, product preferences—on the Internet. Because our interactions
with a computer often take place in isolation (sitting alone at home, at work, or in a cafe), the
experience feels private. It is anything but. In effect, the Internet provides a very large window
through which the government, employers, businesses, and criminals can find out more than
they should about you and your money, habits, beliefs, and health. Even email has its
dangers: Who has not been embarrassed by an email that ended up in the wrong mailbox?
The most troubling aspect of these Internet privacy issues is that consumers are often
unaware of who has access to what personal information, how it is being used, and with what
consequences. As a result, a privacy discussion seems abstract. But the reality is that the
Internet provides many opportunities for good guys and bad to secretly gather information
for their own purposes, both good and bad.
It used to be that marketers geared their ads to specific websites, but now they target
individual consumers. The 50 most popular websites in America (which account for
40 percent of all page views) install thousands of tracking tools on the computers of people
who visit their sites. Called “behavioral targeting,” these tools not only collect data on all
the websites someone visits, they also record keystrokes to keep track of whatever informa-
tion the consumer has entered online. These tools are placed on computers without notice
or warning to the consumer. In a recent report, Dictionary.com was the worst offender,
placing over 200 tools on the computers of unaware visitors. On the other hand, Wikipedia.
org is one highly popular site that installs none.2 To take another example of privacy
issues, as part of its Street View program that provides photographs of streets around
the world, Google (accidentally, it says) captured data from home Wi-Fi networks.
Once the trackers have gathered financial, health, and other personal information, they
sell it to data-gathering companies that build profiles which, while technically anonymous,
can include so much personal information that it is possible to identify individuals. How
many times have you revealed your ZIP code, birth date, and gender on the Internet?
Those three pieces of information are usually enough to identify an individual’s name and
address. The profiles are then sold to advertisers on stock market–like exchanges. Now that
cell phones have GPS tracking devices and readers use electronic books, where you have
been and what you are reading are also available. In a recent Dilbert cartoon, the boss refers
to a smart phone as an “employee locator device.”
Suppose, for example, that you look online at puppies in shelters. You may find that the
next time you go to your gmail account, there will be dog ads. One company markets a
databank with the names of 150 million registered voters. Anyone can buy a list of voters
that is sliced and diced however they want (say, Republicans between the ages of 45 and 60
with Hispanic surnames and incomes greater than $50,000 who live in Kansas City). Puppy
ads seem harmless, or even beneficial, but if marketers can put together a databank of
Hispanic Republican voters, they can also find out who has visited a website for recovering
2Julia Angwin and Tom McGinty, “Sites Feed Personal Details to New Tracking Industry,” The Wall
Street Journal, July 30, 2010.
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alcoholics or unrecovered gamblers or Nazi sympathizers. Or who uses antidepressants or
reads socialist writings. Do you want all this information available to anyone who is willing
to pay for it? What if employers buy information about job candidates so that they can refuse
to hire someone with health issues?
In short, Internet users are inadvertently providing intensely personal data to unknown
people for unknown uses. The problem is likely to grow. The newest web language,
HTML5, permits tracking software to store larger amounts of data. Also, software devel-
opers have created tracking tools that are harder to delete. Every browser uses a different
deletion system, which makes life even more complicated for the concerned consumer.
Many commentators argue that without significant changes in the law, our privacy will
be obliterated. But, so far, consumers have been relatively unconcerned. They tend to be
unaware of the dangers, and they appreciate the benefits—for example, tracking software
can be used to store passwords so that when you log on to Amazon.com, the site recognizes
you and lets you in without your having to enter your email address and password. Con-
sumers can also benefit from targeted advertisements—long-distance runners may like
seeing ads for running shoes, not cigarettes. Industry representatives argue that without
the revenue from ads, many Internet sites would not be free to consumers. As a result,
privacy on the Internet is very much like the weather—everyone talks about it, but (so far)
no one has done much about it. But this you should believe: Highly personal information
about you has been collected without your knowledge or approval.
32-1b Regulation of Online Privacy
There is a wide range of possible sources of laws and regulations to protect online privacy,
but they are in an early, and relatively ineffective, stage of development.
SELF-REGULATION
In an effort to forestall government regulation, several marketing trade groups issued their
own report, “Self-Regulatory Principles for Online Behavioral Advertising.” These princi-
ples require websites that use tracking tools to provide notice of data collection that is
“clear, prominent, and conveniently located.” In addition, the websites must permit con-
sumers to opt out of tracking with only a few clicks. However, we have been unable to find
a single website that complies with these principles, even among the companies that
sponsored the report.
Members of Congress have filed many bills to regulate online privacy. So intense,
however, is the debate between industry and consumer advocates that no consensus—and
little law—has emerged. There is, however, some applicable government regulation.
THE FIRST AMENDMENT
How would you like to be called a cockroach, mega-scumbag, and crook in front of
thousands of people? Or be accused of having a fake medical degree, fat thighs, and poor
hygiene? What would you think if your ex-wife told 55,000 people that your insensitivity
made her so sick she was throwing up every day? The First Amendment to the Constitution
protects free speech, and that includes these postings—and worse—which have appeared on
Internet message boards and blogs. As upsetting as they may be, they are protected as free
speech under the First Amendment so long as the poster is not violating some other law. In
these cases, the plaintiffs argued that the statements were defamatory but the courts
disagreed, ruling that they were simply opinions.
Explaining its ruling in one of the cases, the court said:
Users [of the Internet] are able to engage freely in informal debate and criticism, leading many to
substitute gossip for accurate reporting and often to adopt a provocative, even combative tone.
Hyperbole and exaggeration are common, and “venting” is at least as common as careful and
CHAPTER 32 Cyberlaw 785
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considered argumentation. Some commentators have likened cyberspace to a frontier society free
from the conventions and constraints that limit discourse in the real world.
It hardly need be said that this [court does not] condone [these] rude and childish posts;
indeed, [the] intemperate, insulting, and often disgusting remarks understandably offended
plaintiff and possibly many other readers. Nevertheless, the fact that society may find speech
offensive is not a sufficient reason for suppressing it. Indeed, if it is the speaker’s opinion that
gives offense, that consequence is a reason for according it constitutional protection.3
In the following case, a teacher received hostile emails. Should the First Amendment
protect the anonymous person who sent them?
You Be the Judge
Facts: Juzwiak was a
tenured teacher at Hights-
town High School in New
Jersey. He received three
emails from someone who
signed himself “Josh,”
with the address, “Josh
Hartnett jharthat@yahoo.com.” The teacher did not know
anyone of that name. These emails said:
1. Subject line: “Hopefully you will be gone
permanently”
Text: “We are all praying for that. Josh”
2. Subject line: “I hear Friday is ‘D’ day for you”
Text: “I certainly hope so. You don’t deserve to be
allowed to teach anymore. Not just in Hightstown
but anywhere. If Hightstown bids you farewell I will
make it my lifes [sic] work to ensure that wherever
you look for work they know what you have done.”
3. Subject line: “Mr. Juzwiak in the Hightstown/East
Windsor School System.”
Text: It has been brought to my attention and I am
sure many of you know that Mr. J is reapplying for
his position as a teacher in this town. It has further
been pointed out that certain people are soliciting
supporters for him. This is tantamount to supporting
the devil himself. I am not asking anyone to speak
out against Mr. J but I urge you to then be silent as
we can not continue to allow the children of this
school system nor the parents to be subjected to his
evil ways. Thank you. Josh
It seems that this
third email was sent to
other people, but it was
not clear to whom.
Because Juzwiak did
not know who “Josh”
was, he filed a complaint
against “John/Jane Doe,” seeking damages for intentional
infliction of emotional distress. As part of the lawsuit, he
served a subpoena on Yahoo!, asking it to reveal “Josh’s”
identity. When Yahoo! notified “Josh” of the lawsuit, he
asked the court to quash the subpoena.
In a court hearing, Juzwiak testified that the threaten-
ing emails had severely disrupted his life, causing deep
anger and depression, as well as insomnia that had
impaired his ability to concentrate and function effec-
tively. In addition, this emotional stress had exacerbated
his back problems and caused him to lose 20 pounds.
Although he had already been taking antidepressants, a
psychiatrist prescribed four additional drugs for depres-
sion, anxiety, and insomnia, which were not effective in
reducing his symptoms. Juzwiak also stated that he had
thoughts of hurting himself and the entire episode had
consumed his life for several months.
When the trial court refused to issue the subpoena
against Yahoo!, Juzwiak appealed.
You Be the Judge: Should the trial court have issued the
subpoena? Which interest is more important: “Josh’s” First
Amendment right to free speech or Juzwiak’s protection from
harassing emails?
Argument for “Josh”: Free speech is the first, and most
important, right in the Bill of Rights. To ensure a vibrant
marketplace of ideas, the First Amendment protects not
3Krinsky v. Doe, 6159 Cal. App. 4th 1154, 2008 Cal. App. LEXIS 180.
JUZWIAK V. JOHN/JANE DOE
415 N.J. Super. 442; 2 A.3d 428;
2010 N.J. Super. LEXIS 154
Superior Court of New Jersey, Appellate Division, 2010
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THE FOURTH AMENDMENT
The Fourth Amendment to the Constitution prohibits unreasonable searches and seizures
by the government. In enforcing this provision of the Constitution, the courts ask: Did the
person being searched have a legitimate expectation of privacy in the place searched or the
item seized? If yes, then the government must obtain a warrant from a court before
conducting the search. (For more on this topic, investigate Chapter 7, on crime.) The
Fourth Amendment applies to computers.
The architecture professor in the following case would have benefited from a course in
business law, and perhaps in computer science, too.
only open but also anonymous speech. Sometimes speak-
ers must be allowed to withhold their identities to protect
themselves from harassment and persecution.
Nothing in these messages was a realistic threat to the
teacher’s safety. “Hopefully you will be gone perma-
nently” could easily mean “Hope you will move out of
town.” Juzwiak reported these emails to the police, but
they took no action. Presumably they would have done so
if there had been any real threat.
Nor did these emails constitute an intentional inflic-
tion of emotional distress. They were not so extreme and
outrageous as to be utterly intolerable in a civilized com-
munity. “Josh” did not accuse Juzwiak of vile or criminal
acts. The language was not obscene or profane. In short, if
Juzwiak is going to teach high school, he needs to develop
a thicker skin and a better sense of humor.
Argument for Juzwiak: The right to speak anon-
ymously is not absolute. “Josh” requires protection from
harassment? That is an absurd argument.
These emails contained death threats: “Hopefully
you will be gone permanently” and “I hear Friday is ‘D’
day for you.” Juzwiak was frightened enough to go to the
police. He suffered serious physical and emotional harm.
These emails are not entitled to the protection of the First
Amendment.
Furthermore, the emails constituted intentional
infliction of emotional distress. They were extreme and
outrageous conduct designed to cause harm. They
achieved their goal.
In balancing the rights in this case, why would the
court protect “Josh,” who has set out to cause harm, over
the innocent teacher?
UNITED STATES OF AMERICA V. ANGEVINE
281 F.3d 1130, 2002 U.S. App. LEXIS 2746
United States Court of Appeals for the Tenth Circuit, 2002
C A S E S U M M A R Y
Facts: Professor Eric Angevine taught architecture at
Oklahoma State University. The university provided him
with a computer that was linked to the university network,
and through it to the Internet. Professor Angevine used
this computer to download more than 3,000 pornographic
images of young boys. After viewing the images and print-
ing some of them, he deleted the files. Tipped off by
Professor Angevine’s wife, police officers seized the com-
puter and turned it over to a police computer expert, who
retrieved the pornographic files that the professor had
deleted. The police had not obtained a search warrant.
The Oklahoma State University computer policy
states that:
• The contents of all storage media owned or stored
on university computing facilities are the property
of the university.
• Employees cannot use university computers to
access obscene material.
• The university reserves the right to view or scan
any file or software stored on a computer or passing
through the network, and will do so periodically to
audit the use of university resources. The
university cannot guarantee confidentiality of
stored data.
• System administrators keep logs of file names that
may indicate why a particular data file is being
erased, when it was erased, and what user
identification has erased it.
The trial court held that federal agents did not need a
warrant to search Professor Angevine’s office computer
because he had no expectation of privacy. He was sentenced
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This case involved someone who transmitted information through an electronic system
owned by his employer. What happens if a suspect in a crime sends emails through a system
that he personally pays for? Does he have a reasonable expectation of privacy? The
following case answers these questions.
to 51 months in prison for “knowing possession of child
pornography.” The professor appealed.
Issue: Did Professor Angevine have a reasonable expecta-
tion of privacy in his office computer?
Decision: No, Professor Angevine did not have a reason-
able expectation of privacy.
Reasoning: The university reserved the right to monitor
Internet use by employees. The university’s computer
policy explicitly cautions computer users that information
flowing through the university network is not confidential,
either in transit or in storage on a computer. As a result,
employees cannot have a reasonable expectation of privacy
for downloaded data.
Professor Angevine made a careless effort to protect
his privacy. Although he did attempt to erase the porno-
graphy, the university computer policy warned that sys-
tem administrators kept logs recording when and by
whom files were deleted. In any event, having trans-
mitted pornographic data through a monitored university
network, Professor Angevine could not create a reasonable
expectation of privacy merely by deleting the files.
UNITED STATES OF AMERICA V. WARSHAK
631 F.3d 266; 2010 U.S. App. LEXIS 25415
United States Court of Appeals for the Sixth Circuit, 2010
C A S E S U M M A R Y
Facts: Steven Warshak sold Enzyte, a supplement that
promised to increase masculine endowment. As is the case
with all such products, Enzyte was a fraud. Advertisements
quoted surveys that had never been conducted and doctors
who did not exist. As a result, customers typically did not
buy the product a second time. Warshak had a solution
to this problem—an auto-ship program. A man would
order a free sample, providing his credit card to pay for
the shipping. Warshak’s company would then automa-
tically send him more product, and, of course, charge
his credit card.
Without obtaining a search warrant first, a federal
prosecutor asked Warshak’s Internet service provider
(ISP) for copies of his emails. Based on the evidence
contained in these 25,000 emails, Warshak was convicted
of mail, wire, and bank fraud and sentenced to 25 years in
prison. He appealed on the grounds that the government
had violated the Fourth Amendment by obtaining his
emails without a search warrant. He argued that he had
a reasonable expectation of privacy in these emails.
Issue: Did Warshak have a reasonable expectation of priv-
acy in his emails?
Decision: Yes, his expectation of privacy was reasonable.
Reasoning: Clearly, Warshak thought his emails were
private, or he would not have made so many incriminating
statements in them. Most people would not display so
much dirty laundry in plain view.
However, the defendant has to show not only that he
had an expectation of privacy, but also that it was
reasonable. Given how significant email is to most of us,
this question is very important. People are always sending
sensitive and intimate information to friends, family, and
colleagues around the world. Sweet nothings, business
plans, online purchases, and medical information are
transferred with the click of a mouse. Account is an apt
word to use for email because it does provide an account
of its owner’s life.
The Fourth Amendment must keep pace with
technological progress, or its guarantees will wither and
perish. The law requires the police to obtain a warrant
before they read a letter at the post office or listen to a
private telephone call. An ISP is the functional equivalent
of a post office or a telephone company. It only stands to
reason that the government should not be able to force a
commercial ISP to turn over the contents of a subscriber’s
emails without first obtaining a warrant. Warshak’s
expectation of privacy was reasonable.
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As the Warshak court observes, electronic communications—email, text messages,
instant messaging—have for many people taken the place of letters and telephone calls.
So it is important to know your privacy rights. Although the courts are feeling their way in
this new territory, at this writing, for criminal cases:
1. If your employer has a reasonably articulated policy notifying you that it has the right
to access and read electronic communications on a system that it provides, then you do
not have a reasonable expectation of privacy when using that system. The police need
not obtain a search warrant before reading your messages.
2. You do have a reasonable right to privacy on a system that you provide for yourself, so
the police must obtain a search warrant before accessing these messages.
Note that both of these Fourth Amendment cases involve criminal defendants. How-
ever, Fourth Amendment protections also apply to government workers in civil cases. For
example, when a police officer persistently exceeded his monthly quota of text messages,
his superior accessed these communications to determine if they were work-related. It
turned out that they were mostly sexually suggestive texts sent to the married officer’s
mistress. After the officer was disciplined, he filed suit alleging that the department had
violated his Fourth Amendment rights. The Supreme Court held that a government
employer has the right to review its employee’s electronic communications for a work-
related purpose, if the search was “justified at its inception” and if “the measures adopted
are reasonably related to the objectives of the search and not excessively intrusive in light of
the circumstances giving rise to the search.”4
THE FEDERAL TRADE COMMISSION (FTC)
Section 5 of the FTC Act prohibits unfair and deceptive acts or practices. The FTC applies
this statute to online privacy policies. It does not require websites to have a privacy policy,
but if they do have one, they must comply with it, and it cannot be deceptive. For
example, Sears paid consumers who visited sears.com and kmart.com websites $10 to
become members of the “My SHC Community” and participate in “exciting, engaging,
and on-going interactions—always on your terms and always by your choice.” As part of this
process, consumers downloaded “research” software that tracked their online browsing.
Only at the end of a lengthy user agreement did Sears reveal the full extent of the data
collected, that it could include the contents of shopping carts, online bank statements, drug
prescription records, DVD rental records, and some personal email information. In a
consent decree with the FTC, Sears agreed to stop collecting data from consumers who
downloaded the software and to destroy all data it had previously collected.
The FTC also brought action against Twitter after hackers gained access through
its administrative system to Twitter accounts. Twitter had allowed any employee
access to the administrative system, which was protected by an easy-to-guess pass-
word. The hackers reset passwords and sent fake tweets. For example, an unauthor-
ized person sent a tweet from President-elect Barack Obama’s Twitter account offer-
ing free gasoline to users who took an Internet poll (which seems benign compared
with what the hacker could have said, but still not a good situation). The FTC found
that Twitter had engaged in deceptive acts because its (lack of) security practices had
violated the company’s promise to users that it would protect their information from
unauthorized access. As part of the settlement, Twitter agreed to strengthen its
security practices.
In addition to cases the FTC has brought against individual companies, it also issued a
report entitled “Self-Regulatory Principles for Online Behavioral Advertising.” As the name
4City of Ontario v. Quon, 130 S. Ct. 2619; 2010 U.S. LEXIS 4972 (S. Ct. 2010).
CHAPTER 32 Cyberlaw 789
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implies, these rules are voluntary. They provide that companies should clearly disclose the
information that they collect and also offer consumers an easy-to-use, easy-to-find method
for opting out. However, we have not found a website that complies with this policy. The
FTC has been working on a binding privacy policy for years, with no result yet.
One more cyberlaw issue: Imagine that you are reading a blog that favorably reviews a
new Microsoft product. Before clicking on the Buy button, would you want to know that
Microsoft had given the blogger a free computer? The FTC thinks you should. Under FTC
rules, bloggers face fines as high as $1,000 if they do not disclose all compensation they
receive (either in cash or free products) for writing product reviews. Moreover, celebrities
must disclose their relationships with advertisers when making endorsements outside of
traditional ads, such as on talk shows or in social media.
ELECTRONIC COMMUNICATIONS PRIVACY ACT OF 1986
The Electronic Communications Privacy Act of 1986 (ECPA) is a federal statute that
prohibits unauthorized interception of, access to, or disclosure of wire and electronic com-
munications. The definition of electronic communication includes email and transmissions
from pagers and cell phones. Violators are subject to both criminal and civil penalties. An
action does not violate the ECPA if it is unintentional or if either party consents. Also, the
USA Patriot Act, passed after the September 11 attacks, has broadened the government’s right
to monitor electronic communications.
Under the ECPA:
1. Any intended recipient of an electronic communication has the right to disclose it.
Thus, if you sound off in an email to a friend about your boss, the (erstwhile) friend
may legally forward that email to the boss or anyone else.
2. Internet service providers (ISPs) are generally prohibited from disclosing electronic
messages to anyone other than the addressee, unless this disclosure is necessary for the
performance of their service or for the protection of their own rights or property.
3. An employer has the right to monitor workers’ electronic communications if (1) the
employee consents, (2) the monitoring occurs in the ordinary course of business, or (3)
in the case of email, if the employer provides the computer system.5 Note that an
employer has the right to monitor electronic communication even if it does not relate
to work activities.
One lesson from the ECPA: Email is not private, and it is dangerous. Although the
Warshak court ruled that defendants have an expectation of privacy in emails they have sent
over a system that they provide for themselves, that simply means the police must first
obtain a search warrant before accessing emails, which is not that difficult. To get a search
warrant, the police just need probable cause that they will find evidence of a crime in the
place to be searched.
The majority of employers monitor their employees’ email. In the event of litigation,
the opposing party can access all emails—even messages that have in theory been deleted.
Many people who should have known better have been caught in the email trap. Merrill
Lynch stock analyst Henry Blodget praised stocks to the public even as he was referring to
them in emails as a “piece of s***.” He has been banned for life from the securities
industry. Then there was Harry Stonecipher, the CEO of Boeing, who sent explicit emails
to the employee with whom he was having an extramarital affair. When copies of the
emails were sent to the board of directors, he was fired. In the following case, two important
principles are at stake. Which one should win?
5The ECPA provides that, under certain circumstances, the police can access email without a warrant,
but the Warshak court declared that provision unconstitutional.
790 U N I T 4 Employment, Business Organizations and Property
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CHILDREN’S ONLINE PRIVACY PROTECTION ACT OF 1998
The Children’s Online Privacy Protection Act of 1998 (COPPA) prohibits Internet opera-
tors from collecting information from children under 13 without parental permission. It also
requires sites to disclose how they will use any information they acquire. Enforcement is in
the hands of the FTC. The website for Mrs. Fields cookies offered birthday coupons for
free cookies to children under 13. Although the company did not share information with
outsiders, it did collect personal information without parental consent from 84,000 children.
This information included names, home addresses, and birth dates. Mrs. Fields paid a
penalty of $100,000 and agreed not to violate the law again.
STATE REGULATION
Some states have passed their own online privacy laws. To take some examples, the
California Online Privacy Act of 2003 requires any website that collects personal information
from California residents to post a privacy policy conspicuously and then abide by its terms.
(Further, the California state constitution confers the right to privacy.) Connecticut,
Nebraska, and Pennsylvania also regulate online privacy policies.
You Be the Judge
Facts: Beth Israel Medi-
cal Center (BI)’s email
policy stated:
All information and
documents created, re-
ceived, saved, or sent
on theMedical Center’s
computer or communications systems are the property of
the Medical Center. Employees have no personal privacy
right in any material created, received, saved, or sent using
Medical Center communication or computer systems.
TheMedical Center reserves the right to access and disclose
such material at any time without prior notice.
Dr. Norman Scott was head of the orthopedics
department at BI. His contract with the hospital pro-
vided for $14 million in severance pay if he was fired
without cause. BI did fire him, and the question was
whether it was for cause or not. In preparation for a
lawsuit against BI, Scott used the hospital’s computer
system to send emails to his lawyer. Each of these emails
included the following notice:
This message is intended only for the use of the Addressee
and may contain information that is privileged and confi-
dential. If you are not the intended recipient, you are
hereby notified that any dissemination of this communica-
tion is strictly prohibited. If you have received this commu-
nication in error, please erase all copies of the message and
its attachments and notify us immediately.
BI obtained copies of
all of Scott’s emails. It
notified him that it had
copies of the emails to
his lawyer. No one at BI
had read the emails yet,
but they intended to do
so. Communications between a client and lawyer are gen-
erally protected, but a client waives this privilege if he
publicly discloses the information. When Scott requested
that the emails be returned to him unread, BI refused.
Scott filed a motion seeking the return of the documents.
You Be the Judge: Did Scott have a right to privacy in
emails he sent to his lawyer using the BI system?
Argument for Scott: Despite BI’s policy, all the emails
Scott sent asserted that they were confidential. That
should be enough to protect them. The attorney-client
privilege is a foundation of our legal system. It is abso-
lutely crucial for justice that clients be able to commu-
nicate with their lawyers in confidence. In a test between
a core principle such as attorney-client privilege and a
private entity’s email policy, the privilege must win.
The hospital should not be allowed to read Scott’s emails.
Argument for BI: Scott was aware of BI’s policy and
knew that emails were the property of the hospital.
Therefore, when he sent the emails, he was disclosing
them publicly. If the communications were that impor-
tant, he should have made a greater effort to protect them.
BI has the right to read them.
SCOTT V. BETH ISRAEL
MEDICAL CENTER INC.
847 N.Y.S.2d 436; 2007 N.Y. Misc. LEXIS 7114
Supreme Court of New York, 2007
CHAPTER 32 Cyberlaw 791
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Two states, Minnesota and Nevada, require ISPs to obtain their customers’ consent
before providing information about them. Connecticut and Delaware require employers to
notify their workers before monitoring emails or Internet usage.
EUROPEAN LAW
The European Convention on Human Rights declares, “Everyone has the right to respect
for his private and family life, his home, and his correspondence.” The European Union’s
e-Privacy Directive requires an opt-in system, under which tracking tools cannot be used
unless the consumer is told how the tools will be used and then specifically grants permis-
sion for their use. However, this directive may be interpreted to mean that consumers have
granted permission for tracking tools if they fail to change the default privacy settings on
their web browsers. At this writing, European nations are just beginning to implement the
e-Privacy Directive, so it may be some time before the impact of these rules is clear.
In theory, even companies outside Europe will have to comply with European rules if
they interact with European customers. Recently, European agencies insisted that Google,
Microsoft, and Yahoo! enhance their protection of users’ search histories; and a court in Italy
held that Google had violated that country’s privacy laws by posting a video of students
bullying an autistic boy. Stay tuned.
SPYWARE
Is your computer running sluggishly? Does it crash frequently? Has the home page on your
web browser suddenly changed without your consent? Is there a program in your systems
tray that you do not recognize? You might have spyware on your computer. Spyware is a
computer program that enters a user’s computer without permission and monitors and
reports the user’s activities.
Congress has considered legislation to control spyware but has not taken final action.
California has enacted the Consumer Protection Against Computer Spyware Act, which
makes spyware illegal.
32-2 SPAM
Spam is officially known as unsolicited commercial email (UCE) or unsolicited bulk email (UBE).
Whatever it is called, it is one of the most annoying aspects of email. It has been estimated
that 90 percent of email is spam. And roughly half of these messages were fraudulent—
either in content (promoting a scam) or in packaging (the headers or return address are
false). Aside from the annoyance factor, bulk email adds to the cost of connecting to the
Internet as ISPs increase server capacity to handle the millions of spam emails.
The Controlling the Assault of Non-Solicited Pornography and Marketing Act (CAN-
SPAM) is a federal statute that does not prohibit spam but instead regulates it. This statute
applies to virtually all promotional emails, whether or not the sender has a preexisting
relationship with the recipient. Under this statute, commercial email:
• May not have deceptive headings (From, To, Reply To, Subject),
• Must offer an opt-out system permitting the recipient to unsubscribe (and must honor
those requests promptly),
• Must clearly indicate that the email is an advertisement,
• Must provide a valid physical return address (not a post office box), and
• Must clearly indicate the nature of pornographic messages.
A company can avoid these requirements by obtaining advance permission from the
recipients.
Spyware
A computer program that
enters a user’s computer
without permission and
monitors and reports the
user’s activities.
792 U N I T 4 Employment, Business Organizations and Property
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CAN-SPAM seems to have had little impact on the quantity of spam (although it has
made opt-out provisions more common in legitimate commercial emails). More effective
have been the tools developed by online security firms and governments that prevent as
much as 98 percent of spam from reaching your email inbox.
But spammers have found other outlets. They post messages in the comment sections
of websites and on social media sites such as Facebook and Twitter. Their goal is to entice
you to click on a link that takes you to a website that sells foolproof “investments” or that
simply steals bank information from your computer. If that link seems to come from a
Facebook friend or someone whom you follow on Twitter, it seems more reliable. A recent
study found that 8 percent of links sent via Twitter are fraudulent, but they are 20 times
more likely to be clicked than those in spam email.6
EXAM Strategy
Question: Cruise.com operated a website selling cruise vacations. It sent unsolicited
email advertisements—dubbed “E-deals”—to prospective customers. Eleven of
these “E-deals” went to inbox@webguy.net. Each message offered the recipient an
opportunity to be removed from the mailing list by clicking on a line of text or by
writing to a specific postal address. Has Cruise.com violated the CAN-SPAM Act?
Strategy: Remember that this Act does not prohibit all unsolicited emails.
Result: Cruise.com was not in violation because it offered the recipients a way to
unsubscribe. Also, it provided a valid physical return address.
32-3 INTERNET SERVICE PROVIDERS AND
WEB HOSTS: COMMUNICATIONS
DECENCY ACT OF 1996
ISPs are companies, such as Earthlink, that provide connection to the Internet. Web hosts
post web pages on the Internet. Both play important roles in cyberspace. As the legal
structure that supports the Internet develops, so have legal issues involving these players.
The Internet is an enormously powerful tool for disseminating information. But what if
some of this information happens to be false or in violation of our privacy rights? Is an ISP
liable for transmitting it to the world? In 1995, a trial judge in New York held that an ISP,
Prodigy Services Company, was potentially liable for defamatory statements that an uni-
dentified person posted on one of its bulletin boards.7 The message alleged that the
president of an investment bank had committed “criminal and fraudulent acts.” It was
not only a false statement—it was posted on the most widely read financial online bulletin
board in the country. Although one can only feel sympathy for the target of this slur, the
decision nonetheless alarmed many observers who argued that there was no way ISPs could
review every piece of information that hurtles through their portals. The next year, Congress
overruled the Prodigy case by passing the Communications Decency Act of 1996 (CDA).8
6
“Long life spam,” The Economist, November 20, 2010, p. 67.
7Stratton Oakmont, Inc. v. Prodigy Services Company, 1995 N.Y. Misc. LEXIS 229.
847 U.S.C. 230.
CHAPTER 32 Cyberlaw 793
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Under the CDA, ISPs and web hosts are not liable for information that is provided by
someone else. Only content providers are liable. The following case lays out the arguments
in favor of the CDA, but also illustrates some of the costs of the statute (and of the Internet).
CARAFANO V. METROSPLASH.COM, INC.9
339 F.3d 1119, 2003 U.S. App. LEXIS 16548
United States Court of Appeals for the Ninth Circuit, 2003
C A S E S U M M A R Y
Facts: Matchmaker.com is an Internet dating service that
permits members to post profiles of themselves and to
view the profiles of other members. Before posting is
allowed, Matchmaker reviews photos for inappropriate
material but does not examine written profiles.
Christianne Carafano is an actor who uses the stage
name Chase Masterson. She has appeared in numerous
films and television shows, such as Star Trek: Deep Space
Nine and General Hospital. Without her knowledge or con-
sent, someone in Berlin posted a profile of her in the Los
Angeles section of Matchmaker. In answer to the question
“Main source of current events?” the person posting the
profile put “Playboy Playgirl” and for “Why did you call?”
responded “Looking for a one-night stand.” In addition,
the essays indicated that she was looking for a “hard and
dominant” man with “a strong sexual appetite” and that
she “liked sort of being controlled by a man, in and out of
bed.” Pictures of the actor, taken off the Internet, were
included with the profile. The profile also provided her
home address and an email address, which, when con-
tacted, produced an automatic email reply stating, “You
think you are the right one? Proof it !!” [sic], and providing
Carafano’s home address and telephone number.
Unaware of the improper posting, Carafano began
receiving sexually explicit messages on her home voice
mail, as well as a sexually explicit fax that threatened her
and her son. She received numerous phone calls, letters,
and email from male fans expressing concern that she had
given out her address and phone number (but simulta-
neously indicating an interest in meeting her). Feeling
unsafe, Carafano and her son stayed in hotels or away
from Los Angeles for several months.
One Saturday a week or two after the profile was first
posted, Carafano’s assistant, Siouxzan Perry, learned of
the false profile through a message from “Jeff.” Acting
on Carafano’s instructions, Perry contacted Matchmaker,
demanding that the profile be removed immediately. The
Matchmaker employee did not remove it then because
Perry herself had not posted it, but on Monday morning,
the company blocked the profile from public view, and
then deleted it the following day.
Carafano filed suit against Matchmaker alleging invasion
of privacy, misappropriation of the right of publicity, defama-
tion, and negligence. The district court rejected Match-
maker’s argument for immunity under the CDA on the
grounds that the companyprovidedpart of theprofile content.
Issue: Did the CDA protect Matchmaker from liability?
Decision: Yes, the CDA protected Matchmaker from
liability for the postings.
Reasoning: Under the CDA, Internet publishers are not
liable for false or defamatory material if someone else
provided the information. In this way, Internet publishers
are different from print, television, and radio publishers.
Interactive computer services have millions of users.
It would be impossible for these services to screen each of
their millions of postings. If they were liable for content,
they might choose to severely limit the number and type
of messages. To avoid any restriction on free speech,
Congress chose to protect computer services from liability
if someone else provided the content.
The fact that some of the content in Carafano’s fake
profile was provided in response to Matchmaker’s ques-
tionnaire does not make the company liable. The answers
to the questions were provided exclusively by the user.
No profile has any content until a user actively creates it.
In this case, Carafano’s home address and the email
address that revealed her phone number were transmitted
unaltered to profile viewers. Thus, Matchmaker did not
play a significant role in creating, developing, or
transforming the relevant information.
Despite the serious and utterly deplorable consequences
in this case, the CDA protects Matchmaker from liability.
9Matchmaker.com, Inc., changed its legal name to Metrosplash.com, Inc., but continued to do business as
Matchmaker.com.
794 U N I T 4 Employment, Business Organizations and Property
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Note that the CDA does not protect web hosts or ISPs that engage in wrongdoing. For
example, Bright Builders, Inc, hosted copycatclubs.com, a website that, as you might guess,
sold counterfeit golf clubs. The court held that Bright Builders was liable despite the CDA
because it participated in the design, building, marketing, and support of copycatclubs.com.
It even helped locate the counterfeit clubs that the website sold.10 Ultimately, a jury
returned a verdict of $110,150 against Bright Builders.
Also, the CDA does not protect web hosts and ISPs from contract liability. For
example, after Cynthia Barnes broke up with her boyfriend, he created a profile of her
on a Yahoo! website. He then spitefully posted nude photos of the two of them taken
without her knowledge, together with her addresses and phone numbers at home and at
work. He also suggested that she was interested in sex with random strangers. Many men
were willing to oblige. For months, Yahoo! did not even respond to Barnes’s request to
remove the profile. Not until a TV show prepared to run a story about the incident did the
company’s director of communications contact Barnes to promise that the profile would be
removed immediately.
Still Yahoo! took no action until two months later, when Barnes sued. The appeals court
ruled that Barnes could bring a contract claim against Yahoo! under a theory of promissory
estoppel—that she had relied on the company’s promise.11
EXAM Strategy
Question: Someone posted an anonymous review on TripAdvisor.com alleging that
the owner of a restaurant had entertained a prostitute there. The allegation was false.
TripAdvisor refused to investigate or remove the review. Does the restaurant owner
have a valid claim against the website?
Strategy: Remember that web hosts are liable only if they have engaged inwrongdoing.
Result: As a web host, TripAdvisor is not liable for content. It would be liable only if
it promised to take down the review and then did not.
32-4 CRIME ON THE INTERNET
Despite its great benefits, the Internet has also opened new frontiers in crime for the
dishonest and unscrupulous.
32-4a Hacking
During the 2008 presidential campaign, college student David Kernell guessed vice-presiden-
tial nominee Sarah Palin’s email password, accessed her personal Yahoo! account, and published
the content of some of her emails. To many, his actions seemed like an amusing prank. The
joke turned out not to be so funny when Kernell was sentenced to one year in prison.
Gaining unauthorized access to a computer system is called hacking. It is a major crime.
The Federal Bureau of Investigation ranks cybercrime as its third-highest priority, right
behind terrorism and spying. The Pentagon reports that hackers make more than 250,000
10Roger Cleveland Golf Co. v. Price, 2010 U.S. Dist. LEXIS 128044.
11Barnes v. Yahoo!, Inc., 510 F.3d 1096 (9th Cir., 2008). Promissory estoppel is discussed at greater
length in Chapter 9.
Hacking
Gaining unauthorized access to
a computer system.
CHAPTER 32 Cyberlaw 795
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attempts annually on its computers. The goal of hackers is varied; some do it for little more
than the thrill of the challenge. The objective for other hackers may be espionage, extortion,
theft of credit card information, or revenge for perceived slights. Kernell hoped to prevent
Palin from being elected vice president.
Hacking is a crime under the federal Computer Fraud and Abuse Act of 1986 (CFAA).12
This statute applies to any computer, cell phone, iPod, iPad, or other gadget attached to the
Internet. The CFAA prohibits:
• Accessing a computer without authorization and
obtaining information from it,
• Computer espionage,
• Theft of financial information,
• Theft of information from the U.S. government,
• Theft from a computer,
• Computer fraud,
• Intentional, reckless, and negligent damage to a
computer,
• Trafficking in computer passwords, and
• Computer extortion.
The CFAA also provides for civil remedies so that someone who has been harmed
by a hacker can personally recover damages from the wrongdoer. Employers have begun
to use the CFAA to bring civil cases against former employees who take company
information with them when they go to work for a competitor. At this writing, the courts
are inconsistent on the issue of whether such an activity constitutes “unauthorized
access” and is, therefore, a violation of the CFAA. Also, database owners sometimes
claim that an unauthorized user who “shares” the login credentials of a legitimate
purchaser has violated the CFAA. Because the courts have split on these issues, the
outcome of such a case depends on geography.13
There are two problems with the CFAA. First, while the statute prohibits the use of a
virus to harm a computer, it does not ban the creation of viruses that someone else could use
for hacking. Thus, it is legal for websites to sell source code for viruses—codes that even
beginners can use destructively.
Second, the CFAA applies only to U.S. criminals. Because the Internet is truly inter-
national, cybercriminals do not always fall within the jurisdiction of American laws. For
example, a computer virus called ILOVEYOU caused an estimated $1 billion worth of
damage worldwide. Although the perpetrator would have been subject to prosecution under
the CFAA in the United States, he lived in the Philippines, which did not have laws
prohibiting cybercrime. Nor could the suspect be extradited to the United States because
the extradition treaty only applied if both nations had the same law. The Philippines
ultimately dropped all charges against the suspect.
The FBI ranks cybercrime
as its third-highest
priority, right behind
terrorism and spying.
1218 U.S.C. §1030.
13See, for example, Int’l Airport Centers LLC v. Citrin, 440 F 3d 418 (7th Cir., 2006); Lasco Foods, Inc. v.
Hall & Shaw Sales, 600 F. Supp. 2d 1045 (E. Dist. Mo, 2009); Orbit One Communications Inc. v. Numerex
Corp., 692 F. Supp. 2d 313 (S.D.N.Y. 2010); State Analysis Inc. v. American Financial Services Assoc., 621
F. Supp. 2d 309 (E.D. Va., 2009); and AtPac Inc. v. Aptitude Solutions Inc., 130 F. Supp. 2d 1114, (E.D.
CA, 2010).
796 U N I T 4 Employment, Business Organizations and Property
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32-4b Fraud
Fraud is a growth business on the Internet. The Internet’s anonymity and speed facilitate this
crime, and computers help criminals identify and contact victims. Common scams include
advance fee scams,14 the sale of merchandise that is either defective or nonexistent, the so-
called Nigerian letter scam,15 billing for services that are touted as “free,” fake scholarship
search services, romance fraud (you meet someone online who wants to visit you but needs
money for travel expenses), and credit card scams (for a fee, you can get a credit card, even
with a poor credit rating). One of the new scams involves overpayment. You are renting out a
house, selling a pet, or accepting a job, and “by accident,” you are sent too much money. You
wire the excess back, only to find out that the initial check or funds transfer was no good.
Fraud is the deception of another person for the purpose of obtaining money or property
from him. It can be prosecuted under state law or the Computer Fraud and Abuse Act. In
addition, federal mail and wire fraud statutes prohibit the use of mail or wire communication
in furtherance of a fraudulent scheme.16The FTC can bring civil cases under §5 of the FTC
Act. (Chapter 7, on crime, discusses fraud.)
AUCTIONS
Internet auctions are the number one source of consumer complaints about online fraud.
Wrongdoers either sell goods they do not own, provide defective goods, or offer fakes. In a
recent case (which will not reduce the amount of auction fraud) a court held that eBay, the
Internet auction site, was not liable to Tiffany & Company for the counterfeit Tiffany
products sold on the site. The jewelry company had sued after discovering that most items
advertised on eBay as Tiffany products were, in fact, fakes. The court held that eBay’s only
legal obligation was to remove products once told that they were counterfeit.17
Shilling is an increasingly popular online auction fraud. Shilling means that a seller
either bids on his own goods or agrees to cross-bid with a group of other sellers. Shilling is
prohibited because the owner drives up the price of his own item by bidding on it. Thus, for
example, Kenneth Walton, a San Francisco lawyer, put up for auction on eBay an abstract
painting purportedly by famous artist Richard Diebenkorn. A bidder offered $135,805
before eBay withdrew the item in response to charges that Walton had placed a bid on
the painting himself and had also engaged in cross-bidding with a group of other eBay users.
Although Walton claimed that he had placed the bids for friends, he ultimately pleaded
guilty to charges of federal wire and mail fraud. He was sentenced to almost four years in
prison and paid nearly $100,000 in restitution to those who overpaid for the items he bid on.
To date, eBay has generally responded to shillers by suspending them. Shillers are also
subject to suit under general anti-fraud statutes. In addition, some states explicitly prohibit
shilling.18
14As in, “If you are willing to pay a fee in advance, then you will have access to (pick your choice)
favorable financing, lottery winnings from overseas, attractive investment opportunities that will make
you rich.”
15Victims receive an email from someone alleging to be a Nigerian government official who has stolen
money from the government. He needs some place safe to park the money for a short time. The
official promises that, if the victim will permit her account to be used for this purpose, she will be
allowed to keep a percentage of the stolen money. Instead, of course, once the “official” has the
victim’s bank information, he cleans out the account.
16U.S.C. §§1341–1346.
17Tiffany Inc. v. eBay, Inc., 600 F.3d 93, 2010 U.S. App. LEXIS 6135 (2nd Cir., 2010) and, on remand,
2010 U.S. Dist. LEXIS 96596 (S.D.N.Y, 2010).
18For example, New Mexico law provides that “It shall be unlawful to employ shills or puffers at any
such auction sale or to offer or to make or to procure to be offered or made any false bid or offer any
false bid to buy or pretend to buy any article sold or offered for sale.” N.M. Stat. §61-16-14.
Shilling
When a seller at auction either
bids on his own goods or
agrees to cross-bid with a
group of other sellers.
CHAPTER 32 Cyberlaw 797
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IDENTITY THEFT
Identity theft is one of the scariest crimes against property. Thieves steal the victim’s social
security number and other personal information such as bank account numbers and mother’s
maiden name, which they use to obtain loans and credit cards. The money owed is never
repaid, leaving victims to prove that they were not responsible for the debts. The thieves
may even commit (additional) crimes under their new identities. Meanwhile, the victim may
find himself unable to obtain a credit card, loan, or job. One victim spent several nights in
jail after he was arrested for a crime that his alter ego had committed.
Although identity fraud existed before computers, the Internet has made it much easier.
For example, consumer activists were able to purchase the social security numbers of the
director of the CIA, the Attorney General of the United States, and other top administration
officials. The cost? Only $26 each. No surprise, then, that 8 million Americans are victims of
this crime each year.
A number of federal statutes deal with identity theft or its consequences. The Identity
Theft and Assumption Deterrence Act of 1998 prohibits the use of false identification to
commit fraud or other crimes, and it also permits the victim to seek restitution in court.19
The Truth in Lending Act limits liability on a stolen credit card to $50. The Social Security
Protection Act of 2010 prohibits government agencies from printing social security numbers
on checks.
A number of states have also passed identity theft statutes. Almost every state now
requires companies to notify consumers when their personal information has been stolen.
Many states also restrict the use and disclosure of social security numbers.
What can you do to prevent the theft of your identity?
1. Check your credit reports at least once a year. (Consumers are entitled by law to one
free credit report every year from each of the three major reporting agencies. You can
order these reports at https://www.annualcreditreport.com.)
2. Place a freeze on your credit report so that anyone who is about to issue a loan or
credit card will double-check with you first.
3. If you suspect that your identity has been stolen, contact the FTC at 811-IDTHEFT,
811-438-4338, or google “ftc identity theft” to get to the FTC’s identity theft site.
Also, file a police report immediately and keep a copy to show creditors. Notify the
three credit agencies.
PHISHING
Have you ever received an instant message from a Facebook friend saying, “Hey, what’s
up?” with a link to an IQ test? This instant message is not from a friend, but rather from a
fraudster hoping to lure you into revealing your personal information. In this case, people
who clicked on the link were told that they had to provide their cell phone number to get
the test results. Next thing they knew, they had been signed up for some expensive cell
phone service. This scam is part of one of the most rapidly growing areas of Internet fraud:
phishing. In this crime, a fraudster sends a message directing the recipient to enter personal
information on a website that is an illegal imitation of a legitimate site.
In a traditional phishing scam, large numbers of generic emails are sprayed over the
Internet asking millions of people to log on to, say, a fake bank site. But the latest
development—called spear phishing—involves personalized messages sent from some-
one the victim knows. For example, your sister asks for your social security number so
she can add you as a beneficiary to her life insurance policy. In reality, this email has
1918 U.S. §1028.
Phishing
A fraudster sends a message
directing the recipient to enter
personal information on a
website that is an illegal
imitation of a legitimate site.
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come from a fraudster who hacked into your sister’s Facebook account to gain access to
her lists of friends and family.20 Even “Like” buttons can be “clickjacked” to take
unwary users to bogus sites.
Prosecutors can bring criminal charges against phishers for fraud. The companies whose
websites have been copied can sue these criminals for fraud, trademark infringement, false
advertising, and cybersquatting (discussed further in Chapter 33, on intellectual property).
No reputable company will ask customers to respond to an email with personal
information. When in doubt, close the suspicious email, relaunch your web browser, and
then go to the company’s main website. If the legitimate company needs information from
you, it will so indicate on the site.
EXAM Strategy
Question: TruePrint sent emails to thousands of consumers, advertising its business
card service. The subject line said, “FREE GIFT!” Consumers who opened the
email, were then asked to click on a link, which led to a web page that asked for
personal information. After filling in the information and clicking a “Continue”
button, they landed on a second web page. In the fine print at the bottom of this page
was the following statement: “Printing is free. Pay only for shipping and processing.
Please see our Free Offer Details for more information.” Finally, at the end of the
process on the next web page, consumers learned that shipping the free gift would
cost $5.61, payable by credit card or check. The email did not make any reference to
TruePrint. Has TruePrint violated the law?
Strategy: Indeed, TruePrint has violated two laws.
Result: First, it has advertised a “free gift” when, in fact, the gift costs $5.61. That is
fraud. Second, it has violated the CAN-SPAM act because the subject line of the
email is untrue—the gift is not free. It has further violated CAN-SPAM by its failure
to provide TruePrint’s valid physical return address.
Chapter Conclusion
The Internet has changed our lives in ways that were inconceivable a generation ago, and the
law is rushing to catch up. Courts will apply some old laws in new ways, and, as legislators,
regulators and courts learn from experience, new laws will be enacted.
Inevitably, the law of cyberspace will become increasingly international. What does
Europe accomplish by regulating Internet privacy if its citizens spend a good portion of their
time on American websites? What will the FTC do if scam artists or spammers operate
offshore? Effective regulation of cyberspace will require cooperation among nations and
between government and industry.
20To prevent your Facebook account from being hijacked, be careful when accessing it over a public
network (such as in a hotel or airport), where fraudsters might be able to capture your password. If you
text “otp” to 32665, you will receive a password that can be used only once (a “one-time password”).
Fraudsters thus cannot use this password to access your account.
CHAPTER 32 Cyberlaw 799
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EXAM REVIEW
1. THE FIRST AMENDMENT The First Amendment to the Constitution
protects speech on the Internet so long as the speech does not violate some
other law. (pp. 785–787)
2. THE FOURTH AMENDMENT The Fourth Amendment to the Constitution
prohibits unreasonable searches and seizures by the government. This provision
applies to computers. (pp. 787–789)
3. REASONABLE EXPECTATION OF PRIVACY Under criminal law, if your
employer has a reasonably articulated policy notifying you that it has the right to
access and read electronic communications on a system that it provides, then you do
not have a reasonable expectation of privacy when using that system. You do have a
reasonable right to privacy on a system that you provide for yourself. (pp. 788–789)
Question: Three travel agents use fictitious accounts to steal millions of frequent
flyer miles. Must the police obtain a warrant before searching their email accounts?
Strategy: The answer depends on what type of email account the agents used.
(See the “Result” at the end of this section.)
4. THE FTC ACT Section 5 of the FTC Act prohibits unfair and deceptive practices.
The FTC does not require websites to have a privacy policy, but if they do have
one, it cannot be deceptive, and they must comply with it. (pp. 789–790)
5. THE ECPA The Electronic Communications Privacy Act of 1986 is a federal
statute that prohibits unauthorized interception or disclosure of wire and electronic
communications. However, it permits an employer to monitor workers’
electronic communications if (1) the employee consents, (2) the monitoring
occurs in the ordinary course of business, or (3) the employer provides the
computer system (in the case of email). (pp. 790–791)
6. COPPA The Children’s Online Privacy Protection Act of 1998 prohibits Internet
operators from collecting information from children under 13 without parental
permission. It also requires sites to disclose how they will use any information they
acquire. (p. 791)
7. E-PRIVACY DIRECTIVE The European Union’s e-Privacy Directive requires an
opt-in system under which tracking tools cannot be used unless the consumer is told
how the tools will be used and then specifically grants permission for their use. (p. 792)
8. CAN-SPAM The Controlling the Assault of Non-Solicited Pornography and
Marketing Act (CAN-SPAM) is a federal statute that does not prohibit spam but
instead regulates it. Under this statute, commercial email:
• May not have deceptive headings (From, To, Reply To, Subject),
• Must offer an opt-out system permitting the recipient to unsubscribe (and must
honor those requests promptly),
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• Must clearly indicate that the email is an advertisement,
• Must provide a valid physical return address (not a post office box), and
• Must clearly indicate the nature of pornographic messages. (pp. 792–793)
9. THE CDA Under the Communications Decency Act of 1996, ISPs and web hosts
are not liable for information that is provided by someone else. (pp. 793–795)
Question: Ton Cremers was the director of security at Amsterdam’s famous
Rijksmuseum and the operator of the Museum Security Network (the Network)
website. Robert Smith, a handyman working for Ellen Batzel in North Carolina,
sent an email to the Network alleging that Batzel was the granddaughter of
Heinrich Himmler (one of Hitler’s henchmen) and that she had art that Himmler
had stolen. These allegations were completely untrue. Cremers posted Smith’s
email on the Network’s website and sent it to the Network’s subscribers. Cremers
exercised some editorial discretion in choosing which emails to send to
subscribers, generally omitting any that were unrelated to stolen art. Is Cremers
liable to Batzel for the harm that this inaccurate information caused?
Strategy: Cremers is liable only if he is a content provider. (See the “Result” at
the end of this section.)
10. THE CFAA Hacking is a crime under the federal Computer Fraud and Abuse Act
of 1986. The CFAA prohibits:
• Accessing a computer without authorization and obtaining information from it,
• Computer espionage,
• Theft of financial information,
• Theft of information from the U.S. government,
• Theft from a computer,
• Computer fraud,
• Intentional, reckless, and negligent damage to a computer,
• Trafficking in computer passwords, and
• Computer extortion. (p. 796)
Question: To demonstrate the inadequacies of existing computer security
systems, Cornell student Robert Morris created a computer virus. His plan,
however, went awry, as plans sometimes do. He thought his virus would be
relatively harmless, but it ran amok, crashing scores of computers at universities,
military sites, and medical research sites. Has he committed a crime, or is he liable
only for civil penalties? Does it matter that he did not intend to cause damage?
Strategy: Review the provisions of the CFAA. (See the “Result” at the end of
this section.)
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11. FRAUD Fraud is the deception of another person for the purpose of obtaining
money or property from him. (pp. 797–799)
12. IDENTITY THEFT The Identity Theft and Assumption Deterrence Act of
1998 prohibits the use of false identification to commit fraud or other crimes.
(p. 798)
3. Result: If their employer owns the email system, the agents have no expectation
of privacy, and the police do not need a search warrant. If, however, they are
sending emails over a system they are paying for themselves, then the police do
need a warrant.
9. Result: The court found that Cremers was not liable under the CDA.
10. Result: Morris was convicted of a crime under the CFAA. He intended to
trespass on a computer, so it did not matter that he had no intent to cause harm.
MULTIPLE-CHOICE QUESTIONS
1. Beth sent fraudulent emails through both her account at work and her personal
account at home. Although Beth had never read her employer’s handbook, it said
the company had the right to access work emails. The police obtain a search
warrant before reading her work emails. They obtain a search warrant before
reading the emails from her personal account.
(a) need to, need to
(b) need not, need not
(c) need to, need not
(d) need not, need to
2. Because Blaine Blogger reviews movies on his blog, cinemas allow him in for free.
Nellie Newspaper Reporter also gets free admission to movies. Blaine
disclose on his blog that he receives free tickets. Nellie disclose in her articles
that she receives free tickets.
(a) must, must
(b) need not, need not
(c) must, need not
(d) need not, must
3. An employer has the right to monitor workers’ electronic communications if:
(a) the employee consents
(b) the monitoring occurs in the ordinary course of business
(c) the employer provides the computer system
(d) all of the above
(e) none of the above
802 U N I T 4 Employment, Business Organizations and Property
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4. Spiro Spammer sends millions of emails a day asking people to donate to his college
tuition fund. Oddly enough, many people do. Everything in the emails is accurate
(including his 1.9 GPA). Which of the following statements is true?
(a) Spiro has violated the CAN-SPAM Act because he has sent unsolicited
commercial emails
(b) Spiro has violated the CAN-SPAM Act if he has not offered recipients an
opportunity to unsubscribe
(c) Spiro has violated the CAN-SPAM Act because he is asking for money
(d) Spiro has violated the CAN-SPAM Act unless the recipients have granted
permission to him to send these emails
5. Sushila suspects that her boyfriend is being unfaithful. While he is asleep, she takes
his iPod out from under his pillow and goes through all his playlists. Then she finds
what she has been looking for: Plum’s Playlist. It is full of romantic songs. Sushila
sends Plum an email that says, “You are the most evil person in the universe!” Which
law has Sushila violated?
(a) The First Amendment
(b) The CDA
(c) The ECPA
(d) The CFAA
(e) None
ESSAY QUESTIONS
1. ETHICS Chitika, Inc., provided online tracking tools on websites. When consumers
clicked the “opt-out” button, indicating that they did not want to be tracked, they were
not—for 10 days. After that, the software would resume tracking. Is there a legal problem
with Chitika’s system? An ethical problem? What Life Principles were operating here?
2. YOU BE THE JUDGE WRITING PROBLEM Jerome Schneider wrote several
books on how to avoid taxes. These books were sold on Amazon.com. Amazon permits
visitors to post comments about items for sale. Amazon’s policy suggests that these
comments should be civil (e.g., no profanity or spiteful remarks). The comments about
Schneider’s books were not so kind. One person alleged Schneider was a felon.
When Schneider complained, an Amazon representative agreed that some of the
postings violated its guidelines and promised that they would be removed within one to
two business days. Two days later, the posting had not been removed. Schneider filed suit.
Argument for Schneider: Amazon has editorial discretion over the posted comments. It
both establishes guidelines and then monitors the comments to ensure that they comply
with the guidelines. These activities make Amazon an information content provider, not
protected by the Communications Decency Act. Also, Amazon violated its promise to take
down the content. Argument for Amazon:The right to edit material is not the same thing
as creating the material in the first place.
3. Over the course of 10 months, Joseph Melle sent more than 60 million unsolicited
email advertisements to AOL members. What charges could be brought against him?
Would you need more information before deciding?
CHAPTER 32 Cyberlaw 803
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4. What can you do to protect your privacy online? Draw up a concrete list of steps that
you might reasonably consider. Are there some actions that you would not be willing
to take because they are not worth it to you?
5. Craig Hare offered computers and related equipment for sale on various Internet
auction websites. He accepted payment but not responsibility—he never shipped the
goods. Which government agencies might bring charges against him?
DISCUSSION QUESTIONS
1. Marina Stengart used her company laptop to
communicate with her lawyer via her personal,
password-protected, web-based email account.
The company’s policy stated:
E-mail and voice mail messages, internet use and
communication, and computer files are considered
part of the company’s business and client records.
Such communications are not to be considered
private or personal to any individual employee.
Occasional personal use is permitted; however, the
system should not be used to solicit for outside
business ventures, charitable organizations, or for
any political or religious purpose, unless authorized
by the Director of Human Resources.
After she filed an employment lawsuit against her
employer, the company hired an expert to access her
emails that had been automatically stored on the laptop.
Are these emails protected by the attorney-client
privilege? How does this case differ from
Scott v. Beth Israel earlier in the chapter?
2. Roommates.com operated a website designed to
match people renting spare rooms with those looking
for a place to live. Before subscribers could search
listings or post housing opportunities on Roommate’s
website, they had to create profiles, a process that
required them to answer a series of questions that
included the subscriber’s sex, sexual orientation, and
whether he would bring children to a household. The
site also encouraged subscribers to provide
“Additional Comments,” describing themselves and
their desired roommate in an open-ended essay. Here
are some typical ads:
• “I am not looking for Muslims.”
• “Not acceptable: freaks, geeks, prostitutes
(male or female), druggies, pet cobras, drama
queens, or mortgage brokers.”
• “Must be a black gay male!”
• We are 3 Christian females who Love our Lord
Jesus Christ…. We have weekly bible studies
and bi-weekly times of fellowship.”
Many of the ads violated the Fair Housing Act.
Is Roommates.com liable?
3. ETHICS Matt Drudge published a report on his
website (http://www.drudgereport.com) that White
House aide Sidney Blumenthal “has a spousal abuse
past that has been effectively covered up There are
court records of Blumenthal’s violence against his
wife.”The Drudge Report is an electronic publication
focusing on Hollywood and Washington gossip.
AOL paid Drudge $3,000 a month to make the
Drudge Report available to AOL subscribers. Drudge
emailed his reports to AOL, which then posted
them. Before posting, however, AOL had the right
to edit content. Drudge ultimately retracted his
allegations against Blumenthal, who sued AOL.
He alleged that under the Communications
Decency Act of 1996, AOLwas a “content provider”
because it paid Drudge and edited what he wrote.
Do you agree? Putting liability aside, what moral
obligation did AOL have to its members? To
Blumenthal? Should AOL be liable for content it
bought and provided to its members?
4. Lori Drew created a fake MySpace profile,
pretending to be a teenage boy. Through that
boy’s identity, she bullied 13-year-old Megan
Meier. The girl killed herself shortly after
receiving a message saying, “The world would be a
better place without you.” MySpace requires all
users to agree to its terms of service which require
“truthful and accurate” information. Has Drew
violated the CFAA?
5. Tracking tools provide benefits to consumers but
they also carry risks. Should Congress regulate
them? If so, what should the law provide?
804 U N I T 4 Employment, Business Organizations and Property
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CHAPTER33
INTELLECTUAL
PROPERTY
Cooper is a producer at a small indie film
company in Los Angeles. He puts together
packages that have a script, a director, and
actors. He then finds investors who pay to
make the movie and distributors who purchase
the right to release it in cinemas, on TV, and on
DVD. (Although most people think that box
office results are what count, the reality is that,
historically, over half of most movies’ revenue
came from home entertainment options such as
DVD rentals and sales.)
Cooper is pretty excited about two packages he has
put together: One stars established actor Robert de Niro,
and the other features an up-and-coming director work-
ing with movie star Clive Owen. But his excitement has
turned to disappointment—shockingly, he cannot find
anyone willing to invest in either movie. Cooper hears
the same thing from everyone: “DVD sales are way
down, so we know we won’t get the payback we used to.
We can’t afford to invest in as many movies.”
On a flight to New York in search of investors,
Cooper finds himself sitting next to a man who is
watching a movie on his computer. Cooper knows this
movie has not even been released to DVD yet. Clearly,
the man has downloaded it from an illegal website. Cooper slowly crushes the plastic cup in
his hand. What’s wrong with that guy? Doesn’t he know that movies cost money to make?
Doesn’t he realize people like him are killing an industry?
On a flight to New York
in search of investors,
Cooper finds himself
sitting next to a man who
is watching a movie on
his computer.… Clearly,
the man has downloaded
it from an illegal website.
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33-1 INTRODUCTION
For much of history, land was the most valuable form of property. It was the primary source
of wealth and social status. Today, intellectual property is a major source of wealth. New
ideas—for manufacturing processes, software, apps, medicines, books—bring both affluence
and influence.
Although both can be valuable assets, land and intellectual property are fundamentally
different. The value of land lies in the owner’s right to exclude, to prevent others from
entering it. Intellectual property, however, has little economic value unless others use it.
This ability to share intellectual property is both good news and bad. On the one hand, the
owner can produce and sell unlimited copies of, say, software, but on the other hand, the
owner has no easy way to determine if someone is using the program for free. The high cost
of developing intellectual property, combined with the low cost of reproducing it, makes it
particularly vulnerable to theft.
Because intellectual property is nonexclusive, many people see no problem with using
it for free. But when consumers take intellectual property—movies, songs, and books—
without paying for it, they ensure that fewer of these items will be produced.
Some commentators suggest that the United States has been a technological leader
partly because its laws have always provided strong protection for intellectual property. The
Constitution provided for patent and copyright protection early in the country’s history.
The conflict between those who have intellectual property and those who want to use it
has taken on a global dimension. Developing countries argue that American intellectual
property laws increase the price of medicines, such as AIDS drugs and vaccines, that could
save more lives if only they were cheaper and, therefore, more readily available. “Patents
kill” is their slogan. The United States responds that without patent protection, there would
be no innovation, no miracle drugs.
But even U.S. drug companies admit that patents can sometimes stifle innovation. The
pharmaceutical company Bristol-Meyers Squibb says that it cannot conduct research on
many cancer-fighting drugs because of patents held by its competitors. Information tech-
nology firms make a similar complaint. In a study of the American semiconductor business,
researchers found that more patents did not necessarily mean more innovation. Instead,
some companies were simply more aggressive about patenting every possible aspect of their
research. Nor was there any evidence that innovation increased as patent rights were
enhanced.
The role of intellectual property law is to balance the rights of those who create
intellectual property and those who use it. And as this chapter reveals, such a balancing
act is no easy feat.
33-2 PATENTS
A patent is a grant by the government permitting the inventor exclusive use of an invention
for 20 years from the date of filing (or 14 years from the date of issuance in the case of design
patents). During this period, no one may make, use, or sell the invention without permis-
sion. In return, the inventor publicly discloses information about the invention that anyone
can use upon expiration of the patent.
33-2a Types of Patents
There are three types of patents: utility patents, design patents, and plant patents.
Patent
A grant by the government
permitting the inventor
exclusive use of an invention for
a specified period.
806 U N I T 4 Employment, Business Organizations and Property
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UTILITY PATENT
Whenever people use the word “patent” by itself, they are referring to a utility patent. This
type of patent is available to those who invent (or significantly improve) any of the following:
Type of Invention Example
Mechanical invention A hydraulic jack used to lift heavy aircraft
Electrical invention A prewired, portable wall panel for use in large, open-plan offices
Chemical invention The chemical 2-chloroethylphosphonic acid used as a plant growth
regulator
Process A method for applying a chemical compound to an established plant
such as rice in order to inhibit the growth of weeds selectively; the
application can be patented separately from the actual chemical
Machine A device that enables a helicopter pilot to control all flight functions
(pitch, roll, and heave) with one hand
Composition of matter A sludge used as an explosive at construction sites; the patent
specifies the water content, the density, and the types of solids
contained in the mixture
What about an electronic signal? Is that patentable? An inventor filed a patent
application for a method of encoding additional information on electronic signals emitted
from digital audio files. The process was very useful, but the court ruled that it was not
patentable because the signal is not a mechanical, electrical, or chemical invention, a
process, a machine, or the composition of matter.1
A patent is not available solely for an idea, but only for its tangible application. Thus
patents are not available for laws of nature, scientific principles, mathematical algorithms,
mental processes, intellectual concepts, or formulas such as a2+ b2= c2.
Business Method Patents In recent years, so-called “business method patents”
have been controversial. These patents involve a particular way of doing business that often
includes data processing or mathematical calculations. Business method patents have been
particularly common in e-commerce. For example, Amazon.com patented its One-Click
method of instant ordering. The company then obtained an injunction to prevent barnes-
andnoble.com from using its Express Lane service that was similar to One-Click. The judge
directed barnesandnoble.com to add another step to its ordering process. The Patent and
Trademark Office (PTO) affirmed the Amazon patent, which will expire in 2017.
Facebook has been granted a patent on a process that “dynamically provides a news
feed about a user of a social network.” Most social media sites, such as LinkedIn, Twitter,
and Flickr, use some version of this technology. Two important issues are unknown: the
exact scope of the patent and how aggressive Facebook will be in enforcing it.
It would be very helpful if the courts provided more clarity—and certainty—about the
scope and enforceability of business method patents. In a recent case, Bilski v. Kappos,
the Supreme Court ruled that business methods are generally patentable, even as it held that
the particular patent in the case (a method for hedging risk in commodities trading) was too
abstract to be acceptable.2 In the same case, the Supreme Court encouraged lower courts to
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1In re Nuijten, 500 F.3d 1346; 2007 U.S. App. LEXIS 22426.
22010 U.S. LEXIS 5521 (S. Ct. 2010).
CHAPTER 33 Intellectual Property 807
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narrow the scope of business method patents, but did not offer guidance as to what these
limits should be. As a result, inventors continue to apply for business method patents while
waiting for lower courts to develop standards that meet the approval of the Supreme Court.
As a first step in this direction, a federal appeals court recently struck down a patent that
covered a process for verifying credit card information over the Internet. This process
determined which credit card numbers were linked with Internet Protocol (IP) or email
addresses that had a high incidence of fraud. The court ruled that the patent simply covered
a mental process and was, therefore, invalid.3
Congress also passed the America Invents Act (AIA). Under this statute, anyone who
has been charged with infringement of certain financial service business method patents has
the right (from 2012 to 2020) to challenge the validity of that patent.
Patents on Living Organisms In 1980, the Supreme Court ruled that living organisms
could be patented.4 That case involved genetically engineered bacteria that was used to treat
oil spills. The bacteria could be patented because it was (1) manufactured, (2) different from
anything found in nature, and (3) useful.
As a result of this ruling, the PTO began issuing patents on human genetic material
(although it issued a policy statement that it would not patent human beings). A total of
20 percent of all genes were patented, and the companies that owned these patents were
valued at billions of dollars. However, in 2013, the Supreme Court ruled that ordinary DNA
could not be patented, although synthesized (i.e., altered) DNA could be.5
DESIGN PATENT
A design patent protects the appearance, not the function, of a useful item. It is granted to
anyone who invents a new, original, and ornamental design for an article. For example,
Braun, Inc., patented the look of its handheld electric blenders. Design patents last 14 years
from the date of issuance, not 20 years from the date of filing.
PLANT PATENT
Anyone who creates a new type of plant can patent it, provided that the inventor is able to
reproduce it asexually—through grafting, for instance, rather than by planting its seeds. For
example, one company patented its unique heather plant.
33-2b Requirements for a Patent
To receive a patent, an invention must be:
• Novel. An invention is not patentable if it has already been (1) patented, (2)
described in a printed publication, (3) in public use, (4) for sale, or (5) otherwise
available to the public anywhere in the world. For example, an inventor discovered a
new use for existing chemical compounds but was not permitted to patent it because
the compounds had already been described in prior publications, though the new
uses had not.6 Note, however, that a disclosure does not count under this provision if
it was made by the inventor in the year prior to filing the application.
• Nonobvious. An invention is not patentable if it is obvious to a person with ordinary
skill in that particular area. An inventor was not allowed to patent a waterflush system
designed to remove cow manure from the floor of a barn because it was obvious.7
3CyberSource Corp. v. Retail Decisions, Inc., 654 F.3d 1366 (Fed. Cir. 2011).
4Diamond v. Chakrabarty, 447 U.S. 303 (S. Ct. 1980).
5Association for Molecular Pathology v. Myriad Genetics, 2013 U.S. Lexis 4540 (S. Ct. 2013).
6In re Schoenwald, 964 F.2d 1122, 1992 U.S. App. LEXIS 10181 (Fed. Cir. 1992).
7Sakraida v. Ag Pro, Inc., 425 U.S. 273, 96 S. Ct. 1532, 1976 U.S. LEXIS 146 (1976).
808 U N I T 4 Employment, Business Organizations and Property
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• Useful. To be patented, an invention must be useful. It need not necessarily be
commercially valuable, but it must have some current use. Being merely of scientific
interest is not enough. Thus, a company was denied a patent for a novel process for
making steroids because they had no therapeutic value.8
EXAM Strategy
Question: In 1572, during the reign of Queen Elizabeth I of England, a patent
application was filed for a knife with a bone handle rather than a wooden one. Would
this patent be granted under current U.S. law?
Strategy: Was a bone handle novel, nonobvious, and useful?
Result: It was useful—no splinters from a bone handle. It was novel—no one had
ever done it before. But the patent was denied because it was obvious.
33-2c Patent Application and Issuance
To obtain a patent, the inventor must file a complex application with the PTO. If a patent
examiner determines that the application meets all legal requirements, the PTO will issue
the patent. If an examiner denies a patent application for any reason, the inventor can
appeal that decision to the Patent Trial and Appeal Board in the PTO and from there to the
Court of Appeals for the Federal Circuit in Washington.9
During the patent application process, third parties have the right to submit evidence
that the invention is not novel. For the nine months after a patent has been granted, third
parties have a broad right to challenge its validity in the PTO (without having to go to
court). Thereafter, a patent may still be challenged, but the grounds are limited to evidence
of a prior patent or publication.
PRIORITY BETWEEN TWO INVENTORS
When two people invent the same product, who is entitled to a patent—the first to invent or
the first to file an application? Until 2013, the person who invented and put the invention
into practice had priority over the first filer. But the AIA changed the law so that, beginning
in 2013, the first person to file a patent application has priority. The AIA brought the United
States into conformity with most of the rest of the world.
PRIOR SALE
An inventor must apply for a patent within one year of selling the product commercially
anywhere in the world. The purpose of this rule is to encourage prompt disclosure of
inventions. It prevents someone from inventing a product, selling it for years, and then
obtaining a 20-year monopoly with a patent.
8Brenner v. Manson, 383 U.S. 519, 86 S. Ct. 1033, 1966 U.S. LEXIS 2907 (1966).
9Recall from Chapter 3 that the Court of Appeals for the Federal Circuit is the 13th United States
Court of Appeals. It hears appeals from specialized trial courts.
CHAPTER 33 Intellectual Property 809
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PROVISIONAL PATENT APPLICATION
Inventors who are unable to assess the market value of their ideas sometimes hesitate to file
a patent application because the process is expensive and cumbersome. A successful
application can cost tens of thousands of dollars because the PTO charges a separate fee
for each step of the process. Thus, for example, an inventor must pay a fee each time a
patent examiner raises a legitimate question that requires an amendment to the application.
Even if the examiner is wrong, the applicant may have to pay a fee even to file a
disagreement. Thus, an inventor may struggle to raise sufficient funds to pay for the patent
process. However, the AIA now permits the PTO to charge lower fees to individuals or
small entities.
In addition, the PTO permits inventors to make a simpler, shorter filing called a
provisional patent application (PPA). This application provides a provable date of filing.
Once filed, the application sits dormant for a year, giving the inventors an opportunity to
show their ideas to potential investors without incurring the full expense of a patent
application. PPA protection lasts only one year. To maintain protection after that time, the
inventor must file a nonprovisional patent application.
DURATION OF A PATENT
Patents are valid for 20 years from the date of filing the application (except design patents,
which are valid for 14 years from date of issuance). In the last 15 years, the number of patent
applications has increased from 950 a day to 2,000. And the typical patent application is
longer and more complicated. As a result, more than 1 million applications are now pending.
Approval of a patent can take anywhere from 3 to 6 years from the date of filing. These
delays mean that patent holders effectively receive much less than 20 years of protection
(although in the case of exceptional delays, it is possible to request an extension). They also
threaten the ability of American inventors to attract investors, monetize their inventions,
and compete with foreign businesses.
As permitted under the AIA, the PTO has set up a Track One system that permits
inventors to buy their way to the head of the line by paying an additional fee of $4,800 (for
large companies) and $2,400 (for small). Track One applications are supposed to be
decided within one year. Only 10,000 Track One applications will be accepted in any
given year.
INFRINGEMENT
A patent holder has the exclusive right to use the invention during the term of the patent.
A holder can prohibit others from using any product that is substantially the same, license
the product to others for a fee, and recover damages from anyone who uses the product
without permission.
PATENT TROLLS
As we have seen, the patent office must deal with a growing caseload. As a result, the
examiners typically spend less than 25 hours reviewing each application. Applicants are not
required to demonstrate that the invention is novel, and often the examiner neither knows
nor has the time to research the issue. Thus, patents are sometimes issued for inventions
that are not really new.
Traditionally, this issue was not that important because companies with overlapping
patents did not litigate who the real inventor was. They were too busy developing products
to sell. But then came patent trolls. They do not make or market products—they simply
buy portfolios of patents for the purpose of bringing patent infringement claims against
companies already using the technology. Typically, patent trolls request an injunction to
prevent the use of the technology during litigation, potentially harming a multimillion-dollar
product over a patent worth much less. Because the trolls are not using the technology
Provisional patent
application
A simpler, shorter filing that
provides protection for an
invention for one year.
Patent trolls
Someone who buys a portfolio
of patents for the purpose of
making patent infringement
claims.
810 U N I T 4 Employment, Business Organizations and Property
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themselves, they do not have to worry about a cross-injunction preventing them from using
it. Oftentimes, patent trolls are simply hoping that even legitimate users will pay them to go
away. In a recent report, the FTC found that these practices “can deter innovation by
raising costs and risks without making a technological contribution.”10 In response to
criticism, patent trolls argue that they are encouraging innovation by making patents more
valuable.
Some hedge funds have entered the patent troll business. In addition, a company
owned by Paul Allen, one of Microsoft’s founders, recently began filing suit against
companies that are using technology that his research lab allegedly invented prior to 2005.
These suits have been filed against most of the major players in Silicon Valley—Apple,
eBay, Facebook, Google, and Netflix—for their use of technology that improves users’
online experience. (Such as suggestions for related reading and pop-up ads or stock quotes.)
The technology at issue is key to these companies.
Ethics Is the patent troll business ethical? Under what circumstances would you
be willing to engage in this practice? Paul Allen is wealthy beyond most
people’s dreams. Why would he be involved in this litigation? What is your Life Principle in
this case?
INTERNATIONAL PATENT TREATIES
About half of all patent applications are filed in more than one country. This process used to
be a logistical nightmare because almost every country had its own unique filing procedures
and standards. Companies were reluctant to develop products based on technology that they
were not sure they actually owned. Several treaties now facilitate this process, although it is
still not the one-stop (or one-click) effort that inventors desire. These treaties were drafted
by the World Intellectual Property Organization (WIPO) of the United Nations.
The Paris Convention for the Protection of Industrial Property (Paris Convention)
requires each member country to grant to citizens of other member countries the same rights
under patent law as its own citizens enjoy. Thus, the patent office in each member country
must accept and recognize all patent and trademark applications filed with it by anyone who
lives in any member country. For example, the French patent office cannot refuse to accept
an application from an American, so long as the American has complied with French law.
Under this treaty, inventors who file in one country have up to one year to file elsewhere
and still maintain patent protection.
The Patent Law Treaty requires that countries use the same standards for the form and
content of patent applications (whether submitted on paper or electronically). This treaty
reduces the procedural conflicts over issues such as translations and fees.
The Patent Cooperation Treaty (PCT) is a step toward providing more coordinated
patent review across many countries. Inventors who pay a fee and file a so-called PCT
patent application are granted patent protection in the 143 PCT countries for up to
30 months. During this time, they can decide how many countries they actually want to
file in. (Inventors have one year of protection under the Paris Convention; this treaty grants
an additional 18 months.)
10U.S. Fed. Trade Comm’n, The Evolving IP Marketplace: Aligning Patent Notice and Remedies with
Competition (March 7, 2011).
CHAPTER 33 Intellectual Property 811
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Once a PCT application is filed, one of the major patent offices prepares an “interna-
tional search report” and issues a nonbinding opinion on whether the invention is patent-
able. This report, while nonbinding, helps applicants assess the patentability of their
inventions and provides persuasive evidence to national patent offices. Inventors who wish
to proceed internationally must then have the report translated and file it with applications
and fees in whichever countries they want a patent.
The United States PTO has bilateral agreements with 16 other patent offices under a
so-called Patent Prosecution Highway. Under this system, once a patent is approved by
one country, it goes to the head of the line for patent examination in the other country.
In addition to these treaties, any country that joins the World Trade Organization
(WTO) must agree to trade-related aspects of intellectual property rights (TRIPS). This
agreement does not create an international patent system, but it does require all participants
to meet minimum standards for the protection of intellectual property. How individual
countries achieve that goal is left to them.
Finally, the European Union is in the process of developing a single European patent
that would require only one application.
33-3 COPYRIGHTS
The holder of a copyright owns the particular tangible expression of an idea, but not the
underlying idea or method of operation. Abner Doubleday could have copyrighted a book
setting out his particular version of the rules of baseball, but he could not have copyrighted
the rules themselves, nor could he have required players to pay him a royalty. Similarly, the
inventor of double-entry bookkeeping could copyright a pamphlet explaining his system,
but not the system itself.
Unlike patents, the ideas underlying copyrighted material need not be novel. For
example, three movies—Like Father Like Son, Vice Versa, and Freaky Friday—are about a
parent and child who switch bodies. The movies all have the same plot, but there is no
copyright violation because their expressions of the basic idea are different.
The Copyright Act protects literature, music, drama, choreography, pictures, sculpture,
movies, recordings, architectural works, and computer databases, and computer programs
“to the extent that they incorporate authorship in the programmer’s expression of original
ideas, as distinguished from the ideas themselves.”
A work is copyrighted automatically once it is in tangible form. For example, once a
songwriter puts notes on paper, the work is copyrighted without further ado. But if
she whistles a happy tune without writing it down, the song is not copyrighted, and
anyone else can use it without permission. Registration with the Copyright Office of
the Library of Congress is necessary only if the holder wishes to bring suit to
enforce the copyright. Although authors still routinely place the copyright symbol (©)
on their works, such a precaution is not necessary in the United States. However, some
lawyers still recommend using the copyright symbol because other countries recognize
it. Also, the penalties for intentional copyright infringement are heavier than for
unintentional violations, and the presence of a copyright notice is evidence that the
infringer’s actions were intentional.
In the following case, you can imagine the author’s frustration when a celebrity stole her
thunder and her sales by writing a book on the very same topic. But did the celebrity violate
copyright law? This case also anticipates our discussion of trademarks.
812 U N I T 4 Employment, Business Organizations and Property
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33-3a Copyright Term
More than 300 years ago, on April 10, 1710, Queen Anne of England approved the first
copyright statute. Called the Statute of Anne, it provided copyright protection for 14 years,
which could be extended by another 14 years if the copyright owner was still alive when the
first term expired. Many credit the Statute of Anne with greatly expanding the burst of
intellectual activity that we now refer to as the Enlightenment.
American law adopted these same time limits, which stayed in effect until the twentieth
century. Since then, copyright holders have fought aggressively to lengthen the copyright
period. These efforts have been led by the Walt Disney Company, which wants to protect its
rights in Mickey Mouse. Today, a copyright is valid until 70 years after the death of the
work’s only or last living author, or, in the case of works owned by a corporation, the copyright
lasts 95 years from publication or 120 years from creation, whichever is shorter. Once a
copyright expires, anyone may use the material. Mark Twain died in 1910, so anyone may
now publish Tom Sawyer without permission and without paying a copyright fee.
33-3b Infringement
Anyone who uses copyrighted material without permission is violating the Copyright Act. To
prove a violation, the plaintiff must present evidence that the work was original and that either:
• The infringer actually copied the work, or
• The infringer had access to the original and the two works are substantially similar.
LAPINE V. SEINFELD
375 Fed. Appx. 81; 2010 U.S. App. LEXIS 8778
United States Court of Appeals for the Second Circuit, 2010
C A S E S U M M A R Y
Facts: Missy Chase Lapine wrote a book called The Sneaky
Chef: Simple Strategies for Hiding Healthy Foods in Kids’
Favorite Meals, which was about how to disguise vegetables
so that children would eat them. Her strategy was to add
pureed vegetables to food that children like, such as
macaroni and cheese. (We are not making this up.) Four
months later, Jessica Seinfeld, the wife of comedian Jerry
Seinfeld, published a book entitled Deceptively Delicious:
Simple Secrets to Get Your Kids Eating Good Food, which
featured recipes involving pureed vegetables in (guess
what?) macaroni and cheese and other kid-friendly foods.
Lapine filed suit against Seinfeld, alleging violation of
her copyright in The Sneaky Chef.
Issue: Did Seinfeld violate Lapine’s copyright in The
Sneaky Chef?
Decision: No, Seinfeld did not infringe on Lapine’s
copyright.
Reasoning: While it is true that the two books have a
similar subject matter, no one can copyright the idea of
secretly putting vegetable purees in children’s food. It is
a fundamental principle of our copyright doctrine that
ideas, concepts, and processes are not protected from
copying.
As for the expression of the ideas in Lapine’s work, it is
true that the two books take a vaguely similar approach,
including their titles, illustrations, health advice, recipes,
and language about children’s healthy eating. But any
book with this subject matter would be likely to do the
same. These features follow naturally from the work’s
theme rather than from the author’s creativity.
In any event, the total concept and feel of the two
books is different. Deceptively Delicious lacks an extensive
discussion of child behavior, food philosophy, and parent-
ing. Its recipes are simpler. And it uses brighter colors and
more photographs than The Sneaky Chef.
In short, Lapine cannot copyright the idea of the
book. And because the books look so different, it is clear
that Seinfeld has not stolen the expression of Lapine’s
idea.
CHAPTER 33 Intellectual Property 813
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A court may (1) prohibit the infringer from committing further violations, (2) order
destruction of the infringing material, and (3) require the infringer to pay damages, profits
earned, and attorney’s fees. Damages can be substantial. In a recent case, a jury ordered
SAP to pay Oracle $1.3 billion for copyright infringement of Oracle’s software.
33-3c First Sale Doctrine
Suppose you buy a CD that, in the end, you do not like. Under the first sale doctrine, you
have the legal right to sell that CD. The first sale doctrine permits a person who owns a
lawfully made copy of a copyrighted work to sell or otherwise dispose of the copy. Note,
however, that the first sale doctrine does not permit the owner to make a copy and sell it. If
you listen to a CD and then decide to sell it, that is legal. But it is not legal to copy the CD
onto your iPod and then sell the original or any copy of it.
33-3d Fair Use
Because the period of copyright protection is so long, it has become even more important to
uphold the exceptions to the law. Bear in mind that the point of copyright laws is to
encourage creative work. A writer who can control, and profit from, artistic work will be
inclined to produce more. If enforced oppressively, however, the copyright laws could stifle
creativity by denying access to copyrighted work. The fair use doctrine permits limited use
of copyrighted material without permission of the author for purposes such as criticism,
comment, news reporting, scholarship, or research. Courts generally do not permit a use that
will decrease revenues from the original work by, say, competing with it. A reviewer is
permitted, for example, to quote from a book without the author’s permission, but could not
reproduce so much that the review was competing with the book itself.
Fair use has become a highly controversial issue in this age of the Internet. For example,
Universal Music demanded that YouTube remove a home video of a toddler dancing to a
Prince song. A director making a documentary on torture was denied permission to use a short
clip showing torture on the TV show 24. Then J. K. Rowling, the author of the Harry Potter
series of books, sued to prevent the publication of the Harry Potter Lexicon, an unauthorized
reference guide to the books that contained direct quotations, paraphrases, and plot summa-
ries. The court ruled that although such a guide can be fair use, this one was not because the
author had copied too much of Rowling’s distinctive original language.11
Also under the fair use doctrine, faculty members are permitted to distribute copy-
righted materials to students, so long as the materials are brief and the teacher’s action is
spontaneous. If, over his breakfast coffee one morning, Professor Learned spots a terrific
article in Mad Magazine that perfectly illustrates a point he intends to make in class that day,
the fair use doctrine permits him to distribute it to his class. However, under a misinter-
pretation of the fair use doctrine, some faculty had been in the habit of routinely preparing
lengthy course packets of copyrighted material without permission of the authors. In Basic
Books, Inc. v. Kinkos Graphic Corp.,12 a federal court held that this practice violated the
copyright laws because the material was more than one short passage and because it was
sold to students. Now, when professors put together course packets, they (or the copy shop)
must obtain permission and pay a royalty for the use of copyrighted material. Likewise, it is
illegal for students to make photocopies of a classmate’s course packet or textbook.
11Warner Bros. Entertainment Inc. v. RDR Books, 575 F. Supp. 2d 513; 2008 U.S. Dist. LEXIS 67771
(S.D.N.Y., 2008).
12758 F. Supp. 1522, 1991 U.S. Dist. LEXIS 3804 (S.D.N.Y. 1991). A federal appeals court reached
the same result in Princeton University Press v. Michigan Document Services, Inc., 99 F.3d 1381, 1996 U.S.
App. LEXIS 29132 (6th Cir. 1996).
Fair use doctrine
Permits limited use of
copyrighted material without
permission of the author for
purposes such as criticism,
comment, news reporting,
scholarship, or research.
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PARODY
Parody has a long history in the United States—some of our most cherished songs have
been based on parodies. Before Francis Scott Key wrote the words to “The Star-Spangled
Banner,” other lyrics that mocked colonial governors had been set to the same music. (The
tune was well known as a drinking song.)
Because of the political and social commentary that is inherent in many parodies, courts
have long granted them special respect. In a case involving a 2 Live Crew parody of the
song “Pretty Woman,” the Supreme Court decided in favor of 2 Live Crew, holding that
parody is a fair use of copyrighted material so long as the
use of the original is not excessive.13 The parody may copy
enough to remind the audience of the original work, but
not so much that the parody harms the market for the
original.
The following email exchange between Richard
Saperstein, a movie producer, and Tom Strickler, a talent
agent, which zapped around Hollywood, illustrates the
importance of the 2 Live Crew case (to which Strickler
refers).
[From Saperstein to Strickler:]
Tom–
Please give me a call about a spec script Elia Infascelli-Smith has gone out with called $40,000
MAN. As you know, along with Universal, we control the rights to SIX MILLION DOLLAR
MAN. My understanding is this spec includes characters we own.
Best—Richard
[Strickler’s response:]
Richard:
Good news. As youmay know, The United States Supreme Court has affirmed the right of Parody as
an unassailable First Amendment Right. This has enabled you to make movies like Scream and Scary
Movie, in which you parody many films which Dimension does not own or control.
The script is a parody, and if you have any problems, I suggest you hire a Constitutional lawyer
and file a brief with the US Supreme Court. This will be an uphill battle—the court voted 9 to 0
when this last hit the docket and those stubborn justices all believe in Stare Decisis.
And if you succeed at the Supreme Court—you will have to stop making Scream and Scary Movie.
This will take about 5 to 7 years … and lawyers are an expensive breed, but I wish you good
luck on your journey to deny our First Amendment rights.
All the best,
Tom
33-3e Digital Music and Movies
One of the major challenges for legal institutions in regulating copyrights is simply that
modern intellectual property is so easy to copy. Many consumers are in the habit of violating
the law by downloading copyrighted material—music, movies, and books—for free. They
seem to believe that if it is easy to steal something, then the theft is somehow acceptable. In
one survey of adolescents aged 12 to 17, 75 percent agreed with the statement, “file-sharing
is so easy to do, it’s unrealistic to expect people not to do it.”14
I wish you good luck on
your journey to deny our
First Amendment rights.
13Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 114 S. Ct. 1164, 1994 U.S. LEXIS 2052 (1994).
14http://pewinternet.orgjReports/2009/9-The-State-of-Music-Online-Ten-Years-After-Napster/The-State-
of-Music-Online-Ten-Years-Afer-Napster.aspx?view=all#footnote25 or google “pew 10 years after napster.”
CHAPTER 33 Intellectual Property 815
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The entertainment world used to turn a blind eye, but illegal downloading is threaten-
ing the viability of recording companies, movie studios, and publishers. The statistics are
compelling: In 2008, 40 billion songs were downloaded illegally, which is as much as
95 percent of all downloaded music! In the first decade of this century, music sales at
American record labels declined by 58 percent. Without profitable record labels, who will
find and promote new stars? As we saw in the opening scenario, which is a true story, this
type of theft is having a profound effect on entertainment and publishing. But it is not just
“big companies” that suffer—it is also the artists, musicians, actors, and writers, most of
whom are not wealthy rock stars.
Government and industry are striking back. The Prioritizing Resources and Organization for
Intellectual Property Act (Pro-IP) permits law enforcement officials to confiscate any equipment
used to steal copyrighted material. In addition, the Recording Industry Association of America
(RIAA) developed a strategy of aggressively suing those who download music illegally. Then a
coalition of entertainment businesses sued two companies that distributed the software used by
many consumers to violate copyright law. So important was this issue that the Supreme Court
waded into these murky waters.
METRO-GOLDWYN-MAYER STUDIOS, INC.
V. GROKSTER, LTD.
545 U.S. 913, 2005 U.S. LEXIS 5212
Supreme Court of the United States, 2005
C A S E S U M M A R Y
Facts: Grokster, Ltd., and StreamCast Networks, Inc.,
distributed free software that allowed computer users to
share electronic files through peer-to-peer networks, so
called because users’ computers communicated directly
with each other, not through central servers. The Grokster
and Stream-Cast software could be used for legal purposes.
Indeed, peer-to-peer networks were utilized by universi-
ties, government agencies, corporations, libraries, and indi-
viduals, among others. Even the briefs in this very case
could be downloaded legally with the StreamCast software.
Nonetheless, nearly 90 percent of the files available
for download through Grokster or StreamCast were copy-
righted. Billions of files were shared each month—
the probable scope of copyright infringement was stag-
gering. The two companies even encouraged the illegal
uses of their software. For example, the chief technology
officer of StreamCast said that “the goal is to get in
trouble with the law and get sued. It’s the best way to
get in the news.”
A group of copyright holders (MGM and others) sued
Grokster and StreamCast alleging that they were violating
the copyright law by knowingly and intentionally distri-
buting their software to users who would reproduce and
distribute copyrighted works illegally. Both parties moved
for summary judgment. The trial court held for Grokster
and StreamCast; the appeals court affirmed. The Supreme
Court granted certiorari.
Issue: Were Grokster and StreamCast violating copyright law?
Decision: Yes, Grokster and StreamCast did violate
copyright law.
Reasoning: This case presents a trade-off between pro-
tecting artistic expression and inhibiting technological
innovation. It is important not to discourage the develop-
ment of technologies that could have both lawful and
unlawful potential. Accordingly, mere knowledge that a
product could be used to infringe copyrights is not enough
to create liability. But when users can use Grokster soft-
ware to copy songs or movies easily, they develop a disdain
for copyright protection. If a product is widely used to
commit infringement, copyright holders may not be able
to enforce their rights effectively unless they go against the
distributor of the copying device. To balance these com-
peting interests, we hold that distributors are liable only if
they deliberately encourage copyright violation.
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THE NO ELECTRONIC THEFT ACT
Enacted in 1997, the No Electronic Theft Act is intended to deter the downloading of
copyrighted material. It provides for criminal penalties for the reproduction or distribu-
tion of copyrighted material that has a retail value greater than $1,000, even if the
offender has no profit motive. Thus, for instance, if a student photocopied for 10 of her
friends a textbook that is worth $150, she could be subject to criminal penalties,
including a prison term of one year. Originally, the Justice Department did not enforce
this statute, but it has now begun to do so, particularly against those who set up
networks to trade games, movies, and music.
THE FAMILY ENTERTAINMENT AND COPYRIGHT ACT
Under the Family Entertainment and Copyright Act, it is a criminal offense to use
a camcorder to film a movie in the theater. This statute also establishes criminal penalties
for willful copyright infringement that involves distributing software, music, or film on
a computer network.
THE DIGITAL MILLENNIUM COPYRIGHT ACT
The good news is that Mary Schmich wrote an influential article in the Chicago Tribune.The bad
news is that people deleted her name, attributed the article to Kurt Vonnegut, and sent it around
the world via email. Tom Tomorrow’s cartoon was syndicated to 100 newspapers, but by the
time the last papers received it, the cartoon had already gone zapping around cyberspace.
Because his name had been deleted from the original, some editors thought he had plagiarized it.
In response to such incidents, Congress passed the Digital Millennium Copyright Act
(DMCA), which provides that:
• It is illegal to delete copyright information, such as the name of the author or the title
of the article. It is also illegal to distribute false copyright information. Thus, anyone
who emailed Schmich’s article without her name on it, or who claimed it was his own
work, would be violating the law.
• It is illegal to circumvent encryption or scrambling devices that protect copyrighted
works. For example, some software programs are designed so that they can only be
copied once. Anyone who overrides this protective device to make another copy is
violating the law. (The statute does permit purchasers of copyrighted software to make
one backup copy.) If you buy a Disney DVD that prevents you from fast-forwarding
through commercials, you are violating the DMCA if you figure out how to do it anyway.
• It is illegal to distribute tools and technologies used to circumvent encryption devices.
If you tell others how to fast-forward through the Disney commercials, you have
violated the statute.
Grokster distributed an electronic newsletter contain-
ing links to articles promoting its software’s ability to
access popular copyrighted music. Both Grokster and
StreamCast helped customers locate and play copyrighted
materials. Neither company attempted to develop filter-
ing tools or other mechanisms to reduce the illegal use of
their software. The amount of infringement was gigantic.
These companies made money by selling advertise-
ments that were sent to the screens of computers using
their software. The more the software was used, the more
ads they could send out and the greater their advertising
revenue became. The success of the defendant’s business
model hinged on high-volume use that infringed copy-
rights. The unlawful objective is unmistakable.
Anyone who distributes a product or software and
then promotes its use for the purpose of infringing copy-
rights is liable for the resulting acts of infringement by
third parties.
CHAPTER 33 Intellectual Property 817
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• Online service providers (OSPs) are not liable for posting copyrightedmaterial so long as
they are unaware that the material is illegal and they remove it promptly after receiving
notice that it violates copyright law. This type of provision is called a safe harbor.
EXAM Strategy
Question: Many of the videos posted on YouTube are copyrighted material,
including thousands of hours of shows owned by Viacom, such as The Colbert Report and
The Daily Show. Viacom sued YouTube for violating its copyrights. Among the evidence
Viacom presented was an email from one YouTube founder to another, saying, “…
please stop putting stolen videos on the site. We’re going to have a tough time
defending the fact that we’re not liable for the copyrighted material on the site because
we didn’t put it up when one of the co-founders is blatantly stealing content from other
sites and trying to get everyone to see it.”15 YouTube presented evidence that it had
responded within one day to Viacom’s “takedown notice.” Is YouTube liable?
Strategy: Viacom argued that YouTube was well aware that much of its content was
illegal. YouTube responded that it met the requirements of the safe harbor provision.
Result: The court found for YouTube. General awareness that many postings infringed
copyrights did not impose a duty for YouTube tomonitor its videos. Its only requirement
was to respond when notified of infringement. YouTube did just that in this case.16
33-3f International Copyright Treaties
The Berne Convention requires member countries to provide automatic copyright protec-
tion to any works created in another member country. The protection does not expire until
50 years after the death of the author.17 The WIPO Copyright Treaty and the WIPO
Performances and Phonograms Treaty add computer programs, movies, and music to the list
of copyrightable materials.
In 2004, Congress enacted a law that permits the president to appoint a copyright law enforce-
ment officer charged with the responsibility for stopping copyright infringement overseas. Also, for
the first time, Congress funded the National Intellectual Property Law Enforcement Coordination
Council, which was established to protect American intellectual property internationally.
33-4 TRADEMARKS
A trademark is any combination of words and symbols that a business uses to identify its products
or services and distinguish them from others. Trademarks are important to both consumers and
businesses. Consumers use trademarks to distinguish between competing products. People who
15Quoted in “Federal Judge Hands Google Victory in Viacom’s $1 Billion Suit Over YouTube
Content” by Michael Liedtke on Law.com, June 24, 2010.
16Viacom Int’l, Inc. v. YouTube, Inc., 718 F. Supp. 2d 514 (S.D.N.Y., 2010).
17Under U.S. law, copyrights last 70 years. The United States must grant works created in other
signatory countries a copyright that lasts either 50 years or the length of time granted in that country,
whichever is longer, but in no case longer than 70 years.
Trademark
Any combination of words and
symbols that a business uses to
identify its products or services
and distinguish them from
others.
818 U N I T 4 Employment, Business Organizations and Property
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feel that Nike shoes fit their feet best can rely on the Nike trademark to know they are buying
the shoe they want. A business with a high-quality product can use a trademark to develop a loyal
base of customers who are able to distinguish its product from another.
33-4a Types of Marks
There are four different types of marks:
• Trademarks are affixed to goods in interstate commerce.
• Service marks are used to identify services, not products. Fitness First, Burger King,
and Weight Watchers are service marks. In this chapter, the terms “trademark” and
“mark” are used to refer to both trademarks and service marks.
• Certification marks are words or symbols used by a person or organization to attest
that products and services produced by others meet certain standards. The Good
Housekeeping Seal of Approval means that the Good Housekeeping organization has
determined that a product meets its standards.
• Collective marks are used to identify members of an organization. The Lions Club, the
Girl Scouts of America, and the Masons are examples of collective marks.
33-4b Ownership and Registration
Under common law, the first person to use a mark in trade owns it. Registration with the
federal government is not necessary. However, under the federal Lanham Act, the owner of
a mark may register it on the Lanham Act Principal Register. A trademark owner may use
the symbol ™ at any time, even before registering it, but not until the mark is registered
can the symbol ® be placed next to it. Registration has several advantages:
• Even if a mark has been used in only one or two states, registration makes it valid
nationally.
• Registration notifies the public that a mark is in use because anyone who applies for
registration first searches the Public Register to ensure that no one else has rights to
the mark.
• Five years after registration, a mark becomes virtually incontestable because most
challenges are barred.
• The damages available under the Lanham Act are higher than under
common law.
• The holder of a registered trademark generally has the right to use it as an Internet
domain name.
Under the Lanham Act, the owner files an application with the PTO. The PTO will
accept an application only if the owner has already used the mark attached to a product in
interstate commerce or promises to use the mark within six months after the filing. In
addition, the applicant must be the first to use the mark in interstate commerce. Initially, the
trademark is valid for 10 years, but the owner can renew it for an unlimited number of
10-year terms as long as the mark is still in use.
33-4c Valid Trademarks
Words (Reebok), symbols (Microsoft’s flying window logo), phrases (Nike’s “Just do it”),
shapes (Apple’s iPod), sounds (NBC’s three chimes), colors (Owens Corning’s pink insula-
tion), and even scents (plumeria blossoms on sewing thread) can be trademarked. To be
CHAPTER 33 Intellectual Property 819
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valid, a trademark must be distinctive—that is, the mark must clearly distinguish one
product from another. There are five basic categories of distinctive marks:
• Fanciful marks are made-up words such as Kodak or Saucony.
• Arbitrary marks use existing words that do not describe the product—Prince tennis
racquets, for example. No one really thinks that these racquets are designed by or for
royalty.
• Suggestive marks indirectly describe the product’s function. “Greyhound” implies that
the bus line is swift, and “Coppertone” suggests what customers will look like after
applying the product.
• Marks with secondary meaning cannot, by themselves, be trademarked unless they
have been used for so long that they are now associated with the product in the
public’s mind. When a film company released a movie called Ape, it used as an
illustration a picture that looked like a scene from King Kong—a gigantic gorilla astride
the World Trade Center in New York City. The court held that the movie posters of
King Kong had acquired a secondary meaning in the mind of the public, so the Ape
producers were forced to change their poster.18
• Trade dress is the image and overall appearance of a business or product. It may
include size, shape, color, or texture. The Supreme Court held that a Mexican
restaurant was entitled to protection under the Lanham Act for the shape and general
appearance of the exterior of its building as well as the decor, menu, servers’
uniforms, and other features reflecting the total image of the restaurant.19
The following categories cannot be trademarked:
• Similar to an existing mark. To avoid confusion, the PTO will not grant a trademark
that is similar to one already in existence on a similar product. Once the PTO had
granted a trademark for “Pledge” furniture polish, it refused to trademark “Promise”
for the same product. “Chat noir” and “black cat” were also too similar because one is
simply a translation of the other. Houghton-Mifflin Co. successfully sued to prevent a
punk rock band from calling itself Furious George because the name is too similar to
Curious George, the star of a series of children’s books.
• Generic trademarks. No one is permitted to trademark an item’s ordinary name—
“shoe” or “book,” for example. Sometimes, however, a word begins as a trademark
and later becomes a generic name. Zipper, escalator, aspirin, linoleum, thermos, yoyo,
band-aid, ping-pong, and nylon all started out as trademarks but became generic.
Once a name is generic, the owner loses the trademark because the name can no
longer be used to distinguish one product from another—all products are called the
same thing. That is why Xerox Corp. encourages people to say, “I’ll photocopy this
document,” rather than “I’ll xerox it.” Jeep, Rollerblade, and TiVo are names that
began as trademarks and may now be generic. What about “app store”? Microsoft has
sued Apple, disputing its right to trademark this term. Meanwhile, Facebook has
trademarked, “face,” “book,” “like,” “wall,” and “poke.” The goal is not to prevent
consumers from using these terms but rather to warn off other companies.
• Descriptive marks. Words cannot be trademarked if they simply describe the
product—such as “low-fat,” “green,” or “crunchy.” Descriptive words can, however,
be trademarked if they do not describe that particular product because they then
18Paramount Pictures Corp. v. Worldwide Entertainment Corp., 2 Media L. Rep. 1311, 195 U.S.P.Q.
(BNA) 539, 1977 U.S. Dist. LEXIS 17931 (S.D.N.Y., 1977).
19Two Pesos, Inc. v. Taco Cabana, Inc., 505 U.S. 763, 112 S. Ct. 2753, 1992 U.S. LEXIS 4533 (1992).
820 U N I T 4 Employment, Business Organizations and Property
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become distinctive rather than descriptive. “Blue Diamond” is an acceptable trademark
for nuts so long as the nuts are neither blue nor diamond-shaped.
• Names. The PTO generally will not grant a trademark in a surname because other
people are already using it and have the right to continue. No one could register
“Jefferson” as a trademark. However, a surname can be used as part of a longer
title—“Jefferson Home Tours,” for instance. Similarly, no one can register a
geographical name such as “Boston” unless it is also associated with another word,
such as “Boston Ale.”
• Deceptive marks. The PTO will not register a mark that is deceptive. It refused to
register a trademark with the words “National Collection and Credit Control” and an
eagle superimposed on a map of the United States because this trademark gave the
false impression that the organization was an official government agency.
• Scandalous or immoral trademarks. The PTO refused to register a mark that featured
a nude man and woman embracing. In upholding the PTO’s decision, the court was
unsympathetic to arguments that this was the perfect trademark for a newsletter on
sex.20 This author once had a client who wanted to apply for a trademark for
marijuana: “Sweet Mary Jane, she never lets you down.” However, the client was
unwilling to admit to affixing the name to his product and shipping it in interstate
commerce. Now, medical marijuana is legal in 18 states but the PTO refuses to
register marijuana trademarks.
33-4d Infringement
To win an infringement suit, the trademark owner must show that the defendant’s trade-
mark is likely to deceive customers about who has made the goods or provided the services.
In the Seinfeld case, the court ruled there was no trademark infringement because consumers
would not be confused by the names or covers of the two books.
In the event of infringement, the rightful owner is entitled to (1) an injunction
prohibiting further violations, (2) destruction of the infringing material, (3) up to three
times actual damages, (4) any profits the infringer earned on the product, and (5)
attorney’s fees.
What about a perfume for dogs? Would a reasonable consumer confuse Pucci with
Gucci, Bono Sports with Ralph Lauren Polo Sports, or Miss Claybone for Liz Claiborne?
None of these companies challenged the parody use of their names for a dog perfume. But
Tommy Hilfiger Licensing, Inc. did not see the humor in the name Timmy Holedigger.
The court, however, advised Hilfiger “to chill,” pointing out that there was no evidence of
actual confusion.21On the other hand, auction website eBay did prevent a seller of perfumes
from using the name Perfumebay. The court ruled that the use of “ebay” confused
consumers.22
The following case raises an issue of confusion in cyberspace. Once again, the Internet
is challenging intellectual property laws that were not conceived with this technology in
mind.
20In re McGinley, 660 F.2d 481, 211 U.S.P.Q. (BNA) 668, 1981 CCPA LEXIS 177 (C.C.P.A., 1981).
21Tommy Hilfiger Licensing, Inc. v. Nature Labs, LLC, 221 F. Supp. 2d 410; 2002 U.S. Dist. LEXIS
14841 (2002).
22Perfumebay.com Inc. v. eBay Inc., 506 F.3d 1165, 2007 U.S. App. LEXIS 25726.
CHAPTER 33 Intellectual Property 821
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You Be the Judge
Facts: Network Automa-
tion and Advanced Sys-
tems Concepts both sold
job scheduling and man-
agement software, and
both advertised on the
Internet. Network sold its
software under the trade-
marked name AutoMate,
while Systems used the
trademark ActiveBatch. Customers paid between $995
and $10,995 to use these software programs.
Google AdWords is a program that sells “keywords,”
which are search terms that trigger the display of a sponsor’s
advertisement. When a user enters a keyword, Google
displays the links generated by its own algorithm in the
main part of the page, along with advertisements in a
separate “Sponsored Links” section next to or above
the objective results. Multiple advertisers can pur-
chase the same keyword.
Although ActiveBatch was Systems’s trademark, Net-
work purchased it as a keyword. This purchase meant that
anyone who googled “ActiveBatch” would see a web page
where the top results were links to Systems’ own website
and various articles about the product. But in the “Spon-
sored Sites” section of the page, users would see the
following ad:
Job Scheduler
Windows Job Scheduling +MuchMore. Easy to Deploy,
Scalable. D/L Trial www.NetworkAutomation.com
Sometimes, they would also see an equivalent ad for
Systems’ software—the real ActiveBatch.
Systems alleged that this use of ActiveBatch was a
violation of its trademark on the word. The trial court
issued an injunction prohibiting Network’s purchase of
the Google keyword. Network appealed.
You Be the Judge: Has Network violated Systems’s trade-
mark by purchasing it as a Google keyword?
Argument for Systems: Network and Systems are direct
competitors. Their two products—AutoMate and
ActiveBatch—perform the same functions and are both
advertised on the Internet. Network is deliberately confus-
ing customers about whose product ActiveBatch really is.
When consumers use
the Internet, they tend
not to read carefully—
they just click away. Few
customers analyze the
web address of an ad to
make sure they are going
to the right website.
Indeed, customers may
not even be aware of
who owns ActiveBatch. The Network ad certainly does
not reveal that Systems owns this software. Customers
could easily assume that whatever web address comes
up belongs to the rightful owner.
When customers search for a generic term, they know
that they will encounter links from a variety of sources,
but when they look for a trade name, their expectation is
that they will only be linked to that specific product. For
this reason, the use of another company’s trade name can
create tremendous confusion.
Network has bought the right to use Systems’s trade-
mark as a ruse to fool potential customers. This subter-
fuge is exactly the sort of behavior that trademark laws are
designed to prevent.
Argument for Network: Today, most consumers are
sophisticated about the Internet. They skip from site
to site, ready to hit the Back button whenever they
are not satisfied with a site’s contents. They fully expect to
find somesites that arenotwhat they imaginebasedonaglance
at the domain name or search engine summary. Consumers do
not form any firm expectations about the sponsorship of a
website until they have seen the landing page—if then.
Even if Systems’s arguments were true for consumer
purchases, the typical customer for this software is a
sophisticated businessperson buying an expensive pro-
duct. These purchasers are likely to be very careful and
will not be confused by Google ads. Also, they will prob-
ably understand the mechanics of Internet search engines
and the nature of sponsored links.
In the end, Network’s intent was not to confuse
consumers but rather to allow them to compare its product
to ActiveBatch. That goal is a completely appropriate use
of a trademark.
NETWORK AUTOMATION, INC.
V. ADVANCED SYSTEMS
CONCEPTS, INC.
2011 U.S. App. LEXIS 4488
United States Court of Appeals for the
Ninth Circuit, 2011
822 U N I T 4 Employment, Business Organizations and Property
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33-4e Federal Trademark Dilution Act of 1995
Before Congress passed the Federal Trademark Dilution Act of 1995 (FTDA), a trademark
owner could win an infringement lawsuit only by proving that consumers would be
deceived about who had really made the product. This statute prevents others from using
a trademark in a way that (1) dilutes its value, even though consumers are not confused
about the origin of the product; or (2) tarnishes it by association with unwholesome goods
or services. For example, Barbie’s Playhouse was an adult entertainment website with a font
and colors similar to those used by Mattel for its copyrighted Barbie doll. Also, the doll at
the bottom of the website looked like a Barbie doll. The court found that Barbie’s Play-
house had violated the FTDA.23
33-4f Domain Names
Over 130 million Internet addresses, known as domain names, are currently active, so it is
often difficult to find a distinctive name for a new business. Domain names can be
immensely valuable as they are an important component of doing business. Suppose you
want to buy a new pair of jeans. Without thinking twice, you type in http://www.jcrew.com
and there you are, ready to order. What if that address took you to a different site altogether,
say, the personal site of one Jackie Crew? The store might lose out on a sale. Companies not
only want to own their own domain name, they want to prevent complaint sites such as
http://www.untied.com (about United Airlines), http://www.ihatestarbucks.com, or the
always popular variation on the “sucks” theme, such as http://macdonaldssucks.com. Generic
domain names can be valuable, too. Shopping.com paid $750,000 to acquire its domain name
from the previous (lucky) owner.
CYBERSQUATTING
Who has the right to a domain name? In the beginning, the National Science Foundation,
which maintained the Internet, granted Network Solutions, Inc. (NSI), a private company,
the right to allocate domain names. NSI charged no fee for domain names and the rule was
“first come, first served.” Then so-called cybersquatters began to register domain names,
not to use, but to sell to others. Someone, for example, tried to sell the name “Bill Gates”
for $1 million.
In response to complaints, NSI began suspending any domain name that was chal-
lenged by the holder of a registered trademark. For instance, NSI would not allow Princeton
Review to keep kaplan.com, which Princeton had acquired simply to inconvenience its arch
rival in the test preparation business. Congress then passed the Anticybersquatting Con-
sumer Protection Act (ACPA), which permits both trademark owners and famous people to
sue anyone who registers their name as a domain name in “bad faith.” The rightful owner of
a trademark is entitled to damages of up to $100,000. Verizon was awarded damages of
$33.15 million against OnlineNIC Inc., which had registered 663 domain names that were
confusingly similar to Verizon trademarks.
ICANN
As both the value and the number of domain names soared, the U.S. government transferred
management of the Internet, including the allocation of names, to a private, nonprofit, inter-
national organization, the Internet Corporation for Assigned Names and Numbers (ICANN).
Disputes over domain names can be decided by arbitration under ICANN’s Uniform Domain
Name Dispute Resolution Policy (UDRP) rather than by litigation under the ACPA. For
example, Jay Leno used the ICANN process to win a cybersquatting case against someone
who was using thejaylenoshow.com to attract viewers to his own real estate website.
23Mattel, Inc. v. Jcom, Inc., 1998 U.S. Dist. LEXIS 16195.
CHAPTER 33 Intellectual Property 823
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To bring a UDRP case, the complainant (i.e., the plaintiff) must allege that:
• The domain name creates confusion because it is similar to a registered trademark.
• The respondent (i.e., the defendant) has no legitimate reason to use the domain
name.
• The respondent registered the domain name in bad faith. If the respondent is a
competitor of the complainant and has acquired the domain name to disrupt the
complainant’s business (à la Princeton Review), that is evidence of bad faith. So is an
attempt by the respondent to sell the name to the complainant.
If the complainant wins, it is entitled either to take over the domain name or to cancel it.
For example, in a dispute over wal-martsucks.com, the WIPO arbitrator ordered that the name
be transferred to Walmart. The respondent had demonstrated his bad faith by attempting to
sell the name for $530,000. In a similar case, however, the WIPO arbitrator found for a
respondent who had registered Wallmartcanadasucks.com. In this case, the respondent had
not tried to sell the name and was using the website to criticize Walmart. As the arbitrator
stated in his opinion, “Posting defamatory material on a website would not justify revocation
of a domain name. The Policy should not be used to shut down robust debate and criticism.”
Either party has the option before or after an ICANN arbitration to litigate the issue in court.
At this writing, the courts have also held that criticism sites do not violate the ACPA so
long as they do not have a bad faith intent to make a profit. The sites do not violate
trademark law unless they create consumer confusion.24
THEFT OF DOMAIN NAME
In this crowded world, few people are the first to do anything. David Goncalves
achieved this distinction in an unfortunate way—he became the first person in the
United States to be convicted of stealing a domain name. After hacking into the files of
a domain name registrar, he transferred to himself ownership of P2P.com. He then sold
this name for $111,211 to professional basketball player Mark Madsen, who was running
a business that bought and sold domain names. P2P could be a valuable name for
someone who wanted to operate a peer-to-peer network. Goncalves was convicted
under a state fraud statute as well as the Computer Fraud and Abuse Act (which we
discussed in Chapter 32, on cyberlaw).
TRADEMARKING A DOMAIN NAME
Our discussion thus far has been about registering a trademark as a domain name. Some-
times businesses want to do the opposite—trademark a domain name. The PTO will issue
such a trademark only for services offered via the Internet. Thus, it trademarked “eBay” for
“on-line trading services in which seller posts items to be auctioned and bidding is done
electronically.” The PTO will not trademark a domain name that is merely an address and
does not identify the service provided.
33-4g International Trademark Treaties
Under the Paris Convention, if someone registers a trademark in one country, then he has
a grace period of six months, during which he can file in any other country using the same
original filing date. Under the Madrid Agreement, any trademark registered with the
international registry is valid in all signatory countries. (The United States is a signatory.)
24See, for example, Career Agents Network, Inc. v. careeragentsnetwork.biz, 2010 U.S. Dist. LEXIS 17263
(E.D.MI, 2010).
824 U N I T 4 Employment, Business Organizations and Property
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The Trademark Law Treaty simplifies and harmonizes the process of applying for trademarks
around the world. Now, a U.S. firm seeking international trademark protection need only file
one application, in English, with the PTO, which sends the application to the WIPO, which
transmits it to each country in which the applicant would like trademark protection.
EXAM Strategy
Question: Jerry Falwell was a nationally known Baptist minister. You can read
about him on falwell.com. You can also read about him at fallwell.com—a site
critical of his views on homosexuality. This site has a disclaimer indicating that it
is not affiliated with Reverend Falwell. The minister sued fallwell.com, alleging a
violation of trademark law and the anticybersquatting statute. Was there a violation?
Strategy: To win a trademark claim, the reverend had to show that there was some
confusion between the two sites. To win the cybersquatting claim, he had to show
bad faith on the part of fallwell.com.
Result: The reverend lost on both counts. The court ruled that there was no
confusion—fallwell.com had a clear disclaimer. Also, there was no indication of bad
faith. The court was reluctant to censor political commentary.
33-5 TRADE SECRETS
What do the formulas for Coke and motor oil have in common with computer circuitry, a
machine for making adhesive tape, and a procedure for applying hair dye? They are all trade
secrets. A trade secret is a formula, device, process, method, or compilation of information
that, when used in business, gives the owner an advantage over competitors who do not
know it. In determining if information is a trade secret, courts consider:
• How difficult (and expensive) was the information to obtain? Was it readily available
from other sources?
• Does the information create an important competitive advantage?
• Did the company make a reasonable effort to protect it?
It has been estimated that the theft of trade secrets costs U.S. businesses $100 billion a
year. In response, most states have now adopted the Uniform Trade Secrets Act (UTSA).
Anyone who misappropriates a trade secret is liable to the owner for (1) actual damages,
(2) unjust enrichment, or (3) a reasonable royalty. If the misappropriation was willful or
malicious, the court may award attorney’s fees and double damages. A jury awarded Avery
Dennison Corp. $40 million in damages from a competitor that had misappropriated secret
information about the adhesives used in self-stick stamps.
Although a company can patent some types of trade secrets, it may be reluctant to do so
because patent registration requires that the formula be disclosed publicly. In addition,
patent protection expires after 20 years. Some types of trade secrets cannot be patented—
such as customer lists, business plans, and marketing strategies.
The following case deals with a typical issue: How much information can employees
take with them when they start their own, competing business?
Trade secret
A formula, device, process,
method, or compilation of
information that, when used in
business, gives the owner an
advantage over competitors.
CHAPTER 33 Intellectual Property 825
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Only civil penalties are available under the Uniform Trade Secrets Act. To safe-
guard national security and maintain the nation’s industrial and economic edge, Con-
gress passed the Economic Espionage Act of 1996, which makes it a criminal offense to
steal (or attempt to steal) trade secrets for the benefit of someone other than the owner,
including for the benefit of any foreign government. Xiaodong Sheldon Meng was
convicted of violating this statute after he was caught stealing computer code used in
military weapons. He had committed the theft on behalf of the government of China.
Meng was sentenced to 24 months in prison. Timothy Kissane received the same
sentence for stealing computer source code from an employer. He planned to sell it
to the company’s competitors.
POLLACK V. SKINSMART DERMATOLOGY
AND AESTHETIC CENTER P.C.
2004 Pa. Dist. & Cnty. Dec. LEXIS 214
Common Pleas Court of Philadelphia County, Pennsylvania, 2004
C A S E S U M M A R Y
Facts: Dr. Andrew Pollack owned the Philadelphia Insti-
tute of Dermatology (PID), a dermatology practice. Drs.
Toby Shawe and Samy Badawy worked for PID as inde-
pendent contractors, receiving a certain percentage of the
revenues from each patient they treated. Natalie Wilson
was Dr. Pollack’s medical assistant.
Pollack tentatively agreed to sell the practice to
Shawe and Badawy. But instead of buying his practice,
the two doctors decided to start their own, which they
called Skinsmart. They executed a lease for the Skinsmart
office space, offered Wilson a job, and instructed PID staff
members to make copies of their appointment books and
printouts of the patient list. Then they abruptly resigned
from PID. Wilson called PID patients to reschedule pro-
cedures at Skinsmart. The two doctors also called patients
and sent out a mailing to patients and referring physicians
to tell them about Skinsmart.
Pollack filed suit, alleging that the two doctors had
misappropriated trade secrets.
Issue: Did Shawe and Badawy misappropriate trade secrets
from PID?
Decision: Yes, the two doctors did misappropriate trade
secrets.
Reasoning: The right to protect trade secrets must be
balanced against the right of individuals to pursue what-
ever occupation they choose. For this reason, secrets will
only be protected if they are the particular information of
the employer, not general secrets of the trade. Pollack
must also demonstrate that the trade secrets had value
and importance to his business and that he either discov-
ered or owned the secrets.
Against this backdrop, it is clear the patient list is a
trade secret, worthy of protection. Patient information is
confidential and is not known to anyone outside the
practice. Pollack relied upon the patient list as the core
component of his practice. For this reason, it is valuable.
He made substantial effort to compile the list over a
number of years. It contained 20,000 names with related
information. He spent money on computers, software, and
employees to keep and maintain the list.
He also sought to protect the secrecy of the
information. Within PID’s offices, the information was
not universally known or accessible. Not every staff
member, including the practicing physicians, could
pull the records. Wilson did not have access to them, and
the doctors relied on other PID employees to access the
patient list.
826 U N I T 4 Employment, Business Organizations and Property
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Chapter Conclusion
Intellectual property takes many different forms. It can be an Internet domain name, a
software program, a cartoon character, a formula for motor oil, or a process for making drugs.
Because of its great variety, intellectual property can be difficult to protect. Yet,
for many individuals and companies, intellectual property is the most valuable asset
they will ever own. As its economic value increases, so does the need to understand
the rules of intellectual property law.
EXAM REVIEW
Patent Copyright Trademark
Trade
Secrets
Protects: Mechanical,
electrical,
chemical
inventions;
processes;
machines;
composition
of matter;
designs;
plants
The tangible
expression of
an idea, but
not the idea
itself
Words and
symbols that a
business uses
to identify its
products or
services
A formula,
device,
process,
method, or
compilation of
information
that, when
used in
business,
gives the
owner an
advantage
over
competitors
who do not
know it
Requirements
for Legal
Protection:
Application
approved by
PTO
An item is
automatically
copyrighted
once it is in
tangible form
Use is the only
requirement;
registration is
not necessary
but does offer
some benefits
Must be kept
confidential
Duration: 20 years
after the
application is
filed (14
years from
date of
issuance for
a design
patent)
70 years after
the death of
the work’s only
or last living
author or, for
a corporation,
95 years from
publication or
120 years from
creation
Valid for
10 years but the
owner can
renew for an
unlimited
number of
terms as long
as the mark is
still being used
As long as it is
kept
confidential
CHAPTER 33 Intellectual Property 827
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MULTIPLE-CHOICE QUESTIONS
1. Thomas’s English muffins wanted to protect the method by which it makes muffins
with air pockets—what it calls “nooks and crannies.” What would be the best way to
achieve this goal?
(a) Patent
(b) Copyright
(c) Trademark
(d) Trade secret
(e) This method cannot be protected.
2. VitaminWater has become such a success that other companies are also now selling
similar (but not identical) flavored colored water. Some competitors bottle their drinks in
a similar bell-shaped bottle with a two-toned label that has a horizontal color band. What
is the best infringement claim for VitaminWater to make against these competitors?
(a) Patent
(b) Copyright
(c) Trademark
(d) Trade secret
(e) There is no good claim.
3. Faber-Castell began manufacturing pencils in 1761. Although pencils and erasers had
both existed for some time, the company did not begin putting erasers on the ends of
its pencils until the 1870s. The company was sued by an inventor who had previously
patented this idea. The case went to the Supreme Court. Who won the case?
(a) The patent holder, because no one had ever put an eraser on a pencil before.
(b) The patent holder, because the PTO had approved his patent.
(c) Faber-Castell, because the pencil with an eraser was not novel.
(d) Faber-Castell, because the pencil with an eraser was not useful.
4. If you buy a DVD, you have the legal right to:
(a) watch it as many times as you want and then give it away.
(b) copy it to your computer and then give it to a friend.
(c) copy it to your computer and sell it on eBay.
(d) all of the above.
(e) (a) and (b) only.
5. A couple thought of a clever name for an automobile. They wanted to protect this
name so that they could ultimately sell it to a car manufacturer. What would be the
best method to achieve this goal?
(a) Patent
(b) Copyright
(c) Trademark
(d) Trade secret
(e) This name cannot be protected.
828 U N I T 4 Employment, Business Organizations and Property
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ESSAY QUESTIONS
1. In the documentary movie Expelled: No Intelligence Allowed, there was a 15-second clip
of “Imagine,” a song by John Lennon. The purpose of the scene was to criticize the
song’s message. His wife and sons, who held the copyright, sued to block this use of
the song. Under what theory did the movie makers argue that they had the right to
use this music? Did they win?
2. ETHICS After Edward Miller left his job as a salesperson at the New England
Insurance Agency, Inc., he took some of his New England customers to his new
employer. At New England, the customer lists had been kept in file cabinets.
Although the company did not restrict access to these files, it claimed there was a
“You do not peruse my files and I do not peruse yours” understanding. The lists were
not marked “confidential” or “not to be disclosed.” Did Miller steal New England’s
trade secrets? Whether or not he violated the law, was it ethical for him to use this
information at his new job? What is your Life Principle?
3. Rebecca Reyher wrote (and copyrighted) a children’s book entitled My Mother Is the
Most Beautiful Woman in the World. The story was based on a Russian folk tale told to
her by her own mother. Years later, the children’s TV show Sesame Street televised a
skit entitled “The Most Beautiful Woman in the World.” The Sesame Street version
took place in a different locale and had fewer frills, but the sequence of events in both
stories was identical. Has Sesame Street infringed Reyher’s copyright?
4. Roger Schlafly applied for a patent for two prime numbers. (A prime number cannot be
evenly divided by any number other than itself and 1. Examples of primes are 2, 3, 5, 7, 11,
and 13.) Schlafly’s numbers are a bit longer—one is 150 digits, the other is 300. His
numbers, when used together, can help perform the type of mathematical operation
necessary for exchanging codedmessages by computer. Should the PTO issue this patent?
5. Frank B. McMahon wrote one of the first psychology textbooks to feature a light,
easily readable style. He also included many colloquialisms and examples that
appealed to a youthful student market. Charles G. Morris wrote a psychology
textbook that copied McMahon’s style. Has Morris infringed McMahon’s copyright?
6. Victoria’s Secret, a well-known lingerie company, found out that a man named
Victor Moseley was running a small store in Kentucky named “Victor’s Little
Secret.” Moseley’s shop sold clocks, patches, temporary tattoos, stuffed animals,
coffee mugs, leather biker wallets, Zippo lighters, diet formula, jigsaw puzzles,
handcuffs, hosiery, greeting cards, incense burners, car air fresheners, sunglasses,
jewelry, candles, and adult novelties. Women’s lingerie represented about 5 percent of
its sales. Does Victoria’s Secret have a valid intellectual property claim?
7. Question: DatagraphiX manufactured and sold computer graphics equipment
that allowed users to transfer large volumes of information directly from computers
to microfilm. Customers were required to keep maintenance documentation on
site for the DatagraphiX service personnel. The service manual carried this
legend: “No other use, direct or indirect, of this document or of any information
derived there from is authorized. No copies of any part of this document shall be
E
X
A
M
S
tr
a
te
g
y
CHAPTER 33 Intellectual Property 829
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made without written approval by DatagraphiX.” In addition, on every page of the
maintenance manual, the company placed warnings that the information was
proprietary and not to be duplicated. Frederick J. Lennen left DatagraphiX to
start his own company that serviced DatagraphiX equipment. Can DatagraphiX
prevent Lennen from using its manuals?
Strategy: With trade secrets, the key is that the owner has made a reasonable
effort to protect them. (See the “Result” at the end of this section.)
8. Question: “Hey, Paula,” a pop hit that spent months on the music charts, was
back on the radio 30 years later, but in a form the song’s author never intended.
Talk-show host Rush Limbaugh played a version with the same music as the
original but with lyrics that made fun of President Bill Clinton’s alleged sexual
misconduct with Paula Jones. Has Limbaugh violated the author’s copyright?
Strategy: Although this example may look like a copyright violation, it falls under
an exception. (See the “Result” at the end of this section.)
9. Question: Research Corp. applied for a patent for a so-called halftoning
technique that uses a mathematical formula to enable monitors and printers with
limited color options to simulate a wider range of colors. Is this technique
patentable?
Strategy: Are these inventors attempting to patent a mathematical algorithm or
formula? (See the “Result” at the end of this section.)
E
X
A
M
S
tr
a
te
g
y
E
X
A
M
S
tr
a
te
g
y
7. Result: The court held that these manuals were DatagraphiX’s trade secrets.
8. Result: Parody (especially about politics!) is a fair use of copyrighted material so long as
use of the original is not excessive.
9. Result: The trial court ruled that this patent application was invalid because it was too
abstract. But the appellate court overruled, holding that, although the patent used mathe-
matical algorithms, the inventors were patenting the process not the algorithms. It upheld
the patent.25
25Research Corporation Technologies, Inc. v. Microsoft Corporation, 627 F.3d 859; 2010 U.S. App. LEXIS
24984; 97 U.S.P.Q.2D (BNA) 1274 (Fed. Cir. 2010).
830 U N I T 4 Employment, Business Organizations and Property
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DISCUSSION QUESTIONS
1. ETHICS Virtually any TV show, movie, or song
can be downloaded for free on the Internet. Most
of this material is copyrighted and was very
expensive to produce. Most of it is also available
for a fee through such legitimate sites such as
iTunes. What is your ethical obligation? Should
you pay $1.99 to download an episode of American
Idol from iTunes or take it for free from an illegal
site? What is your Life Principle?
2. For much of history, the copyright term was
limited to 28 years. Now it is as long as 120 years.
What is a fair copyright term? Some commentators
argue that because so much intellectual property is
stolen, owners need longer protection. Do you
agree with this argument?
3. Do you agree with the court that the band Furious
George violated the copyright of Curious George?
4. Should Amazon be able to patent the One-Click
method of ordering? What about Facebook’s
patent on a process that “dynamically provides a
news feed about a user of a social network”? Were
these inventions really novel and nonobvious?
What should the standard be for business method
patents?
5. Fredrik Colting wrote a book entitled 60 Years
Later: Coming Through the Rye, a riff on J. D.
Salinger’s famous Catcher in the Rye. Colting’s book
imagined how Salinger’s protagonist, Holden
Caulfield, would view life as a 76-year old. Alice
Randall wrote a novel entitled The Wind Done Gone,
which retells the Civil War novel Gone with the Wind
from the perspective of Scarlett O’Hara’s
(imagined) black half-sister. Both Colting and
Randall were sued and both alleged fair use.
Should they win?
6. The Susan G. Komen breast cancer charity
trademarked the term “for the cure.” It has brought
suit against other charities that use the term, as in
“run for the cure” or “kites for the cure.” It also
sues charities that use the same shade of pink that it
has long used on its ribbons. Should Komen be able
to trademark “for the cure” and the color pink?
7. Should a wildflower garden be eligible for
intellectual property protection?
CHAPTER 33 Intellectual Property 831
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CHAPTER34
REAL AND
PERSONAL
PROPERTY
“My only child is a no-good thief,” Riley mur-
murs sadly to his visitors. “He has always treated
me contemptuously. Now he’s been sentenced
to five years for stealing from a children’s charity.
He is my only heir, but why should I leave him
everything?”
Riley continues talking to his three guests: a
bishop, a rabbi, and Earnest, a Boy Scout leader. “I have
$500,000 in stocks and bonds in my bank deposit box.
Tomorrow morning, I’m going to go down to the bank,
take out all the papers, and hand them over to the Boy
Scouts so that other kids won’t turn out so bad.”
Everyone applauds his generosity, and they photograph
Riley and Earnest shaking hands. But the following
morning, on his way to the bank, Riley is struck by an
ambulance and killed. A dispute arises over the money.
The three witnesses assure the court that Riley was on
his way to give the money to the Boy Scouts. From
prison, the ne’er-do-well son demands the money as Riley’s sole heir. Who wins? Property
law holds the answer.
In this chapter, we will examine personal property. In the section on gifts, we learn that
Riley’s no-good son gets the money. Riley intended to give the stocks and bonds to the
Boy Scouts the following day, but he never completed a valid gift because he failed to
deliver the papers.
But first, we will take a look at real property and landlord-tenant law.
My only child is a
no-good thief. He is
my only heir, but why
should I leave him
everything?
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34-1 NATURE OF REAL PROPERTY
Property falls into three categories: real, personal, and intellectual. Real property consists of
the following:
• Land. Land is the most common and important form of real property. In England, land
was historically the greatest source of wealth and social status, far more important than
industrial or commercial enterprises. As a result, the law of real property has been of
paramount importance for nearly 1,000 years, developing very gradually to reflect changing
conditions. Some real property terms sound medieval for the simple reason that they are
medieval. By contrast, the common law of torts and contracts is comparatively new.
Real property usually also includes anything underground (subsurface rights), and some
amount of airspace above land (air rights).
• Buildings. Buildings are real property. Houses, office buildings, apartment
complexes, and factories all fall in this category.
• Plant life. Plant life growing on land is real property whether the plants are
naturally occurring, such as trees, or cultivated crops. When a landowner sells
his property, plant life is automatically included in the sale unless the parties
agree otherwise. A landowner may also sell the plant life separately if he wishes.
A sale of the plant life alone, without the land, is a sale of goods. (Goods, as you
may recall, are movable things.) If Douglas agrees to sell all of the fir trees on his
property, this sale of goods will be governed by the Uniform Commercial Code
(UCC), regardless of whether Douglas or the buyer is obligated to cut the trees.1
• Fixtures. Fixtures are goods that have become attached to real property. A house
(which is real property) contains many fixtures. The furnace and heating ducts were
goods when they were manufactured and when they were sold to the builder because
they were movable. But when the builder attached them to the house, the items
became fixtures. By contrast, neither the refrigerator nor the grand piano is a fixture.
When an owner sells real property, the buyer normally obtains the fixtures unless the
parties specify otherwise. Sometimes it is difficult to determine whether something is a
fixture. The general rule is this: An object is a fixture if a reasonable person would consider
the item to be a permanent part of the property.
For many, beef is a dietary fixture. But is the cattle scale in the following case a fixture?
FREEMAN V. BARRS
237 S.W.3d 285
Missouri Court of Appeals, 2007
C A S E S U M M A R Y
Facts: Mary Ann Barrs paid $3.5 million to Francis Free-
man for 4,000 acres of ranch land, including a covered
“pole-barn,” which had open sides, a large cattle scale,
and an enclosed veterinarian’s office. The parties used a
form contract, which stated that all fixtures were included
with the sale. The document offered space for the parties
to specify items that were included or excluded with the
sale, but neither party listed the cattle scale as either in or
out of the deal. After the agreement went through, Barrs
and Freeman got into a beef over who owned the scale.
1UCC §2-107(2).
CHAPTER 34 Real and Personal Property 833
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34-2 ESTATES IN REAL PROPERTY
Use and ownership of real estate can take many different legal forms. A person may own
property outright, having the unrestricted use of the land and an unlimited right to sell it.
Such a person owns a fee simple absolute. However, someone may also own a lesser interest
in real property. The different rights that someone can hold in real property are known as
estates or interests. Both terms simply indicate specified rights in property.
34-2a Concurrent Estates
When two or more people own real property at the same time, they have concurrent estates.
The most common forms of concurrent estates are tenancy in common, joint tenancy, and
tenancy by the entirety.
TENANCY IN COMMON
The most common form of concurrent estate is tenancy in common. Suppose Patricia owns
a house. Patricia agrees to sell her house to Quincy and Rebecca. When she conveys the
deed (that is, transfers the deed) “to Quincy and Rebecca,” those two now have a tenancy in
common. This kind of estate can also be created in a will. If Patricia had died still owning
the house, and left it in her will to “Sam and Tracy,” then Sam and Tracy would have a
tenancy in common. Tenancy in common is the “default setting” when multiple people
acquire property. Co-owners are automatically considered tenants in common unless another
type of interest (joint tenancy, tenancy by the entirety) is specified.
A tenancy in common might have 2 owners, or 22, or any number. The tenants in
common do not own a particular section of the property; they own an equal interest in the
entire property. Quincy and Rebecca each own a 50 percent interest in the entire house.
Any co-tenant may convey her interest in the property to another person. Thus, if
Rebecca moves 1,000 miles away, she may sell her 50 percent interest in the house to
Sidney. Further, when a co-tenant dies, her interest in the property passes to her heirs,
along with all of her other assets.
Partition Since any tenant in common has the power to convey her interest, some
people may find themselves sharing ownership with others they do not know or, worse,
dislike. What to do? Partition, or division of the property among the co-tenants. Any
co-tenant is entitled to demand partition of the property. If the various co-tenants cannot
agree on a fair division, a co-tenant may request a court to do it. All co-tenants have an
absolute right to partition.
The trial judge grilled numerous witnesses and ultimately
weighed in on the side of Barrs, declaring the scale a
fixture that belonged to the real estate. Broiling, Freeman
appealed.
Issue: Was the cattle scale a fixture?
Decision: Yes, the scale was a fixture. Affirmed.
Reasoning: The scale’s maker testified that it was
designed to be portable. It would only take him an hour
to cut away a welded metal fence and then fifteen
minutes to move the scale itself.
On the other hand, the scale weighs 6,500 pounds. It
is inside a covered barn that also includes a vet’s office.
To install the scale, a fence and gates within the barn had
to be cut. There were concrete ramps and fencing around
the scale to direct cattle onto it. The fence posts were set
in concrete. No one had moved the scale since its
installation.
A 6,500-pound scale placed inside a structure on a
specially sized concrete pad and surrounded by metal
pole fencing is annexed to the real estate. The scale
was a fixture, and was included in the sale of the real
estate.
Fee simple absolute
Full ownership privileges in a
property.
Concurrent estates
Two or more people owning
property at the same time.
Tenancy in common
Two or more people holding
equal interest in a property, but
with no right of survivorship.
834 U N I T 4 Employment, Business Organizations and Property
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A court will normally attempt a partition by kind, meaning that it actually divides the
land equally among the co-tenants. If three co-tenants own a 300-acre farm and the court
can divide the land so that the three sections are of roughly equal value, it will perform a
partition in kind, even if one or two of the co-tenants oppose partition. If partition by kind is
impossible because there is no fair way to divide the property, the court will order the real
estate sold and the proceeds divided equally.
JOINT TENANCY
Joint tenancy is similar to tenancy in common but is used less frequently. The parties, called
joint tenants, again own a percentage of the entire property and also have the absolute right
of partition. The primary difference is that a joint tenancy includes the right of survivorship.
This means that when one joint tenant dies, his interest in the property passes to the
surviving joint tenants. Recall that a tenant in common, by contrast, has the power to leave
his interest in the real estate to his heirs. Because a joint tenant cannot leave the property to
his heirs, courts do not favor this form of ownership. The law presumes that a concurrent
estate is a tenancy in common; a court will interpret an estate as a joint tenancy only if the
parties creating it clearly intended that result.
Joint tenancy has one other curious feature. Although joint tenants may not convey
their interest by will, they may do so during their lifetime. If Frank and George own
vacation property as joint tenants, Frank has the power to sell his interest to Harry. But as
soon as he does so, the joint tenancy is severed; that is, broken. Harry and George are now
tenants in common, and the right of survivorship is destroyed.
But when does a severance officially take place? The answer was of critical importance
in the following case.
JACKSON V. ESTATE OF GREEN
771 N.W.2d 675
Supreme Court of Michigan, 2009
C A S E S U M M A R Y
Facts: Green and Jackson owned land as joint tenants.
Green filed a petition asking a court to partition the
parcels, that is, to sever the joint tenancy, But he died
while the partition was still pending.
The lower courts found that because the partition was
not complete at the time of Green’s death, the land
reverted to Jackson.
Green’s estate appealed.
Issue: Did filing for the partition of a joint tenancy termi-
nate survivorship rights?
Decision: No, filing alone did not terminate the joint
tenancy.
Reasoning: The principal characteristic of a joint
tenancy is the right of survivorship. That is, when
one joint tenant dies, the surviving owner takes the
whole estate. But when a joint tenancy is severed, this
right of survivorship is destroyed. Severance occurs if
ordered by a court, or if either owner sells his share of
the property.
In this case, Green filed for a partition of the parcel,
but before the court approved the partition, he died. The
question was whether the act of filing alone was enough
to undo the joint tenancy.
Sadly for Green’s already-grieving heirs, severance
takes place at the moment a court enters the final order
of partition. No court had entered such an order in this
case, so when Green died, his interest automatically went
to Jackson. Green’s estate lost.
Joint tenancy
Two or more people holding
equal interest in a property,
with the right of survivorship.
CHAPTER 34 Real and Personal Property 835
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EXAM Strategy
Question: Thomas, age 80, has spent a lifetime accumulating unspoiled land in
Oregon. He owns 16,000 acres, which he plans to leave to his five children. He is not
so crazy about his grandchildren. Thomas cringes at the problems the grandchildren
would cause if some of them inherited an interest in the land and became part-owners
along with Thomas’s own children. Should Thomas leave his land to his children as
tenants in common or joint tenants?
Strategy: When a co-tenant dies, her interest in property passes to her heirs. When a
joint tenant dies, his interest in the property passes to the surviving joint tenants.
Result: Thomas is better off leaving the land to his children as joint tenants. That
way, when one of his children dies, that child’s interest in the land will go to
Thomas’s surviving children, not to his grandchildren.
Tenancy in Common
Three tenants in common, each owning
a 1/3 interest in the entire property.
Joint Tenancy
Three joint tenants, each owning a 1/3 interest
in the entire property, with right of survivorship.
Ben
Ben
Larry
Clem
Clem
Clem
Alice
Kate
Kate
Eliza
Eliza
Eliza
Fred
Fred
George
Doug
dies
sells
dies
conveys to
Kate inherits
and becomes
a tenant in
common with
Ben and Clem
Larry buys and becomes
a tenant in common
with Kate and Clem
Eliza and George
now have a tenancy
in common
Fred’s
conveyance
severs his
joint tenancy
with Eliza
Doug’s interest
passes to
Eliza and Fred
EXHIB IT 34.1 The Differences Between Tenancy in Common and Joint Tenancy
©
C
en
ga
ge
Le
ar
ni
ng
836 U N I T 4 Employment, Business Organizations and Property
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TENANCY BY THE ENTIRETY
This form of ownership exists in slightly over half of the states. The husband and wife each
own the entire property, and they both have a right of survivorship. So when the husband
dies, his one-half interest in the property automatically passes to his wife. Neither party has
a right to convey his or her interest. If the parties wish to sell their interests, they must do so
together. An advantage of this is that no creditor may seize the property based on a debt
incurred by only one spouse. If a husband goes bankrupt, creditors may not take his house if
he and his wife own it as tenants by the entirety. Divorce terminates a tenancy by the
entirety and leaves the two parties as tenants in common.
34-3 NONPOSSESSORY INTERESTS
All of the estates and interests that we have examined thus far focused on one thing:
possession of the land. Now we look at interests that never involve possession. These
interests may be very valuable, even though the holder never lives on the land.
34-3a Easements
The Alabama Power Co. drove a flatbed truck over land owned by Thomas Burgess,
damaging the property. The power company did this to reach its power lines and wooden
transmission poles. Burgess had never given Alabama Power permission to enter his land,
and he sued for the damage that the heavy trucks caused. He recovered—nothing. Alabama
Power had an easement to use Burgess’s land.
An easement gives one person the right to enter land belonging to another and make a
limited use of it, without taking anything away. Burgess had bought his land from a man
named Denton, who years earlier had sold an easement to Alabama Power. The easement
gave the power company the right to construct several transmission poles on one section of
Denton’s land and to use reasonable means to reach the poles. Alabama Power owned that
easement forever, and when Burgess bought the land, he took it subject to the easement.
Alabama Power drove its trucks across a section of land where the power company had never
gone before, and the easement did not explicitly give the company this right. But the court
found that the company had no other way to reach its poles, and therefore, the easement
allowed this use. Burgess is stuck with his uninvited guest as long as he owns the land.2
34-3b Profit
A profit gives one person the right to enter land belonging to another and take something
away. You own 100 acres of vacation property, and suddenly a mining company informs you
that the land contains valuable nickel deposits. You may choose to sell a profit to the mining
company, allowing it to enter your land and take away the nickel. You receive cash up front,
and the company earns money from the sale of the mineral. The rules about creating and
transferring easements apply to profits as well.
34-3c License
A license gives the holder temporary permission to enter another’s property. Unlike an
easement or profit, a license is a temporary right. When you attend a basketball game by
buying a ticket, the basketball team that sells you the ticket is the licensor and you are the
licensee. You are entitled to enter the licensor’s premises, namely the basketball arena,
and to remain during the game, though the club can revoke the license if you behave
unacceptably, and you must leave when the game is over.
2Burgess v. Alabama Power Co., 658 So. 2d 435, 1995 Ala. LEXIS 119 (Ala. 1995).
Easement
The right to enter land
belonging to another and make
limited use of it.
Profit
The right to enter land
belonging to another and take
something from it.
License
The right to enter land
belonging to another
temporarily.
CHAPTER 34 Real and Personal Property 837
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34-3d Mortgage
Generally, in order to buy a house, a prospective owner must borrow money. The bank or
other lender will require security before it hands over its money, and the most common form
of security for a real estate loan is a mortgage. A mortgage is a security interest in real
property. The homeowner who borrows money is the mortgagor because she is giving the
mortgage to the lender. The lender, in turn, is the mortgagee, the party acquiring a security
interest. The mortgagee in most cases obtains a lien on the house, meaning the right to
foreclose on the property if the mortgagor fails to pay back the money borrowed. A
mortgagee forecloses by taking legal possession of the property, auctioning it to the highest
bidder, and using the proceeds to pay off the loan.
34-4 LAND USE REGULATION
34-4a Nuisance Law
A nuisance is an unprivileged interference with a person’s use and enjoyment of her
property. Offensive noise, odors, or smoke often give rise to nuisance claims. Courts
typically balance the utility of the act that is causing the problem against the harm done
to neighboring property owners. If a suburban homeowner begins to raise pigs in her
backyard, the neighbors may find the bouquet offensive; a court will probably issue an
abatement; that is, an order requiring the homeowner to eliminate the nuisance.
Community members can use the old doctrine of nuisance for more serious
problems than pigs. An apartment building in Berkeley, California, became widely
known as a drug house, and the neighbors suffered. Here is how two of the neighbors
described their lives:
I have been confronted by the drug dealers, drug customers, and prostitutes that frequent and
work around and from 1615–1617 Russell Street. Weekly I have lost many hours of sleep from the
cars that burn rubber after each drug buy in the middle of the night.
Because of this illegal activity, my child is unable to use our front yard, and I even have to
check the back yard since it has been intruded upon from time to time by people running from
the police. He is learning to count by how many gunshots he hears and can’t understand why he
can’t even enjoy our rose garden.
These were but two of the affidavits written by neighbors of a 36-unit building
owned by Albert Lew. Month after month neighbors complained to Lew that his
tenants were destroying the neighborhood. But Lew refused to evict the drug dealers
or take any serious steps to limit the crime. So the neighbors used the law of nuisance
to restore their community.
Sixty-six neighbors of the drug house each filed a small claims case against Lew,
claiming that he was permitting a nuisance to exist on his property. The neighbors won
their small claims cases, but Lew appealed, as he had a right to, for a new trial in
Superior Court. A sergeant testified that he had been to the building over 250 times
during two years. Residents testified about how frightening life had become. The
Superior Court awarded damages of $218,325 to the neighbors, and the court of appeals
affirmed the award, holding that neighbors injured by a nuisance may seek an
abatement and damages. As Lew discovered, the law of nuisance can be a powerful
weapon for creating a better neighborhood.3
3Lew v. Superior Court, 20 Cal. App. 4th 866, 1993 Cal. App. LEXIS 1198 (Cal. Ct. App. 1993).
Mortgage
A security interest in real
property.
Mortgagor
An owner who gives a security
interest in property in order to
obtain a loan.
Mortgagee
The party acquiring a security
interest in property.
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34-4b Zoning
Zoning statutes are state laws that permit local communities to regulate building and land
use. The local communities, whether cities, towns, or counties, then pass zoning ordinances
that control many aspects of land development. For example, a town’s zoning ordinance may
divide the community into an industrial zone where factories may be built, a commercial zone
in which stores of a certain size are allowed, and several residential zones in which only houses
may be constructed. Within the residential zones, there may be further divisions, for example,
permitting two-family houses in certain areas and requiring larger lots in others.
An owner prohibited by an ordinance from erecting a certain kind of building, or adding on
to his present building, may seek a variance from the zoning board, meaning an exception
granted for special reasons unique to the property. Whether a board will grant a variance
generally depends upon the type of the proposed building, the nature of the community, the
reason the owner claims he is harmed by the ordinance, and the reaction of neighbors.
Ethics Many people abhor “adult” businesses, such as strip clubs and
pornography shops. Urban experts agree that a large number of these
concerns in a neighborhood often causes crime to increase and property values to drop.
Nonetheless, many people patronize such businesses, which can earn a good profit. Should
a city have the right to restrict adult businesses? New York City officials determined that the
number of sex shops had grown steadily for two decades and that their presence harmed
various neighborhoods. With the support of community groups, the city passed a zoning
ordinance that prohibited adult businesses from all residential neighborhoods, from some
commercial districts, and from being within 500 feet of schools, houses of worship, day-
care centers, or other sex shops (to avoid clustering). Owners and patrons of these shops
protested, claiming that the city was unfairly denying the public access to a form of
entertainment that it obviously desired. Is the New York City zoning ordinance reasonable?
34-4c Eminent Domain
Eminent domain is the power of the government to take private property for public use. A
government may need land to construct a highway, airport, university, or public housing. All levels
of government—federal, state, and local—have this power. But the Fifth Amendment of the
United States Constitution states: “… nor shall private property be taken for public use, without
just compensation.”The Supreme Court has held that this clause, the Takings Clause, applies not
only to the federal government but also to state and local governments. So, although all levels of
government have the power to take property, they must pay the owner a fair price.
A “fair price” generally means the reasonable market value of the land. Generally, if the
property owner refuses the government’s offer, the government will file suit seeking con-
demnation of the land; that is, a court order specifying what compensation is just and
awarding title to the government.
A related issue concerns local governments requiring property owners to dedicate some of their
land to public use in exchange for zoning permission to build or expand on their own property. For
example, if a store owner wishes to expand his store, a town might grant zoning permission only if
the owner dedicates a different part of his property for use as a public bike path. The Supreme
Court has diminished the power of local governments to require such dedication.4
4The Supreme Court’s ruling came in Dolan v. City of Tigard, 512 U.S. 374, 114 S. Ct. 2309, 1994 U.S.
LEXIS 4836 (1994).
Variance
An exception from zoning laws
that is granted by a zoning
board for special reasons
unique to the property.
Eminent domain
The power of the government
to take private property for
public use.
CHAPTER 34 Real and Personal Property 839
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34-5 LANDLORD-TENANT LAW
Apartments are certainly a type of real property, and many students are keenly interested in
renters’ rights. We now turn our attention to landlord-tenant law.
A freehold estate is the right to possess real property and use it in any lawful manner.
What we think of as “owning” land is in fact a freehold estate. When an owner of a freehold
estate allows another person temporary, exclusive possession of the property, the parties have
created a landlord-tenant relationship. The freehold owner is the landlord, and the person
allowed to possess the property is the tenant. The landlord has conveyed a leasehold
interest to the tenant, meaning the right to temporary possession. Courts also use the word
tenancy to describe the tenant’s right to possession.
A leasehold may be commercial or residential. In a commercial tenancy, the owner of
a building may rent retail space to a merchant, offices to a business, or industrial space to
a manufacturer. When someone rents an apartment or house, he has a residential
leasehold.
34-5a Three Legal Areas Combined
Property law influences landlord-tenant cases because the landlord is conveying rights in
real property to the tenant. She is also keeping a reversionary interest in the property,
meaning the right to possess the property when the lease ends. Contract law plays a role
because the basic agreement between the landlord and tenant is a contract. A lease is
a contract that creates a landlord-tenant relationship. And negligence law increasingly
determines the liability of landlord and tenant when there is an injury to a person or
property. Many states have combined these three legal issues into landlord-tenant
statutes.
34-5b Lease
The Statute of Frauds generally requires that a lease be in writing. Some states will enforce
an oral lease if it is for a short term, such as one year or less, but even when an oral lease is
permitted, it is wiser for the parties to put their agreement in writing because a written lease
avoids many misunderstandings. At a minimum, a lease must state the names of the parties,
the premises being leased, the duration of the agreement, and the rent. But a well-drafted
lease generally includes many provisions, called covenants and conditions. A covenant is
simply a promise by either the landlord or the tenant to do something or refrain from doing
something. For example, most leases include a covenant concerning the tenant’s payment
of a security deposit and the landlord’s return of the deposit, a covenant describing how the
tenant may use the premises, and several covenants about who must maintain and repair the
property. Generally, tenants may be fined but not evicted for violating lease covenants. A
condition is similar to a covenant, but it allows for a landlord to evict a tenant if there is a
violation. In many states, conditions in leases must be clearly labeled as “conditions” or
“evictable offenses.”
34-6 TYPES OF TENANCY
There are four types of tenancy: a tenancy for years, a periodic tenancy, a tenancy at will, and
a tenancy at sufferance. The most important feature distinguishing one from the other is
how each tenancy terminates. In some cases, a tenancy terminates automatically, while in
others, one party must take certain steps to end the agreement.
Landlord
The owner of a freehold estate
who allows another person
temporarily to live on his
property.
Tenant
A person given temporary
possession of the landlord’s
property.
Reversionary interest
The right of an owner (or her
heirs) to property upon the
death of a life tenant.
Lease
An agreement in which an
owner gives a tenant the right
to use property.
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34-6a Tenancy for Years
Any lease for a stated, fixed period is a tenancy for years. If a landlord rents a summer
apartment for the months of June, July, and August of next year, that is a tenancy for years.
A company that rents retail space in a mall beginning January 1, 2014, and ending
December 31, 2020, also has a tenancy for years. A tenancy for years terminates automatically
when the agreed period ends.
34-6b Periodic Tenancy
A periodic tenancy is created for a fixed period and then automatically continues for
additional periods until either party notifies the other of termination. This is probably the
most common variety of tenancy, and the parties may create one in either of two ways.
Suppose a landlord agrees to rent you an apartment “from month to month, rent payable on
the first.” That is a periodic tenancy. The tenancy automatically renews itself every month
unless either party gives adequate notice to the other that she wishes to terminate. A
periodic tenancy could also be for one-year periods—in which case it automatically renews
for an additional year if neither party terminates—or for any other period.
34-6c Tenancy at Will
A tenancy at will has no fixed duration and may be terminated by either party at any
time. Tenancies at will are unusual tenancies.5 Typically, the agreement is vague, with
no specified rental period and with payment, perhaps, to be made in kind. The parties
might agree, for example, that a tenant farmer could use a portion of his crop as rent.
Since either party can end the agreement at any time, it provides no security for either
landlord or tenant.
34-6d Tenancy at Sufferance
A tenancy at sufferance occurs when a tenant remains on the premises, against the wishes of
the landlord, after the expiration of a true tenancy. Thus, a tenancy at sufferance is not a
true tenancy because the tenant is staying without the landlord’s agreement. The landlord
has the option of seeking to evict the tenant or of forcing the tenant to pay a use and
occupancy fee for as long as she stays.
34-7 LANDLORD’S DUTIES
34-7a Duty to Deliver Possession
The landlord’s first important duty is to deliver possession of the premises at the beginning
of the tenancy; that is, to make the rented space available to the tenant. In most cases, this
presents no problems and the new tenant moves in. But what happens if the previous tenant
has refused to leave when the new tenancy begins? In most states, the landlord is legally
required to remove the previous tenant. In some states, it is up to the new tenant either to
evict the existing occupant or begin charging him rent.
5The courts of some states, annoyingly, use the term “tenancy at will” for what are, in reality, periodic
tenancies. They do this to bewilder law students and even lawyers, a goal at which they are quite
successful. This text uses tenancy at will in its more widely known sense, meaning a tenancy
terminable at any time.
Tenancy for years
A lease for a stated, fixed
period.
Periodic tenancy
A lease for a fixed period,
automatically renewable unless
terminated.
Tenancy at will
A tenancy with no fixed
duration, which may be
terminated by either party at
any time.
Tenancy at sufferance
A tenancy that exists without
the permission of the landlord,
after the expiration of a true
tenancy.
CHAPTER 34 Real and Personal Property 841
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34-7b Quiet Enjoyment
All tenants are entitled to quiet enjoyment of the premises, meaning the right to use the
property without the interference of the landlord. Most leases expressly state this covenant
of quiet enjoyment. And if a lease includes no such covenant, the law implies the right of
quiet enjoyment anyway, so all tenants are protected. If a landlord interferes with the
tenant’s quiet enjoyment, he has breached the lease, entitling the tenant to damages.
The most common interference with quiet enjoyment is an eviction, meaning some act
that forces the tenant to abandon the premises. Of course, some evictions are legal, as when
a tenant fails to pay the rent. But some evictions are illegal. There are two types of eviction:
actual and constructive.
ACTUAL EVICTION
If a landlord prevents the tenant from possessing the premises, he has actually evicted her.
Suppose a landlord decides that a group of students are “troublemakers.” Without going
through lawful eviction procedures in court, the landlord simply waits until the students are
out of the apartment and changes all the locks. By denying the students access to the
premises, the landlord has actually evicted them and has breached their right of quiet
enjoyment. He is liable for all expenses they suffer, such as retrieving their possessions,
the cost of alternate housing, and moving expenses. In some states, he may be liable for
punitive damages for failing to go through proper eviction procedures.
Even a partial eviction is an interference with quiet enjoyment. Suppose Louise rents
an apartment with a storage room. If the landlord places his own goods in the storage room,
he has partially evicted Louise because a tenant is entitled to the exclusive possession of the
premises. In all states, Louise would be allowed to deduct from her rent the value of
the storage space, and in many states, she would not be obligated to pay any rent for
the apartment so long as the landlord continued the partial eviction.
CONSTRUCTIVE EVICTION
If a landlord substantially interferes with the tenant’s use and enjoyment of the premises, he
has constructively evicted her. Courts construe certain behavior as the equivalent of an
eviction. In these cases, the landlord has not actually prevented the tenant from possessing
the premises but has instead interfered so greatly with her use and enjoyment that the law
regards the landlord’s actions as equivalent to an eviction. Suppose the heating system in an
apartment house in Juneau, Alaska, fails during January. The landlord, an avid sled dog
racer, tells the tenants he is too busy to fix the problem. If the tenants move out, the
landlord has constructively evicted them and is liable for all expenses they suffer.
To claim a constructive eviction, the tenant must vacate the premises. The tenant must
also prove that the interference was sufficiently serious and lasted long enough that she was
forced to move out. A lack of hot water for two days is not fatal, but lack of any water for two
weeks creates a constructive eviction.
34-7c Duty to Maintain Premises
Historically, the common law placed no burden on the landlord to repair and maintain the
premises. This made sense because rental property had traditionally been farmland.
Buildings, such as a house or barn, were far less important than the land itself, and no
one expected the landlord to fix a leaking roof. Today, the vast majority of rental property
is used for housing or business purposes. Space in a building is frequently all that a tenant
is renting, and the condition of the building is of paramount importance. Most states have
changed the common law rule and placed various obligations on the landlord to maintain
the property.
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In most states, a landlord has a duty to deliver the premises in a habitable condition
and a continuing duty to maintain the habitable condition. This duty overlaps with the
quiet enjoyment obligation, but it is not identical. The tenant’s right to quiet enjoyment
focuses primarily on the tenant’s ability to use the rented property. The landlord’s duty
to maintain the property focuses on whether the property meets a particular legal standard.
The required standard may be stated in the lease, created by a state statute, or implied
by law.
LEASE
The lease itself generally obligates the landlord to maintain the exterior of any buildings
and the common areas. If a lease does not do so, state law may imply the obligation.
BUILDING CODES
Many state and local governments have passed building codes, which mandate minimum
standards for commercial and/or residential property. The codes are likely to be stricter for
residential property and may demand such things as minimum room size, sufficient hot
water, secure locks, proper working kitchens and bathrooms, absence of insects and rodents,
and other basics of decent housing. Generally, all rental property must comply with the
building code, whether the lease mentions the code or not.
IMPLIED WARRANTY OF HABITABILITY
Students Maria Ivanow, Thomas Tecza, and Kenneth Gearin rented a house from Les and
Martha Vanlandingham. The monthly rent was $900. But the roommates failed to pay any
rent for the final five months of the tenancy. After they moved out, the Vanlandinghams
sued. How much did the landlords recover? Nothing. The landlords had breached the
implied warranty of habitability.
The implied warranty of habitability requires that a landlord meet all standards set by
the local building code, or that the premises be fit for human habitation. Most states,
though not all, imply this warranty of habitability, meaning that the landlord must meet
this standard whether the lease includes it or not. In some states, the implied warranty
means that the premises must at least satisfy the local building code. Other states require
property that is “fit for human habitation,” which means that a landlord might comply with
the building code, yet still fail the implied warranty of habitability if the rental property is
unfit to live in.
The Vanlandinghams breached the implied warranty. The students had complained
repeatedly about a variety of problems. The washer and dryer, which were included in the
lease, frequently failed. A severe roof leak caused water damage in one of the bedrooms.
Defective pipes flooded the bathroom. The refrigerator frequently malfunctioned, and the
roommates repaired it several times. The basement often flooded, and when it was dry, rats
and opossums lived in it. The heat sometimes failed.
In warranty of habitability cases, a court normally considers the severity of the problems
and their duration. If the defective conditions seriously interfere with the tenancy, the court
declares the implied warranty breached and orders a rent abatement; that is, a reduction in
the rent owed. The longer the defects continued and the greater their severity, the more the
rent is abated. In the case of Maria Ivanow and friends, the court abated the rent 50 percent.
The students had already paid more than the abated rent to the landlord, so they owed
nothing for the last five months.6
6Vanlandingham v. Ivanow, 246 III. App. 3d 348, 615 N.E.2d 1361, 1993 Ill. App. LEXIS 985 (III. Ct.
App. 1993).
CHAPTER 34 Real and Personal Property 843
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DUTY TO RETURN SECURITY DEPOSIT
Most landlords require tenants to pay a security deposit, in case the tenant damages the
premises. In many states, a landlord must either return the security deposit soon after
the tenant has moved out or notify the tenant of the damage and the cost of the repairs.
In addition, landlords are often obligated to credit tenants with interest earned on the
deposit. In many states, a landlord who fails to return the deposit in a timely fashion
can be forced to pay double or even triple damages to the tenant, a question raised in
the following dispute.
Final Word on Security Deposits The discussion and case both concerned
residential leases, where security deposits are almost inevitable. Note that, in a
commercial lease, the tenant may have less statutory protection but more bargaining
power. A financially sound company might negotiate a lease with no security deposit or
perhaps offer a letter of credit for security instead of cash. The interest saved over several
years could be substantial.
MISHKIN V. YOUNG
107 P.3d 393, 2005 WL 452168
Supreme Court of Colorado, 2005
C A S E S U M M A R Y
Facts: A Colorado statute required a landlord either to
return a security deposit or provide an accounting of why
money was being withheld. The landlord had to do this
within 30 days of the tenant’s surrender of the property, or
up to 60 days if the lease permitted. If the landlord failed
to refund the money, the tenant, after giving seven days’
notice, could sue for treble damages. The landlord could
avoid the treble damages by refunding the deposit within
those seven days.
Marc Mishkin leased an apartment from Dean Young,
paying a security deposit of $1,625. The lease stated that
the deposit would be returned no later than 45 days after
the tenant moved out. After Mishkin left, Young did not
return the money. Forty-eight days after leaving, Mishkin
sent a demand for the deposit, notifying Young that in
seven days he would sue for treble damages. Six days
later, Young gave Mishkin a statement detailing
$1,574.60 worth of property damage, along with a check
for $50.40.
Mishkin sued. The trial court ruled that Young was
entitled to withhold the money because of the damages.
Mishkin appealed. The appellate court ruled that the
Colorado statute required the landlord to return the full
security deposit within the seven-day period. Young
appealed.
Issue: Did the landlord avoid the treble damages by account-
ing for the security deposit within seven days of the tenant’s
notice to sue?
Decision: No, the landlord could have avoided treble
damages during the seven-day period only by refunding
the full deposit. Affirmed.
Reasoning: Landlords may withhold security deposits
only if they account for all deductions within 30 days.
The language in Mishkin’s lease legally extended
this deadline to 45 days. Young failed to make an
accounting within 45 days, and therefore he forfeited
the right to retain any portion of Mishkin’s security
deposit.
The notice period creates only two possibilities. A
landlord may refund every penny of a former tenant’s
security deposit within seven days. If he fails to do so,
he is liable to the tenant for treble damages. The law is
strict, and it acts as a significant deterrent to landlords who
choose to keep deposits wrongfully.
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34-8 TENANT’S DUTIES
34-8a Duty to Pay Rent
Rent is the compensation the tenant pays the landlord for use of the premises, and paying
the rent is the tenant’s foremost obligation. The lease normally specifies the amount of rent
and when it must be paid. Typically, the landlord requires that rent be paid at the beginning
of each rental period, whether that is monthly, annually, or otherwise.
Both parties must be certain they understand whether the rent includes utilities such as
heat and hot water. Some states mandate that the landlord pay certain utilities, such as water.
Many leases include an escalator clause, permitting the landlord to raise the rent during the
course of the lease if his expenses increase for specified reasons. For example, a tax escalator
clause allows the landlord to raise the rent if his real estate taxes go up. Any escalator clause
should state the percentage of the increase that the landlord may pass on to the tenant.
LANDLORD’S REMEDIES FOR NONPAYMENT OF RENT
If the tenant fails to pay rent on time, the landlord has several remedies. She is entitled to
apply the security deposit to the unpaid rent. She may also sue the tenant for nonpayment
of rent, demanding the unpaid sums, cost of collection, and interest. Finally, the landlord
may evict a tenant who has failed to pay rent.
State statutes prescribe the steps a landlord must take to evict a tenant for nonpayment.
Typically, the landlord must serve a termination notice on the tenant and wait for a court
hearing. At the hearing, the landlord must prove that the tenant has failed to pay rent on
time. If the tenant has no excuse for the nonpayment, the court grants an order evicting
him. The order authorizes a sheriff to remove the tenant’s goods and place them in storage,
at the tenant’s expense. However, if the tenant was withholding rent because of unlivable
conditions, the court may refuse to evict.
EXAM Strategy
Question: Leo rents an apartment from Donna for $900 per month, both parties
signing a lease. After six months, Leo complains about defects, including bugs,
inadequate heat, and window leaks. He asks Donna to fix the problems, but she
responds that the heat is fine and that Leo caused the insects and leaks. Leo begins to
send in only $700 for the monthly rent. Donna repeatedly phones Leo, asking for the
remaining rent. When he refuses to pay, she waits until he leaves for the day, then has
a moving company place his belongings in storage. She changes the locks, making it
impossible for him to re-enter. Leo sues. What is the likely outcome?
Strategy: A landlord is entitled to begin proper eviction proceedings against a tenant
who has not paid rent. However, the landlord must follow specified steps, including a
termination notice and a court hearing. Review the consequences for actual eviction,
described in the section “Quiet Enjoyment.”
Result: Donna has ignored the legal procedures for evicting a tenant. Instead, she
engaged in actual eviction, which is quick, and in the short term, effective. However,
by breaking the law, Donna has ensured that Leo will win his lawsuit. He is entitled
to possession of the apartment, as well as damages for rent he may have been forced
to pay elsewhere, injury to his possessions, and the cost of retrieving them. He may
receive punitive damages as well. Bad strategy, Donna.
Rent
Compensation paid by a tenant
to a landlord.
Escalator clause
A clause in a lease allowing the
landlord to raise the rent for
specified reasons.
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LANDLORD’S DUTY TO MITIGATE
Pickwick & Perkins, Ltd., was a store in the Burlington Square Mall in Burlington,
Vermont. Pickwick had a five-year lease but abandoned the space almost two years early
and ceased paying rent. The landlord waited approximately eight months before renting the
space to a new tenant and then sued, seeking the unpaid rent. Pickwick defended on the
grounds that Burlington had failed to mitigate damages; that is, to keep its losses to a
minimum by promptly seeking another tenant. Burlington argued that it had no legal
obligation to mitigate. Burlington’s position accurately reflected the common law rule,
which permitted the landlord to let the property lie vacant and allow the damages to add
up. But the common law evolves over time, and this time, the Vermont Supreme Court
changed the rule. The judges pointed out that, historically, a lease was a conveyance of an
estate, and property law had never required mitigation. However, the court asserted, a lease
is now regarded as both a contract and a conveyance. Under contract law, the nonbreaching
party must make a reasonable effort to minimize losses, and that same rule applies, said the
court, to a landlord. Burlington lost. The Vermont ruling is typical of current decisions,
although some courts still do not require mitigation.7
34-8b Duty to Use Premises for Proper Purpose
A lease normally lists what a tenant may do in the premises and prohibits other activities.
For example, a residential lease allows the tenant to use the property for normal living
purposes, but not for any retail, commercial, or industrial purpose. A commercial lease might
allow a tenant to operate a retail clothing store, but not a restaurant. A landlord may evict a
tenant who violates the lease by using the premises for prohibited purposes.
A tenant may not use the premises for any illegal activity, such as gambling or selling
drugs. The law itself implies this condition in every lease, so a tenant who engages in illegal
acts on the leased property is subject to eviction, regardless of whether the lease mentions
such conduct.
34-8c Duty Not to Damage Premises
A tenant is liable to the landlord for any significant damage he causes to the property. The
tenant is not liable for normal wear and tear. If, however, he knocks a hole in a wall or
damages the plumbing, the landlord may collect the cost of repairs, either by using the
security deposit or by suing, if necessary. A landlord may also seek to evict a tenant for
serious damage to the property.
A tenant is permitted to make reasonable changes in the leased property so that he can
use it as intended. Someone leasing an apartment is permitted to hang pictures on the wall.
But a tenant leasing commercial space should make certain that the lease specifies the
alterations he can make and whether he is obligated to return the premises to their original
condition at the end of the lease.
34-8d Duty Not to Disturb Other Tenants
Most leases, commercial and residential, include a covenant that the tenant will not disturb
other tenants in the building. A landlord may evict a tenant who unreasonably disturbs
others. The test is reasonableness. A landlord does not have the right to evict a residential
tenant for giving one loud party but may evict a tenant who repeatedly plays loud music late
at night and disturbs the quiet enjoyment of other tenants.
7O’Brien v. Black, 162 Vt. 448, 648 A.2d 1374, 1994 Vt. LEXIS 89 (1994).
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34-9 INJURIES
You invite a friend to dinner in your rented home, but after the meal, she slips and falls,
seriously injuring her back. Are you liable? Is the landlord?
34-9a Tenant’s Liability
A tenant is generally liable for injuries occurring within the premises she is leasing, whether
that is an apartment, a store, or otherwise. If a tenant permits grease to accumulate on a
kitchen floor and a guest slips and falls, the tenant is liable. If a merchant negligently installs
display shelving that tips onto a customer, the merchant pays for the harm. Generally, a
tenant is not liable for injuries occurring in common areas over which she has no control,
such as exterior walkways. If a tenant’s dinner guest falls because the building’s common
stairway has loose steps, the landlord is probably liable.
34-9b Landlord’s Liability
COMMON LAW RULES
Historically, the common law held a landlord responsible for injuries on the premises only in
a limited number of circumstances, which we will describe. In reading these common law
rules, be aware that many states have changed them, dramatically increasing the landlord’s
liability.
Latent Defects If the landlord knows of a dangerous condition on the property and
realizes the tenant will not notice it, the landlord is liable for any injuries. For example, if a
landlord knows that a porch railing is weak and fails to inform the tenant, the landlord is
responsible if the tenant plunges off the porch. But notice that, under the common law, if
the landlord notifies the tenant of the latent defect, he is no longer liable.
Common Areas The landlord is usually responsible for maintaining the common
areas, and along with this obligation may go liability for torts. As we saw above, if your
guest falls downstairs in a common hallway because the stairs were defective, the landlord
is probably liable.
Negligent Repairs Even in areas where the landlord has no duty to make repairs, if he
volunteers to do so and does the work badly, he is responsible for any resulting harm.
Public Use If the premises are to be used for a public purpose, such as a store or office,
the landlord is generally obligated to repair any dangerous defects, although the tenant is
probably liable as well. The purpose of this stricter rule is to ensure that the general public
can safely visit commercial establishments. If a landlord realizes that the plate glass in a
store’s door is loose, he must promptly repair it or suffer liability for any injuries.
MODERN TREND
Increasingly, state legislatures and courts are discarding the common law classifications
described above and holding landlords liable under the normal rules of negligence law. In
many states, a landlord must use reasonable care to maintain safe premises and is liable for
foreseeable harm. For example, the common law rule merely required a landlord to notify a
tenant of a latent defect, such as a defective porch railing. Most states now have building
codes that require a landlord to maintain structural elements such as railings in safe
condition. States further imply a warranty of habitability, which mandates reasonably safe
living conditions. So, in many states, a landlord is no longer saved from negligence suits
merely by giving notice of defects—he has to fix them.
CHAPTER 34 Real and Personal Property 847
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34-10 PERSONAL PROPERTY
Personal property is all property other than real property. In this section, we look at two
important aspects of personal property: gifts and bailments.
34-11 GIFTS
A gift is a voluntary transfer of property from one person to another without any considera-
tion. Recall from Chapter 11 that, for consideration to exist, parties must normally make an
exchange. But a gift is a one-way transaction, without anything given in return. The person
who gives property away is the donor, and the one who receives it is the donee.
A gift involves three elements:
• The donor intends to transfer ownership of the property to the donee immediately.
• The donor delivers the property to the donee.
• The donee accepts the property.
If all three elements are met, the donee becomes the legal owner of the property. If the
donor later says, “I’ve changed my mind, give that back!” the donee is free to refuse.
34-11a Intention to Transfer Ownership
The donor must intend to transfer ownership to the property right away, immediately giving
up all control of the item. Notice the two important parts of this element. First, the donor’s
intention must be to transfer ownership; that is, to give title to the donee. Merely proving that
the owner handed you property does not guarantee that you have received a gift; if the
owner only intended that you use the item, there is no gift, and she can demand it back.
Second, the donor must also intend the property to transfer immediately. A promise to
make a gift in the future is unenforceable. Promises about future behavior are governed by
contract law, and a contract is unenforceable without consideration. If Sarah hands Lenny
the keys to a $600,000 yacht and says, “Lenny, it’s yours,” then it is his, since Sarah intends
to transfer ownership right away. But if Sarah says to Max, “Next week, I’m going to give
you my yacht,” Max has not received a gift because Sarah did not intend an immediate
transfer. Neither does Max have an enforceable contract since there is no consideration for
Sarah’s promise.
A revocable gift is governed by a special rule, and it is actually not a gift at all. Suppose
Harold tells his daughter Faith, “The mule is yours from now on, but if you start acting
stupid again, I’m taking her back.” Harold has retained some control over the animal, which
means he has not intended to transfer ownership. There is no gift, and no transfer of
ownership. Harold still owns the mule.
When Dominic Tenaglia’s automobile broke down, his brother Nick generously offered
to give him a replacement car. Nick delivered a Chevrolet to Dominic, and both brothers
understood that the car was a gift. Nick wrote “gift” on the car’s certificate of title, but he did
not immediately give the certificate to Dominic. A week later, while Dominic was driving the
Chevrolet, he was involved in an accident. Both brothers had insurance, through different
insurers, for cars they owned. The two companies disputed which one was liable for Domin-
ic’s accident. The court determined that Nick’s company was still liable for any damage
caused by the Chevrolet. Nick had presented the car to Dominic but had not relinquished all
control over it. Ownership of a car is unlike ownership of a computer or a sweater because it
requires possession of a certificate of title. Because Nick still had the certificate at the time of
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the accident, he had the power to take back the Chevrolet whenever he wanted. He had not
made a valid gift of the automobile, and Dominic’s insurer won the case.8
34-11b Delivery
PHYSICAL DELIVERY
The donor must deliver the property to the donee. Generally, this involves physical delivery—
a handoff, if you will. If Anna hands Eddie a Rembrandt drawing, saying “I want you to
have this forever,” she has satisfied the delivery requirement. In the chapter opening, Riley
promised to give half a million dollars to the Boy Scouts the following day. But he never
delivered the stocks and bonds, so there was no gift. The Boy Scouts received nothing, and all
the money became part of Riley’s estate, to be inherited by his unworthy son.
CONSTRUCTIVE DELIVERY
Physical delivery is the most common and the surest way to make a gift, but it is not always
necessary. A donor makes constructive delivery by transferring ownership without a physical
delivery. Most courts permit constructive delivery only when physical delivery is impossible
or extremely inconvenient. Suppose that Anna wants to give her niece Jen a blimp, which is
parked in a hangar at the airport. The blimp will not fit through the doorway of Jen’s dorm.
Instead of flying the aircraft to the university, Anna may simply deliver to Jen the certificate
of title and the keys to the blimp. When she has done that, Jen owns the aircraft.
DELIVERY TO AN AGENT
A donor might deliver the property to an agent, either someone working for him or for the
donee. Assume that Randolph says to Mortimer, “Old boy, I should like for you to have my
Rolls Royce.” If Randolph gives the keys and the title to his own butler, there is no gift. By
definition, the agent works for the donor, and thus the donor still has control and ownership
of the property. But if the donor delivers the property to the donee’s agent, the gift is made.
So, if Randolph delivers the car to Mortimer’s butler, then Mortimer owns the car.
PROPERTY ALREADY IN DONEE’S POSSESSION
Sometimes a donor decides to give property to a donee who already has possession of it. In
that case, no delivery is required, and the donee need only demonstrate that the donor
intended to transfer present ownership. Larry lends a grand piano to Leslie for the summer.
At the end of the summer, Larry announces that she can keep the instrument. So long as
Larry clearly intends that Leslie gets ownership of the piano, the gift is completed.
34-11c Inter Vivos Gifts and Gifts Causa Mortis
A gift can be either inter vivos or causa mortis. An inter vivos gift means a gift made “during
life”; that is, when the donor is not under any fear of impending death. The vast majority of
gifts are inter vivos, involving a healthy donor and donee. Shirley, age 30 and in good health,
gives Terry an eraser for his birthday. This is an inter vivos gift, which is absolute. The gift
becomes final upon delivery, and the donor may not revoke it. If Shirley and Terry have a
fight the next day, Shirley has no power to erase her eraser gift.
A gift causa mortis is one made in contemplation of approaching death.The gift is valid if the
donor dies as expected, but it is revoked if he recovers. Suppose that Lenny’s doctors have told
him he will probably die of a liver ailment within a month. Lenny calls Jane to his bedside and
hands her a fistful of cash, saying, “I’mdying, this money is yours.” Jane sheds a tear, then sprints
8Motorists Mutual Insurance Co. v. State Farm Mutual Automobile Insurance Co., 1990 Ohio App. LEXIS
3027 (Ohio Ct. App. 1990).
CHAPTER 34 Real and Personal Property 849
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to the bank. If Lenny dies of the liver ailment within a few weeks, Jane gets to keep the money.
The law permits the gift causa mortis to act as a kind of substitute for a will since the donor’s
delivery of the property clearly indicates his intentions. But note that this kind of gift is
revocable. Since a gift causa mortis is conditional (upon the donor’s death), the donor has the
right to revoke it at any time before he dies. If Lenny telephones Jane the next day and says that
he has changed his mind, he gets the money back. Further, if the donor recovers and does not
die as expected, the gift is automatically revoked.
EXAM Strategy
Question: Julie does good deeds for countless people, and many are deeply grateful.
On Monday, Wilson tells Julie, “You are a wonderful person, and I have a present for
you. I am giving you this baseball, which was the 500th home run hit by one of the great
players of all time.” He hands her the ball, which is worth nearly half a million dollars.
Julie’s good fortune continues on Tuesday, when another friend, Cassandra, tells
Julie, “I only have a few weeks to live. I want you to have this signed first edition of
Ulysses. It is priceless, and it is yours.” The book is worth about $200,000. On
Wednesday, Wilson and Cassandra decide they have been foolhardy, and both
demand that Julie return the items. Must she do so?
Strategy: Both of these donors are attempting to revoke their gifts. An inter vivos gift
cannot be revoked, but a gift causa mortis can be. To answer the question, you must
know what kind of gifts these were.
Result: A gift causa mortis is one made in fear of approaching death, and this rule
applies to Cassandra. Such a gift is revocable any time before the donor dies, so
Cassandra gets her book back. A gift inter vivos is one made without any such fear of
death. Most gifts fall in this category, and they are irrevocable. Wilson was not
anticipating his demise, so his was a gift inter vivos. Julie keeps the baseball.
34-11d Acceptance
The donee must accept the gift. This rarely leads to disputes, but if a donee should refuse a
gift and then change her mind, she is out of luck. Her repudiation of the donor’s offer means
there is no gift, and she has no rights in the property.
The following case offers a combination of love, alcohol, and diamonds—always
a volatile mix.
You Be the Judge
Facts: MichelleHarris and
Michael Albinger lived
together, on and off, for
three years. Their roller-
coaster relationship was
marred by alcohol abuse and violence.When they announced
their engagement, Albinger gave Harris a $29,000 diamond
ring, but the couple broke off their wedding plans because of
emotional and physical turmoil. Harris returned the ring.
Later, they reconciled and resumed their marriage plans,
and Albinger gave his fian-
cée the ring again. This
cycle repeated several
times over the three years.
Each time they broke off
their relationship, Harris returned the ring to Albinger, and
each time they made up, he gave it back to her.
On one occasion, Albinger held a knife over Harris as she
lay in bed, threatening to chop off her finger if she did not
remove the ring. He beat her and forcibly removed the ring.
ALBINGER V. HARRIS
2002 Mont. 118, 2002 WL 1226858
Montana Supreme Court, 2002
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The following table distinguishes between a contract and a gift:
A Contract and a Gift Distinguished
A Contract:
Lou: I will pay you $2,000 to paint the
house, if you promise to finish by July.
Abby: I agree to paint the house
by July 3, for $2,000.
Lou and Abby have a contract. Each promise is consideration in support of the
other promise. Lou and Abby can each enforce the other’s promise.
A Gift:
Lou hands Phil two opera tickets, saying:
I want you to have these two tickets to
Rigoletto.”
Phil says, “Hey, thanks.”
This is a valid inter vivos gift. Lou intended to transfer ownership immediately
and delivered the property to Phil, who now owns the tickets.
Neither Contract nor Gift:
Lou: You’re a great guy. Next week, I’m
going to give you two tickets to Rigoletto.
Jason: Hey, thanks.
There is no gift because Lou did not intend to transfer ownership immediately,
and he did not deliver the tickets. There is no contract because Jason has given no
consideration to support Lou’s promise.
Criminal charges were brought but then dropped when,
inevitably, the couple reconciled. Another time, Albinger told
her to “take the car, the horse, the dog, and the ring and get
the hell out.” Finally, mercifully, they ended their stormy
affair, and Harris moved to Kentucky—keeping the ring.
Albinger sued for the value of the ring. The trial court
found that the ring was a conditional gift, made in con-
templation of marriage, and ordered Harris to pay its full
value. She appealed. The Montana Supreme Court had to
decide, in a case of first impression, whether an engage-
ment ring was given in contemplation of marriage. (In
Montana, and many states, neither party to a broken
engagement may sue for breach of contract.)
You Be the Judge: Who owns the ring?
Argument for Harris: The main problem with calling
the ring a “conditional gift” is that there is no such thing.
The elements of a gift are intent, delivery, and acceptance,
and Harris has proved all three. A gift is not a contract, nor
is it a loan. Once a gift has been accepted, the donor has no
more rights in the property and may not demand its return.
Hundreds of years of litigation have resulted in only one
exception to this rule—a gift causa mortis—and despite
some cynical claims to the contrary, marriage is not death.
If this court carves a new exception to the longstanding
rule, other unhappy donors will dream up more “condi-
tions” that supposedly entitle them to their property. What
is more, to create a special rule for engagement rings would
be blatant gender bias because the exception would only
benefit men. This court should stick to settled law and
permit the recipient of a gift to keep it.
Argument for Albinger: The symbolism of an engage-
ment ring is not exactly news. For decades, Americans have
given rings—frequently diamond—in contemplation of mar-
riage. All parties understand why the gift is made and what is
expected if the engagement is called off: The ring must be
returned. Albinger’s intent, to focus on one element, was
conditional—and Michelle Harris understood that. Each
time the couple separated, she gave the ring back. She knew
that she could wear this beautiful ring in anticipation of their
marriage, but that custom and decency required its return if
the wedding was off. She knew it, that is, until greed got the
better of her and she fled to Kentucky, attempting to profit at
the expense of Albinger’s generosity. We are not asking for
new law, but for confirmation of what everyone has known
for generations: There is no wedding ring when there is no
wedding.
©
C
en
ga
ge
Le
ar
ni
ng
CHAPTER 34 Real and Personal Property 851
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34-12 BAILMENT
A bailment is the rightful possession of goods by someone who is not the owner. The one
who delivers the goods is the bailor and the one in possession is the bailee. Bailments are
common. Suppose that you are going out of town for the weekend and lend your motorcycle
to Stan. You are the bailor, and your friend is the bailee. When you check your suitcase with
the airline, you are again the bailor and the airline is the bailee. If you rent a car at your
destination, you become the bailee, while the rental agency is the bailor. In each case,
someone other than the true owner has rightful, temporary possession of personal property.
Parties generally create a bailment by agreement. In each of the examples above, the
parties agreed to the bailment. In two cases, the agreement included payment, which is
common but not essential. When you buy your airline ticket, you pay for your ticket, and
the price includes the airline’s agreement, as bailee, to transport your suitcase. When you
rent a car, you pay the bailor for the privilege of using it. By lending your motorcycle, you
engage in a bailment without either party paying compensation.
A bailment without any agreement is called a constructive or involuntary bailment.
Suppose that you find a wristwatch in your house that you know belongs to a friend. You are
obligated to return the watch to the true owner, and until you do so, you are the bailee,
liable for harm to the property. This is called a constructive bailment because, with no
agreement between the parties, the law is construing a bailment.
34-12a Control
To create a bailment, the bailee must assume physical
control of an item with intent to possess. A bailee may be
liable for loss or damage to the property, so it is not fair to hold
him liable unless he has taken physical control of the goods,
intending to possess them.
Disputes about whether someone has taken control
often arise in parking lot cases. When a car is damaged or
stolen, the lot’s owner may try to avoid liability by claiming it
lacked control of the parked auto and therefore was not a
bailee. If the lot is a “park and lock” facility, where the car’s
owner retains the key and the lot owner exercises no control at
all, there is probably no bailment and no liability for damage.
By contrast, when a driver leaves her keys with a
parking attendant, the lot clearly is exercising control of
the auto, and the parties have created a bailment. The lot
is probably liable for loss or damage in that case.
34-12b Rights of the Bailee
The bailee’s primary right is possession of the property. Anyone who interferes with the
bailee’s rightful possession is liable to her. Suppose that, after you lend your motorcycle to
Stan, Mel sees Stan park the bike, realizes Stan is not the owner, rides the motorcycle away,
and locks it up until you return. Mel is liable to Stan for any damages Stan suffered while
deprived of transportation.
Even a bailor is liable if he wrongfully takes back property from a bailee. If a car agency rents
Francine a car for a three-day weekend but then repossesses it for use elsewhere, it is liable to her
for any damages, even though it owns the car. The bailor must abide by the agreement.
The bailee is typically, though not always, permitted to use the property. Obviously, a
customer is permitted to drive a car rented from an agency. When a farmer lends his tractor
If you store your furniture
in a warehouse, the
storage company is your
bailee, but it has no right
to curl up in your bed.
Bailment
The rightful possession of
goods by someone who is not
the owner, usually by mutual
agreement between the bailor
and bailee.
Involuntary bailment
A bailment that occurs without
an agreement between the
bailor and bailee.
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to a neighbor, the bailee is entitled to use the machine for normal farm purposes. But some
bailees have no authority to use the goods. If you store your furniture in a warehouse, the storage
company is your bailee, but it has no right to curl up in your bed. The bailee may be entitled to
compensation. This depends upon the agreement. If Owner leaves a power boat at the boatyard
for repairs, the boatyard, a bailee, is entitled to payment for the work it does. As with any
contract, the exact compensation should be clearly agreed upon before any work begins. If there
is no agreement, the boatyard will probably receive the reasonable value of its services.
34-12c Duties of the Bailee
The bailee is strictly liable to redeliver the goods on time to the bailor, or to whomever the
bailor designates. Strict liability means there are virtually no exceptions. Rudy stores his
$6,000 drum set with Melissa’s Warehouse while he is on vacation. Blake arrives at the
warehouse and shows a forged letter, supposedly from Rudy, granting Blake permission to
remove the drums. If Melissa permits Blake to take the drums, she will owe Rudy $6,000,
even if the forgery was a high-quality job.
DUE CARE
The bailee is obligated to exercise due care. The level of care required depends upon who
receives the benefit of the bailment. There are three possibilities:
• Sole benefit of bailee. If the bailment is for the sole benefit of the bailee, the bailee is
required to use extraordinary care with the property. Generally, in these cases, the
bailor lends something for free to the bailee. Since the bailee is paying nothing for the
use of the goods, most courts consider her the only one to benefit from the bailment.
If your neighbor lends you a power lawn mower, the bailment is probably for your
sole benefit. You are liable if you are even slightly inattentive in handling the lawn
mower and can expect to pay for virtually any harm done.
• Mutual benefit. When the bailment is for the mutual benefit of bailor and bailee,
the bailee must use ordinary care with the property. Ordinary care is what a reasonably
prudent person would use under the circumstances. When you rent a car, you benefit
from the use of the car, and the agency profits from the fee you pay. When the airline
hauls your suitcase to your destination, both parties benefit. Most bailments benefit
both parties, and courts decide the majority of bailment disputes under this standard.
• Sole benefit of bailor. When the bailment benefits only the bailor, the bailee must use
only slight care. This kind of bailment is called a gratuitous bailment, and the bailee
is liable only for gross negligence. Sheila enters a pie-eating contest and asks you to
hold her $14,000 diamond engagement ring while she competes. You put the ring in
your pocket. Sheila wins the $20 first prize, but the ring has disappeared. This was a
gratuitous bailment, and you are not liable to Sheila unless she can prove gross
negligence on your part. If the ring dropped from your pocket or was stolen, you are
not liable. If you used the ring to play catch with friends, you are liable.
BURDEN OF PROOF
In an ordinary negligence case, the plaintiff has the burden of proof to demonstrate that the
defendant was negligent and caused the harm alleged. In bailment cases, the burden of
proof is reversed. Once the bailor has proven the existence of a bailment and loss or harm to
the goods, a presumption of negligence arises, and the burden shifts to the bailee to prove
adequate care. This is a major change from ordinary negligence cases. Georgina’s car is
struck by another auto. If Georgina sues for negligence, it is her burden to prove that
the defendant was driving unreasonably and caused the harm. By comparison, assume
that Georgina rents Chance her sailboat for a month. At the end of the month, Chance
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announces that the boat is at the bottom of Lake Michigan. If Georgina sues Chance,
she only needs to demonstrate that the parties had a bailment and that Chance failed to
return the boat. The burden then shifts to Chance to prove that the boat was lost
through no fault of his own. If Chance cannot meet that burden, Georgina recovers the
full value of the boat.
The following case raises many of the issues in this section. Long before his time as
president, Abraham Lincoln was a lawyer who argued more than 150 cases before the
Supreme Court of Illinois. The case for Weedman is modeled after the arguments that a
young Lincoln actually made.
34-12d Rights and Duties of the Bailor
The bailor’s rights and duties are the reverse of the bailee’s. The bailor is entitled to the
return of his property on the agreed-upon date. He is also entitled to receive the property in
good condition and to recover damages for harm to the property if the bailee failed to use
adequate care.
Chapter Conclusion
Real property law is ancient but forceful. Although real property today is not the dominant
source of wealth that it was in medieval England, it is still the greatest asset that most
people will ever possess—and it is worth understanding.
You Be the Judge
Facts: Johnson left his
horse withWeedman, pay-
ing him to board and feed
the animal. Johnson did
not grant Weedman per-
mission to ride the horse.
Nonetheless, Weedman took the horse for a 15-mile ride.
Later that day, the horse died. However, the trial
court found that Weedman had not abused the animal
and that the ride had not caused the horse’s death. The
court did not grant damages to Johnson, and Johnson
appealed.
You Be the Judge: Should Weedman pay for Johnson’s
dead horse?
Argument for Johnson: Your honor, Weedman was in
possession of my client’s horse only to feed him and see to
his basic needs. My client did not give him permission to
take the horse out of the
pasture. Weedman made
personal use of my client’s
property when he took a
15-mile ride that was in no
way necessary. The trial
court’s finding that Weedman did not abuse the horse
during the ride is irrelevant. My client must be
compensated for the loss of his animal.
Argument for Weedman: My client had a legal right to
possession of the horse. Riding the horse was not a
substantial abuse of his rights as bailee. The horse was
returned to the pasture in good condition. It was not
abandoned and was not devalued in any way by the ride.
The plaintiff is therefore not entitled to any
compensation. The coincidental death of the horse does
not change that fact.
JOHNSON V. WEEDMAN
5 III. 495
Supreme Court of Illinois, 1843
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EXAM REVIEW
1. REAL PROPERTY; FIXTURES Real property includes land, buildings, air and
subsurface rights, plant life, and fixtures. A fixture is any good that has become
attached to other real property, such as land. (pp. 833–834)
Question: Paul and Shelly Higgins had two wood stoves in their home. Each
rested on, but was not attached to, a built-in brick platform. The downstairs wood
stove was connected to the chimney flue and was used as part of the main heating
system for the house. The upstairs stove, in the master bedroom, was purely
decorative. It had no stovepipe connecting it to the chimney. The Higginses sold
their house to Jack Everitt, and neither party said anything about the two stoves.
Is Everitt entitled to either stove? Both stoves?
Strategy: An object is a fixture if a reasonable person would consider the item to
be a permanent part of the property, taking into account attachment, adaptation,
and other objective manifestations of permanence. (See the “Result” at the end of
this section.)
2. CONCURRENT ESTATES When two or more people own real property at the
same time, they have a concurrent estate. In both a tenancy in common and a joint
tenancy, all owners have a share in the entire property. The primary difference is
that joint tenants have the right of survivorship, meaning that when a joint tenant
dies, his interest passes to the other joint tenants. A tenant in common has the power
to leave her estate to her heirs. (pp. 834–837)
Question: Howard Geib, Walker McKinney, and John D. McKinney owned
two vacation properties as joint tenants with right of survivorship. The parties
were not getting along well, and Geib petitioned the court to partition the
properties. The trial court ruled that the fairest way to do this was to sell both
properties and divide the proceeds. The two McKinneys appealed, claiming that
a partition by sale was improper because it would destroy their right of
survivorship. Comment.
Strategy: Do joint tenants have a right to partition? Are there any limits on that
right? (See the “Result” at the end of this section.)
3. NONPOSSESSORY INTERESTS Some valuable interests in real property do
not involve possession. Easements, profits, and licenses grant limited rights to use
property owned by someone else. (pp. 837–838)
4. GOVERNMENT REGULATION Nuisance law, zoning ordinances, and
eminent domain all permit a government to regulate property and, in some cases, to
take it for public use. (pp. 838–839)
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5. LANDLORD-TENANT When an owner of a freehold estate allows another
person temporary, exclusive possession of the property, the parties have created a
landlord-tenant relationship. (p. 840)
6. TENANCIES Any lease for a stated, fixed period is a tenancy for years. A
periodic tenancy is created for a fixed period and then automatically continues for
additional periods until either party notifies the other of termination. A tenancy at
will has no fixed duration and may be terminated by either party at any time. A
tenancy at sufferance occurs when a tenant remains, against the wishes of the
landlord, after the expiration of a true tenancy. (pp. 840–841)
7. QUIET ENJOYMENT All tenants are entitled to the quiet enjoyment of the
premises, without the interference of the landlord. (p. 842)
8. SECURITY DEPOSITS Landlords may require tenants to post a deposit that
can be used to pay for repairs if a tenant damages the property. But many landlords
fail to promptly return security deposits to tenants who leave no damage behind. In
those cases, tenants are often able to sue for as much as three times their security
deposit. (p. 844)
9. RENT The tenant is obligated to pay the rent, and the landlord may evict for
nonpayment. The modern trend is to require a landlord to mitigate damages caused
by a tenant who abandons the premises before the lease expires. (pp. 845–846)
Question: Loren Andreo leased retail space in his shopping plaza to Tropical Isle
Pet Shop for five years, at a monthly rent of $2,100. Tropical Isle vacated the
premises 18 months early, turned in the key to Andreo, and acknowledged
liability for the unpaid rent. Andreo placed a FOR RENT sign in the store window
and spoke to a commercial real estate broker about the space. But he did not enter
into a formal listing agreement with the broker, or take any other steps to rent the
space, for about nine months. With approximately nine months remaining on the
unused part of Tropical’s lease, Andreo hired a commercial broker to rent the
space. He also sued Tropical for 18 months’ rent. Comment.
Strategy: When a tenant abandons leased property early, the landlord is
obligated to mitigate damages. Did Andreo? (See the “Result” at the end of this
section.)
10. TENANT’S LIABILITY A tenant is liable to the landlord for any significant
damage he causes to the property. A tenant is also generally liable for injuries
occurring within the premises she is leasing. (p. 847)
11. PERSONAL INJURY At common law, a landlord had very limited liability for
injuries on the premises, but today, many courts require a landlord to use reasonable
care and hold her liable for foreseeable harm. (p. 847)
12. GIFTS A gift is a voluntary transfer of property from one person to another
without consideration. The elements of a gift are intention to transfer ownership
immediately, delivery, and acceptance. (pp. 848–851)
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13. BAILMENT A bailment is the rightful possession of goods by one who is not the
owner. The one who delivers the goods is the bailor, and the one in possession is the
bailee. To create a bailment, the bailee must assume physical control with intent to
possess. (pp. 852–854)
14. BAILEE’S RIGHTS The bailee is always entitled to possess the property, is
frequently allowed to use it, and may be entitled to compensation. (pp. 852–853)
15. BAILEE’S DUTY OF CARE The bailee is obligated to exercise due care. The
level of care required depends upon who receives the benefit of the bailment: If the
bailee is the sole beneficiary, she must use extraordinary care; if the parties mutually
benefit, the bailee must use ordinary care; and if the bailor is the sole beneficiary of
the bailment, the bailee must use only slight care. (p. 853)
1. Result: A buyer normally takes all fixtures. The downstairs stove was perma-
nently attached to the house and used as part of the heating system. The owner
who installed it intended that it remain, and it was a fixture; Everitt got it. The
upstairs stove was not permanently attached and was not a fixture; the sellers could
take it with them.
2. Result: The McKinneys lost. Any co-tenant (including a joint tenant) has an
absolute right to partition. Difficulties in partitioning are irrelevant.
9. Result: For about nine months, Andreo made no serious effort to lease the store.
The court rejected his rent claim for that period, permitting him to recover unpaid
money only for the period he made a genuine effort to lease the space.
MULTIPLE-CHOICE QUESTIONS
1. Quick, Onyx, and Nash were deeded a piece of land as tenants in common. The deed
provided that Quick owned one-half the property and Onyx and Nash owned one-
quarter each. If Nash dies, the property will be owned as follows:
(a) Quick 1/2, Onyx 1/2
(b) Quick 5/8, Onyx 3/8
(c) Quick 1/3, Onyx 1/3, Nash’s heirs 1/3
(d) Quick 1/2, Onyx 1/4, Nash’s heirs 1/4
2. Which of the following forms of tenancy will be created if a tenant stays in possession
of leased premises without the landlord’s consent, after the tenant’s one-year written
lease expires?
(a) Tenancy at will
(b) Tenancy for years
(c) Periodic tendency
(d) Tenancy at sufferance
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3. Consider the following:
I. A house (value: $150,000)
II. A giant high-definition television in the house (value: $4,999)
III. The land that the house sits upon (value: $30,000)
IV. An old car in the house’s garage (value: $5,001) How many of these items are
personal property?
(a) All four of them
(b) Three of them
(c) Two of them
(d) One of them
(e) None of them
4. Holding out an envelope, Alan says, “Ben, I’m giving you these opera tickets.”
Without taking the envelope, Ben replies, “Why would I want opera tickets? Loser.”
Alan leaves, crestfallen. Later that day, a girl whom Ben has liked for some time says,
“I sure wish I were going to the opera tonight.” Ben scrambles, calls Alan, and says,
“Alan, old buddy, I accept your gift of the opera tickets. I’m on my way over to pick
them up.”
Does Ben have a legal right to the tickets?
(a) Yes, because Alan intended to transfer ownership.
(b) Yes, because offers to give gifts cannot be revoked.
(c) No, because no consideration was given.
(d) No, because Ben did not accept the gift when offered.
5. A tenant renting an apartment under a three-year written lease that does not contain
any specific restrictions may be evicted for:
(a) counterfeiting money in the apartment.
(b) keeping a dog in the apartment.
(c) failing to maintain a liability insurance policy on the apartment.
(d) making structural repairs to the apartment.
ESSAY QUESTIONS
1. YOU BE THE JUDGE WRITING PROBLEM Frank Deluca and his son David
owned the Sportsman’s Pub on Fountain Street in Providence, Rhode Island. The
Delucas applied to the city for a license to employ topless dancers in the pub. Did
the city have the power to deny the Delucas’ request? Argument for the Delucas:
Our pub is perfectly legal. Further, no law in Rhode Island prohibits topless
dancing. We are morally and legally entitled to present this entertainment. The city
should not use some phony moralizing to deny customers what they want.
Argument for Providence: This section of Providence is zoned to prohibit topless
dancing, just as it is zoned to bar manufacturing. There are other parts of town
where the Delucas can open one of their sleazy clubs if they want to, but we are
entitled to deny a permit in this area.
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2. Kenmart Realty sued to evict Mr. and Ms. Alghalabio for nonpayment of rent and
sought the unpaid monies, totaling several thousand dollars. In defense, the
Alghalabios claimed that their apartment was infested with rats. They testified that
there were numerous rat holes in the walls of the living room, bedroom, and kitchen,
that there were rat droppings all over the apartment, and that on one occasion, they
saw their toddler holding a live rat. They testified that the landlord had refused
numerous requests to exterminate. Please rule on the landlord’s suit.
3. Lisa Preece rented an apartment from Turman Realty, paying a $300 security deposit.
Georgia law states: “Any landlord who fails to return any part of a security deposit
which is required to be returned to a tenant pursuant to this article shall be liable to
the tenant in the amount of three times the sum improperly withheld plus reasonable
attorney’s fees.” When Preece moved out, Turman did not return her security
deposit, and she sued for triple damages plus attorney’s fees, totaling $1,800. Turman
offered evidence that its failure to return the deposit was inadvertent and that it had
procedures reasonably designed to avoid such errors. Is Preece entitled to triple
damages? Attorney’s fees?
4. Ronald Armstead worked for First American Bank as a courier. His duties
included making deliveries between the bank’s branches in Washington, D.C.
Armstead parked the bank’s station wagon near the entrance of one branch in
violation of a sign saying: NO PARKING—RUSH HOUR ZONE. In the rear luggage
section of the station wagon were four locked bank dispatch bags containing
checks and other valuable documents. Armstead had received tickets for illegal
parking at this spot on five occasions. Shortly after Armstead entered the bank, a
tow truck arrived, and its operator prepared to tow the station wagon.
Transportation Management, Inc., operated the towing service on behalf of the
District of Columbia. Armstead ran out to the vehicle and told the tow truck
operator that he was prepared to drive the vehicle away immediately. But the
operator drove away with the station wagon in tow. One-and-a-half hours later, a
bank employee paid for the car’s release, but one dispatch bag, containing
documents worth $107,000, was missing. First American sued Transportation
Management and the District of Columbia. The defendants sought summary
judgment, claiming they could not be liable. Were they correct?
5. YOU BE THE JUDGE WRITING PROBLEM Eileen Murphy often cared for
her elderly neighbor, Thomas Kenney. He paid her $25 per day for her help and once
gave her a bank certificate of deposit worth $25,000. She spent the money. Murphy
alleged that shortly before his death, Kenney gave her a large block of shares in three
corporations. He called his broker, intending to instruct him to transfer the shares to
Murphy’s name, but the broker was ill and unavailable. So Kenney told Murphy to
write her name on the shares and keep them, which she did. Two weeks later,
Kenney died. When Murphy presented the shares to Kenney’s broker to transfer
ownership to her, the broker refused because Kenney had never endorsed the shares
as the law requires—that is, signed them over to Murphy. Was Murphy entitled to the
$25,000? To the shares? Argument for Murphy: The purpose of the law is to do what
a donor intended, and it is obvious that Kenney intended Murphy to have the $25,000
and the shares. Why else would he have given them to her? A greedy estate should
not be allowed to interfere with the deceased’s intentions. Argument for the Estate:
Murphy is not entitled to the $25,000 because we have no way of knowing what
Kenney’s intentions were when he gave her the money. She is not entitled to the
shares of stock because Kenney’s failure to endorse them over to her meant he never
delivered them, and that is an essential element of a gift.
CHAPTER 34 Real and Personal Property 859
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DISCUSSION QUESTIONS
1. Is it sensible to distinguish between inter vivos gifts
and gifts causa mortis? Should someone “on his
deathbed” be able to change his mind so easily?
2. Donny Delt and Sammy Sigma are students and
roommates. They lease a house in a
neighborhood near campus. Few students live
on the block. The students do not have large
parties, but they often have friends over at
night. The friends sometimes play high-volume
music in their cars and sometimes speak loudly
when going to and from their cars. Also,
departing late-night guests often leave beer cans
and fast-food wrappers in the street.
Neighbors complain about being awakened
in the wee hours of the morning. They are
considering filing a nuisance lawsuit against
Donny and Sammy. Would such an action be
reasonable? Do you think Donny and Sammy are
creating a nuisance? If so, why? If not, where is
the line—what amount of late-night noise does
amount to a nuisance?
3. Imagine that you sign a lease and that you are to
move into your new apartment on August 15.
When you arrive, the previous tenant has not
moved out. In fact, he has no intention of moving
out. Should the landlord be in charge of getting rid
of the old tenant, or should you have the obligation
to evict him?
4. When landlords wrongfully withhold security
deposits, they can often be sued for three times the
amount of the security deposit. Is this reasonable?
Should a landlord have to pay $3,000 for a $1,000
debt? What if you fail to pay a rent on time? Should
you have to pay three times the amount of your
normal rent? If your answers to these two questions
are different, why?
5. In the case of a gratuitous bailment, the bailee is
liable only if he is grossly negligent. Is this good
policy? If you agree to watch someone’s property,
shouldn’t you be required to be careful even if you
are not being paid?
860 U N I T 4 Employment, Business Organizations and Property
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APPENDIXA
THE CONSTITUTION OF THE UNITED STATES
Preamble We the People of the United States, in Order to form a
more perfect Union, establish Justice, insure domestic
Tranquility, provide for the common defense, promote
the general Welfare, and secure the Blessings of Liberty
to ourselves and our Posterity, do ordain and establish this
Constitution for the United States of America.
ARTICLE I
Section 1. All legislative Powers herein granted shall be vested in a Congress of the United
States, which shall consist of a Senate and House of Representatives.
Section 2. The House of Representatives shall be composed of Members chosen every second
Year by the People of the several States, and the Electors in each State shall have the
Qualifications requisite for Electors of the most numerous Branch of the State
Legislature.
No Person shall be a Representative who shall not have attained to the Age of twenty
five Years, and been seven Years a Citizen of the United States, and who shall not,
when elected, be an Inhabitant of that State in which he shall be chosen.
Representatives and direct Taxes shall be apportioned among the several States
which may be included within this Union, according to their respective Numbers,
which shall be determined by adding to the whole Number of free Persons, includ-
ing those bound to Service for a Term of Years, and excluding Indians not taxed,
three fifths of all other Persons. The actual Enumeration shall be made within three
Years after the first Meeting of the Congress of the United States, and within every
subsequent Term of ten Years, in such Manner as they shall by Law direct. The
number of Representatives shall not exceed one for every thirty Thousand, but each
State shall have at Least one Representative; and until such enumeration shall be
made, the State of New Hampshire shall be entitled to chuse three, Massachusetts
eight, Rhode Island and Providence Plantations one, Connecticut five, New-York
six, New Jersey four, Pennsylvania eight, Delaware one, Maryland six, Virginia ten,
North Carolina five, South Carolina five, and Georgia three.
When vacancies happen in the Representation from any State, the Executive
Authority thereof shall issue Writs of Election to fill such vacancies.
The House of Representatives shall chuse their Speaker and other Officers; and shall
have the sole Power of Impeachment.
Section 3. The Senate of the United States shall be composed of two Senators from each State,
chosen by the Legislature thereof, for six Years; and each Senator shall have
one Vote.
A1
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Immediately after they shall be assembled in Consequence of the first Election, they
shall be divided as equally as may be into three Classes. The Seats of the Senators of
the first Class shall be vacated at the Expiration of the second Year, of the second
Class at the Expiration of the fourth Year, and of the third Class at the Expiration of
the sixth Year, so that one third may be chosen every second Year; and if Vacancies
happen by Resignation or otherwise, during the Recess of the Legislature of any
State, the Executive thereof may make temporary Appointments until the next
Meeting of the Legislature, which shall then fill such Vacancies.
No Person shall be a Senator who shall not have attained to the Age of thirty Years,
and been nine Years a Citizen of the United States, and who shall not, when elected,
be an Inhabitant of that State for which he shall be chosen.
The Vice President of the United States shall be President of the Senate, but shall
have no Vote, unless they be equally divided.
The Senate shall chuse their other Officers, and also a President pro tempore, in the
Absence of the Vice President, or when he shall exercise the Office of President of
the United States.
The Senate shall have the sole power to try all Impeachments. When sitting for that
Purpose, they shall be an Oath or Affirmation. When the President of the United
States is tried, the Chief Justice shall preside: And no Person shall be convicted
without the Concurrence of two thirds of the Members present.
Judgment in Cases of Impeachment shall not extend further than to removal from
Office, and disqualification to hold and enjoy any Office of honor, Trust or Profit
under the United States: but the Party convicted shall nevertheless be liable and
subject to Indictment, Trial, Judgment and Punishment, according to Law.
Section 4. The Times, Places and Manner of holding Elections for Senators and Representa-
tives, shall be prescribed in each State by the Legislature thereof: but the Congress
may at any time by Law make or alter such Regulations, except as to the Places of
chusing Senators.
The Congress shall assemble at least once in every Year, and such Meeting shall be
on the first Monday in December, unless they shall by Law appoint a different Day.
Section 5. Each House shall be the Judge of the Elections, Returns and Qualifications of its
own Members, and a Majority of each shall constitute a Quorum to do Business; but a
smaller Number may adjourn from day to day, and may be authorized to compel the
Attendance of absent Members, in such Manner, and under such Penalties as each
House may provide.
Each House may determine the Rules of its Proceedings, punish its Members for
disorderly Behaviour, and, with the Concurrence of two thirds, expel a Member.
Each House shall keep a Journal of its Proceedings, and from time to time publish
the same, excepting such Parts as may in their Judgment require Secrecy; and the
Yeas and Nays of the Members of either House on any question shall, at the Desire
of one fifth of those Present, be entered on the Journal.
Neither House, during the Session of Congress, shall, without the Consent of the
other, adjourn for more than three days, nor to any other Place than that in which the
two Houses shall be sitting.
Section 6. The Senators and Representatives shall receive a Compensation for their Services, to
be ascertained by Law, and paid out of the Treasury of the United States. They shall
in all Cases, except Treason, Felony and Breach of the Peace, be privileged from
Arrest during their Attendance at the Session of their respective Houses, and in going
to and returning from the same; and for any Speech or Debate in either House, they
shall not be questioned in any other Place.
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No Senator or Representative shall, during the Time for which he was elected, be
appointed to any civil Office under the Authority of the United States, which shall
have been created, or the Emoluments whereof shall have been encreased during
such time; and no Person holding any Office under the United States, shall be a
Member of either House during his Continuance in Office.
Section 7. All Bills for raising Revenue shall originate in the House of Representatives; but the
Senate may propose or concur with Amendments as on other Bills.
Every Bill which shall have passed the House of Representatives and the Senate,
shall, before it become a Law, be presented to the President of the United States; If
he approve he shall sign it, but if not he shall return it, with his Objections to that
House in which it shall have originated, who shall enter the Objections at large on
their Journal, and proceed to reconsider it. If after such Reconsideration two thirds of
that House shall agree to pass the Bill, it shall be sent, together with the Objections,
to the other House, by which it shall likewise be reconsidered, and if approved by
two thirds of that House, it shall become a Law. But in all such Cases the Votes of
both Houses shall be determined by Yeas and Nays, and the Names of the Persons
voting for and against the Bill shall be entered on the Journal of each House
respectively. If any Bill shall not be returned by the President within ten Days
(Sundays excepted) after it shall have been presented to him, the Same shall be a
Law, in like Manner as if he had signed it, unless the Congress by their Adjournment
prevent its Return, in which Case it shall not be a Law.
Every Order, Resolution, or Vote to which the Concurrence of the Senate and House
of Representatives may be necessary (except on a question of Adjournment) shall be
presented to the President of the United States; and before the Same shall take
Effect, shall be approved by him, or being disapproved by him, shall be repassed by
two thirds of the Senate and House of Representatives, according to the Rules and
Limitations prescribed in the Case of a Bill.
Section 8. The Congress shall have Power to lay and collect Taxes, Duties, Imposts and Excises, to
pay the Debts and provide for the common Defence and general Welfare of the United
States; but all Duties, Imposts and Excises shall be uniform throughout theUnited States;
To borrow Money on the credit of the United States;
To regulate Commerce with foreign Nations, and among the several States, and with
the Indian Tribes;
To establish an uniform Rule of Naturalization, and uniform Laws on the subject of
Bankruptcies throughout the United States;
To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard
of Weights and Measures;
To provide for the Punishment of counterfeiting the Securities and current Coin of
the United States;
To establish Post Offices and post Roads;
To promote the Progress of Science and useful Arts, by securing for limited Times
to Authors and Inventors the exclusive Right to their respectiveWritings andDiscoveries;
To constitute Tribunals inferior to the Supreme Court;
To define and punish Piracies and Felonies committed on the high Seas, and
Offenses against the Law of Nations;
To declare War, grant Letters of Marque and Reprisal, and make Rules concerning
Captures on Land and Water;
To raise and support Armies, but no Appropriation of Money to that Use shall be for
a longer Term than two Years;
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To provide and maintain a Navy;
To make Rules for the Government and Regulation of the land and naval Forces;
To provide for calling forth the Militia to execute the Laws of the Union, suppress
Insurrections and repel Invasions;
To provide for organizing, arming, and disciplining, the Militia, and for governing
such Part of them as may be employed in the Service of the United States, reserving
to the States respectively, the Appointment of the Officers, and the Authority of
training the Militia according to the discipline described by Congress;
To exercise exclusive Legislation in all Cases whatsoever, over such District (not
exceeding ten Miles square) as may, by Cession of particular States, and the Accep-
tance of Congress, become the Seat of the Government of the United States, and to
exercise like Authority over all Places purchased by the Consent of the Legislature of
the State in which the Same shall be, for the Erection of Forts, Magazines, Arsenals,
dock-Yards, and other needful Buildings;—And
To make all Laws which shall be necessary and proper for carrying into Execution
the foregoing Powers, and all other Powers vested by this Constitution in the
Government of the United States, or in any Department or Officer thereof.
Section 9. The Migration or Importation of such Persons as any of the States now existing shall
think proper to admit, shall not be prohibited by the Congress prior to the Year one
thousand eight hundred and eight, but a Tax or Duty may be imposed on such
Importation, not exceeding ten dollars for each Person.
The Privilege of the Writ of Habeas Corpus shall not be suspended, unless when in
Cases of Rebellion or Invasion the public Safety may require it.
No Bill of Attainder or ex post facto Law shall be passed.
No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census
or Enumeration herein before directed to be taken.
No Tax or Duty shall be laid on Articles exported from any State.
No Preference shall be given by any Regulation of Commerce or Revenue to the
Ports of one State over those of another; nor shall Vessels bound to, or from, one
State, be obliged to enter, clear, or pay Duties in another.
No Money shall be drawn from the Treasury, but in Consequence of Appropriations
made by Laws; and a regular Statement and Account of the Receipts and Expendi-
tures of all public Money shall be published from time to time.
No Title of Nobility shall be granted by the United States: And no Person holding
any Office of Profit or Trust under them, shall, without the Consent of the Congress,
accept of any present, Emolument, Office, or Title, of any kind whatever, from any
King, Prince, or foreign State.
Section 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of
Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold
and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto
Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.
No State shall, without the Consent of the Congress, lay any Imposts or Duties on
Imports or Exports, except what may be absolutely necessary for executing its
inspection Laws: and the net Produce of all Duties and Imposts, laid by any State
on Imports or Exports, shall be for the Use of the Treasury of the United States; and
all such Laws shall be subject to the Revision and Controul of the Congress.
No State shall, without the Consent of Congress, lay any Duty of Tonnage, keep
Troops, or Ships of War in time of Peace, enter into any Agreement or Compact with
another State, or with a foreign Power, or engage in War, unless actually invaded, or
in such imminent Danger as will not admit of delay.
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ARTICLE II
Section 1. The executive Power shall be vested in a President of the United States of America.
He shall hold his Office during the Term of four Years, and, together with the Vice
President, chosen for the same Term, be elected, as follows:
Each State shall appoint, in suchManner as the Legislature thereof may direct, a Number
of Electors, equal to the whole Number of Senators and Representatives to which the
State may be entitled in the Congress: but no Senator or Representative, or Person
holding anOffice of Trust or Profit under theUnited States, shall be appointed anElector.
The Electors shall meet in their respective States, and vote by Ballot for two Persons,
of whom one at least shall not be an Inhabitant of the same State with themselves.
And they shall make a list of all the Persons voted for, and of the Number of Votes
for each; which List they shall sign and certify, and transmit sealed to the Seat of the
Government of the United States, directed to the President of the Senate. The
President of the Senate shall, in the presence of the Senate and House of Repre-
sentatives, open all the Certificates, and the Votes shall be counted. The Person
having the greatest Number of Votes shall be the President, if such Number be a
Majority of the whole Number of Electors appointed; and if there be more than one
who have such Majority, and have an equal Number of Votes, then the House of
Representatives shall immediately chuse by Ballot one of them for President; and if
no Person have a Majority, then from the five highest on the List the said House
shall in like Manner chuse the President. But in chusing the President, the Votes
shall be taken by States, the Representation from each State having one Vote; A
quorum for this Purpose shall consist of a Member or Members from two thirds of the
States, and a Majority of all the States shall be necessary to a Choice. In every Case,
after the Choice of the President, the Person having the greatest Number of Votes of
the Electors shall be the Vice President. But if there should remain two or more who
have equal Votes, the Senate shall chuse from them by Ballot the Vice President.
The Congress may determine the Time of Chusing the Electors, and the Day on which
they shall give their Votes; which Day shall be the same throughout the United States.
No Person except a natural born Citizen, or a Citizen of the United States, at the time
of the Adoption of this Constitution, shall be eligible to the Office of President; neither
shall any Person be eligible to that Office who shall not have attained to the Age of
thirty five Years, and been fourteen Years a Resident within the United States.
In Case of the Removal of the President from Office, or of his Death, Resignation, or
Inability to discharge the Powers and Duties of the said Office, the Same shall
devolve on the Vice President, and the Congress may by Law provide for the Case
of Removal, Death, Resignation or Inability, both of the President and Vice Pre-
sident, declaring what Officer shall then act as President, and such Officer shall act
accordingly, until the Disability be removed, or a President shall be elected.
The President shall, at stated Times, receive for his Services, a Compensation, which
shall neither be encreased nor diminished during the Period for which he shall have
been elected, and he shall not receive within that Period any other Emolument from
the United States, or any of them.
Before he enter on the Execution of his Office, he shall take the following Oath or
Affirmation:—“I do solemnly swear (or affirm) that I will faithfully execute the
Office of President of the United States, and will to the best of my Ability, preserve,
protect and defend the Constitution of the United States.”
Section 2. The President shall be Commander in Chief of the Army and Navy of the United
States, and of the Militia of the several States, when called into the actual Service of
the United States; he may require the Opinion, in writing, of the principal Officer in
each of the executive Departments, upon any Subject relating to the Duties of their
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respective Offices, and he shall have Power to grant Reprieves and Pardons for
Offenses against the United States, except in Cases of Impeachment.
He shall have Power, by and with the Advice and Consent of the Senate, to make
Treaties, providing two thirds of the Senators present concur; and he shall nominate,
and by and with the Advice and Consent of the Senate, shall appoint Ambassadors,
other public Ministers and Consuls, Judges of the supreme Court, and all other
Officers of the United States, whose Appointments are not herein otherwise pro-
vided for, and which shall be established by Law: but the Congress may by Law vest
the Appointment of such inferior Officers, as they think proper, in the President
alone, in the Courts of Law, or in the Heads of Departments.
The President shall have Power to fill up all Vacancies that may happen during the
Recess of the Senate, by granting Commissions which shall expire at the End of their
next Session.
Section 3. He shall from time to time give to the Congress Information of the State of the Union,
and recommend to their Consideration such Measures as he shall judge necessary
and expedient; he may, on extraordinary Occasions, convene both Houses, or either
of them, and in Case of Disagreement between them, with Respect to the Time of
Adjournment, he may adjourn them to such Time as he shall think proper, he shall
receive Ambassadors and other public Ministers; he shall take Care that the Laws be
faithfully executed, and shall Commission all the Offices of the United States.
Section 4. The President, Vice President and all civil Officers of the United States, shall be
removed from Office on Impeachment for, and Conviction of, Treason, Bribery, or
other high Crimes and Misdemeanors.
ARTICLE III
Section 1. The judicial Power of the United States, shall be vested in one supreme Court, and
in such inferior Courts as the Congress may from time to time ordain and establish.
The Judges, both of the supreme and inferior Courts, shall hold their Offices during
good Behaviour, and shall, at Times, receive for their Services, a Compensation,
which shall not be diminished during their Continuance in Office.
Section 2. The judicial Power shall extend to all Cases, in Law and Equity, arising under this
Constitution, the Laws of the United States, and Treaties made, or which shall be
made, under their Authority;—to all Cases affecting Ambassadors, other public
Ministers and Consuls;—to all Cases of admiralty and maritime Jurisdiction;—to
Controversies to which the United States shall be a Party;—to controversies between
two or more States;—between a State and Citizens of another State;—between
Citizens of different States;—between Citizens of the same State claiming Lands
under Grants of different States; and between a State, or the Citizens thereof, and
foreign States, Citizens or Subjects.
In all Cases affecting Ambassadors, other public Ministers and Consuls, and those in
which a State shall be Party, the supreme Court shall have original Jurisdiction. In all
the other Cases before mentioned, the supreme Court shall have appellate Jurisdic-
tion, both as to Law and Fact, with such Exceptions, and under such Regulations as
the Congress shall make.
The Trial of all Crimes, except in Cases of Impeachment, shall be by Jury; and such
Trial shall be held in the State where the said Crimes shall have been committed;
but when not committed within any State, the Trial shall be at such Place or Places
as the Congress may by Law have directed.
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Section 3. Treason against the United States, shall consist only in levying War against them, or
in adhering to their Enemies, giving them Aid and Comfort. No Person shall be
convicted of Treason unless on the Testimony of two Witnesses to the same overt
Act, or on Confession in open Court.
The Congress shall have Power to declare the Punishment of Treason, but no
Attainder of Treason shall work Corruption of Blood, or Forfeiture except during
the Life of the Person attainted.
ARTICLE IV
Section 1. Full Faith and Credit shall be given in each State to the public Acts, Records, and
judicial Proceedings of every other State. And the Congress may by general Laws
prescribe the Manner in which such Acts, Records and Proceedings shall be proved,
and the Effect thereof.
Section 2. The Citizens of each State shall be entitled to all Privileges and Immunities of
Citizens in the several States.
A Person charged in any State with Treason, Felony, or other Crime, who shall flee
from Justice, and be found in another State, shall on Demand of the executive
Authority of the State from which he fled, be delivered up, to be removed to the
State having Jurisdiction of the Crime.
No Person held to Service or Labour in one State, under the Laws thereof, escaping
into another, shall, in Consequence of any Law or Regulation therein, be discharged
from such Service or Labour, but shall be delivered up on Claim of the Party to
whom such Service or Labour may be due.
Section 3. New States may be admitted by the Congress into this Union; but no new State shall
be formed or erected within the Jurisdiction of any other State; nor any State be
formed by the Junction of two or more States, or Parts of States, without the Consent
of the Legislatures of the States concerned as well as the Congress.
The Congress shall have Power to dispose of and make all needful Rules and
Regulations respecting the Territory or other Property belonging to the United
States; and nothing in this Constitution shall be so construed as to Prejudice any
Claims of the United States, or of any particular State.
Section 4. The United States shall guarantee to every State in this Union a Republican Form of
Government, and shall protect each of them against Invasion; and on Application of
the Legislature, or of the Executive (when the Legislature cannot be convened)
against domestic Violence.
ARTICLE V
The Congress, whenever two thirds of both Houses shall deem it necessary, shall
propose Amendments to this Constitution, or, on the Application of the Legislatures
of two thirds of the several States, shall call a Convention for proposing Amend-
ments, which, in either Case, shall be valid to all Intents and Purposes, as Part of this
Constitution, when ratified by the Legislatures of three fourths of the several States,
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or by Conventions in three fourths thereof, as the one or the other Mode of Ratifica-
tion may be proposed by the Congress; Provided that no Amendment which may be
made prior to the Year One thousand eight hundred and eight shall in any Manner
affect the first and fourth Clauses in the Ninth Section of the first Article; and that no
State, without its Consent, shall be deprived of its equal Suffrage in the Senate.
ARTICLE VI
All Debts contracted and Engagements entered into, before the Adoption of this
Constitution, shall be as valid against the United States under this Constitution, as
under the Confederation.
This Constitution, and the Laws of the United States which shall be made in Pursuance
thereof; and all Treaties made, or which shall be made, under the Authority of the
United States, shall be the supreme Law of the Land; and the Judges in every State
shall be bound thereby, any Thing in the Constitution or Laws of any State to the
Contrary notwithstanding.
The Senators and Representatives before mentioned, and the Members of the
several State Legislatures, and all executive and judicial Officers, both of the United
States and of the Several States, shall be bound by Oath or Affirmation, to support
this Constitution; but no religious Test shall ever be required as a Qualification to
any Office or public Trust under the United States.
ARTICLE VII
The Ratification of the Conventions of nine States, shall be sufficient for the
Establishment of this Constitution between the States so ratifying the Same.
Amendment I
[1791].
Congress shall make no law respecting an establishment of religion, or prohibiting
the free exercise thereof; or abridging the freedom of speech, or the press; or the
right of the people peaceably to assemble, and to petition the Government for a
redress of grievances.
Amendment II
[1791].
A well regulated Militia, being necessary to the security for a free State, the right of
the people to keep and bear Arms, shall not be infringed.
Amendment III
[1791].
No Soldier shall, in time of peace be quartered in any house, without the consent of
the Owner, nor in time of war, but in a manner to be prescribed by law.
Amendment IV
[1791].
The right of the people to be secure in their persons, houses, papers, and effects,
against unreasonable searches and seizures, shall not be violated, and no Warrants
shall issue, but upon probable cause, supported by Oath or Affirmation, and particu-
larly describing the place to be searched, and the persons or things to be seized.
Amendment V
[1791].
No person shall be held to answer for a capital, or otherwise infamous crime, unless
on a presentment or indictment of a Grand Jury, except in cases arising in the land or
naval forces, or in the Militia, when in actual service in time of War or public danger;
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nor shall any person be subject for the same offense to be twice put in jeopardy of
life or limb; nor shall be compelled in any criminal case to be a witness against
himself, nor be deprived of life, liberty, or property, without due process of law; nor
shall private property be taken for public use, without just compensation.
Amendment VI
[1791].
In all criminal prosecutions, the accused shall enjoy the right to a speedy and public
trial, by an impartial jury of the State and district wherein the crime shall have been
committed, which district shall have been previously ascertained by law, and to be
informed of the nature and cause of the accusation; to be confronted with the
Witnesses against him; to have compulsory process for obtaining witnesses in his
favor, and to have the Assistance of counsel for his defence.
Amendment VII
[1791].
In suits at common law, where the value in controversy shall exceed twenty dollars,
the right of trial by jury shall be preserved, and no fact tried by a jury, shall be
otherwise re-examined in any Court of the United States, than according to the rules
of the common law.
Amendment VIII
[1791].
Excessive bail shall not be required, no excessive fines imposed, nor cruel and
unusual punishments inflicted.
Amendment IX
[1791].
The enumeration in the Constitution, of certain rights, shall not be construed to deny
or disparage others retained by the people.
Amendment X
[1791].
The powers not delegated to the United States by the Constitution, nor prohibited
by it to the States, are reserved to the States respectively, or to the people.
Amendment XI
[1798].
The judicial power of the United States shall not be construed to extend to any suit
in law or equity, commenced or prosecuted against one of the United States by
Citizens of another State, or by Citizens or Subjects of any Foreign State.
Amendment XII
[1804].
The Electors shall meet in their respective states and vote by ballot for President
and Vice-President, one of whom, at least, shall not be an inhabitant of the same
state with themselves; they shall name in their ballots the person voted for as
President, and in distinct ballots the person voted for as Vice-President, and they
shall make distinct lists of all persons voted for as President, and of all persons
voted for as Vice-President, and of the number of votes for each, which lists they
shall sign and certify, and transmit sealed to the seat of the government of the
United States, directed to the President of the Senate;—The President of the
Senate shall, in the presence of the Senate and House of Representatives, open
all the certificates and the votes shall then be counted;—The person having the
greatest number of votes for President, shall be the President, if such number be
a majority of the whole number of Electors appointed; and if no person have
such majority, then from the persons having the highest numbers not exceeding
three on the list of those voted for as President, the House of Representatives
shall choose immediately, by ballot, the President. But in choosing the President,
the votes shall be taken by states, the representation from each state having
one vote; a quorum for this purpose shall consist of a member or members from
two-thirds of the states, and a majority of all the states shall be necessary to a
choice. And if the House of Representatives shall not choose a President when-
ever the right of choice shall devolve upon them, before the fourth day of March
next following, then the Vice-President shall act as President, as in the case of
the death or other constitutional disability of the President. The person having
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the greatest number of votes as Vice-President, shall be the Vice-President, if
such number be a majority of the whole number of Electors appointed, and if no
person have a majority, then from the two highest numbers on the list, the
Senate shall choose the Vice-President; a quorum for the purpose shall consist
of two-thirds of the whole number of Senators, and a majority of the whole
number shall be necessary to a choice. But no person constitutionally ineligible
to the office of President shall be eligible to that of the Vice-President of the
United States.
Amendment XIII
[1865].
Section 1. Neither slavery nor involuntary servitude, except as a punishment for
crime whereof the party shall have been duly convicted, shall exist within the United
States, or any place subject to their jurisdiction.
Section 2. Congress shall have power to enforce this article by appropriate
legislation.
Amendment
XIV [1868].
Section 1. All persons born or naturalized in the United States, and subject to
the jurisdiction thereof, are citizens of the United States and of the State wherein
they reside. No State shall make or enforce any law which shall abridge the privileges
or immunities of citizens of the United States; nor shall any State deprive any person
of life, liberty, or property, without due process of law; nor deny to any person within
its jurisdiction the equal protection of the laws.
Section 2. Representatives shall be appointed among the several States
according to their respective numbers, counting the whole number of persons in
each State, excluding Indians not taxed. But when the right to vote at any election
for the choice of electors for President and Vice President of the United States,
Representatives in Congress, the Executive and Judicial officers of a State, or the
members of the Legislature thereof, is denied to any of the male inhabitants of
such State, being twenty-one years of age, and citizens of the United States, or in
any way abridged, except for participation in rebellion, or other crime, the basis of
representation therein shall be reduced in the proportion which the number of such
male citizens shall bear the whole number of male citizens twenty-one years of age
in such State.
Section 3. No person shall be a Senator or Representative in Congress, or
elector of President and Vice President, or hold any office, civil or military, under
the United States, or under any State, who, having previously taken an oath, as a
member of Congress, or as an officer of the United States, or as a member of any
State legislature, or as an executive or judicial officer of any State, to support the
Constitution of the United States, shall have engaged in insurrection or rebellion
against the same, or given aid or comfort to the enemies thereof. But Congress may
by a vote of two-thirds of each House, remove such disability.
Section 4. The validity of the public debt of the United States, authorized by
law, including debts incurred for payment of pensions and bounties for services in
suppressing insurrection or rebellion, shall not be questioned. But neither the United
States nor any State shall assume or pay any debt or obligation incurred in aid of
insurrection of rebellion against the United States, or any claim for the loss or
emancipation of any slave; but all such debts, obligations and claims shall be held
illegal and void.
Section 5. The Congress shall have power to enforce, by appropriate legislation,
the provisions of this article.
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Amendment XV
[1870].
Section 1. The right of citizens of the United States to vote shall not be denied
or abridged by the United States or by any State on account of race, color, or previous
condition of servitude.
Section 2. The Congress shall have power to enforce this article by appropriate
legislation.
Amendment
XVI [1913].
The Congress shall have power to lay and collect taxes on incomes, from whatever
source derived, without apportionment among the several States, and without regard
to any census or enumeration.
Amendment
XVII [1913].
The Senate of the United States shall be composed of two Senators from each State,
elected by the people thereof, for six years; and each Senator shall have one vote.
The electors in each State shall have the qualifications requisite for electors of the
most numerous branch of the State legislatures.
When vacancies happen in the representation of any State in the Senate, the
executive authority of each State shall issue writs of election to fill such vacancies;
Provided, That the legislature of any State may empower the executive thereof to
make temporary appointments until the people fill the vacancies by election as the
legislature may direct.
This amendment shall not be construed as to affect the election or term of any
Senator chosen before it becomes valid as part of the Constitution.
Amendment
XVIII [1919].
Section 1. After one year from the ratification of this article the manufacture,
sale, or transportation of intoxicating liquors within, the importation thereof into, or
the exportation thereof from the United States and all territory subject to the
jurisdiction thereof for beverage purposes is hereby prohibited.
Section 2. The Congress and the several States shall have concurrent power to
enforce this article by appropriate legislation.
Section 3. This article shall be inoperative unless it shall have been ratified as
an amendment to the Constitution by the legislatures of the several States, as
provided in the Constitution, within seven years from the date of the submission
hereof to the States by the Congress.
Amendment
XIX [1920].
The right of citizens of the United States to vote shall not be denied or abridged by
the United States or by any State on account of sex.
Congress shall have power to enforce this article by appropriate legislation.
Amendment XX
[1933].
Section 1. The terms of the President and Vice President shall end at noon
on the 20th day of January, and the terms of Senators and Representatives at
noon on the 3d day of January, of the years in which such terms would have
ended if this article had not been ratified; and the terms of their successors shall
then begin.
Section 2. The Congress shall assemble at least once in every year, and such
meeting shall begin at noon on the 3d day of January, unless they shall by law
appoint a different day.
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Section 3. If, at the time fixed for the beginning of the term of the Pre-
sident, the President elect shall have died, the Vice President elect shall become
President. If a President shall not have been chosen before the time fixed for the
beginning of his term, or if the President elect shall have failed to qualify, then
the Vice President elect shall act as President until a President shall have
qualified; and the Congress may by law provide for the case wherein neither a
President elect nor a Vice President elect shall have qualified, declaring who
shall then act as President, or the manner in which one who is to act shall be
selected, and such person shall act accordingly until a President or Vice President
shall have qualified.
Section 4. The Congress may by law provide for the case of the death of any of
the persons from whom the House of Representatives may choose a President
whenever the right of choice shall have devolved upon them, and for the case of
the death of any of the persons from whom the Senate may choose a Vice President
whenever the right of choice shall have devolved upon them.
Section 5. Sections 1 and 2 shall take effect on the 15th day of October follow-
ing the ratification of this article.
Section 6. This article shall be inoperative unless it shall have been ratified as
an amendment to the Constitution by the legislatures of three-fourths of the several
States within seven years from the date of its submission.
Amendment
XXI [1933].
Section 1. The eighteenth article of amendment to the Constitution of the
United States is hereby repealed.
Section 2. The transportation or importation into any State, Territory, or pos-
session of the United States for delivery or use therein of intoxicating liquors, in
violation of the laws thereof, is hereby prohibited.
Section 3. This article shall be inoperative unless it shall have been ratified as
an amendment to the Constitution by conventions in the several States, as provided
in the Constitution, within seven years from the date of the submission hereof to the
States by the Congress.
Amendment
XXII [1951].
Section 1. No person shall be elected to the office of the President more than
twice, and no person who has held the office of President, or acted as President, for
more than two years of a term to which some other person was elected President shall
be elected to the office of the President more than once. But this Article shall not
apply to any person holding the office of President when this Article was proposed by
the Congress, and shall not prevent any person who may be holding the office of
President, or acting as President, during the term within which this Article becomes
operative from holding the office of President, or acting as President during the
remainder of such term.
Section 2. This article shall be inoperative unless it shall have been ratified as
an amendment to the Constitution by the legislatures of three-fourths of the several
States within seven years from the date of its submission to the States by the
Congress.
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Amendment
XXIII [1961].
Section 1. The District constituting the seat of Government of the United
States shall appoint in such manner as the Congress may direct:
A number of electors of President and Vice President equal to the whole number of
Senators and Representatives in Congress to which the District would be entitled if
it were a State, but in no event more than the least populous State; they shall be in
addition to those appointed by the States, but they shall be considered, for the
purposes of the election of President and Vice President, to be electors appointed by
a State; and they shall meet in the District and perform such duties as provided by
the twelfth article of amendment.
Section 2. The Congress shall have power to enforce this article by appropriate
legislation.
Amendment
XXIV [1964].
Section 1. The right of citizens of the United States to vote in any primary or other
election for President or Vice President, for electors for President or Vice President, or
for Senator or Representative in Congress, shall not be denied or abridged by the
United States or any State by reason of failure to pay any poll tax or other tax.
Section 2. The Congress shall have power to enforce this article by appropriate
legislation.
Amendment
XXV [1967].
Section 1. In case of the removal of the President from office or of his death or
resignation, the Vice President shall become President.
Section 2. Whenever there is a vacancy in the office of the Vice President, the
President shall nominate a Vice President who shall take office upon confirmation by
a majority vote of both Houses of Congress.
Section 3. Whenever the President transmits to the President pro tempore of
the Senate and the Speaker of the House of Representatives his written declaration
that he is unable to discharge the powers and duties of his office, and until he
transmits to them a written declaration to the contrary, such powers and duties shall
be discharged by the Vice President as Acting President.
Section 4. Whenever the Vice President and a majority of either the principal
officers of the executive departments or of such other body as Congress may by law
provide, transmit to the President pro tempore of the Senate and the Speaker of the
House of Representatives their written declaration that the President is unable to
discharge the powers and duties of his office, the Vice President shall immediately
assume the powers and duties of the office as Acting President.
Thereafter, when the President transmits to the President pro tempore of the Senate
and the Speaker of the House of Representatives his written declaration that no
inability exists, he shall resume the powers and duties of his office unless the Vice
President and a majority of either the principal officers of the executive department
or of such other body as Congress may by law provide, transmit within four days to
the President pro tempore of the Senate and the Speaker of the House of Repre-
sentatives their written declaration that the President is unable to discharge the
powers and duties of his office. Thereupon Congress shall decide the issue, assem-
bling within forty-eight hours for that purpose if not in session. If the Congress,
within twenty-one days after receipt of the latter written declaration, or, if Congress
is not in session, within twenty-one days after Congress is required to assemble,
determines by two-thirds vote of both Houses that the President is unable to
discharge the powers and duties of his office, the Vice President shall continue
to discharge the same as Acting President; otherwise, the President shall resume
the powers and duties of his office.
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Amendment
XXVI [1971].
Section 1. The right of citizens of the United States, who are eighteen years of
age or older, to vote shall not be denied or abridged by the United States or by any
State on account of age.
Section 2. The Congress shall have power to enforce this article by appropriate
legislation.
Amendment
XXVII [1992].
No law, varying the compensation for the services of the Senators and Representa-
tives, shall take effect, until an election of Representatives shall have intervened.
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APPENDIXB
UNIFORM COMMERCIAL CODE (SELECTED PROVISIONS)
ARTICLE I
GENERAL PROVISIONS
PART 1 Short Title, Construction,
Application and Subject Matter
of the Act
§ 1–101. Short Title.
This Act shall be known and may be cited as Uniform Commer-
cial Code.
§ 1–102. Purposes; Rules of Construction;
Variation by Agreement.
(1) This Act shall be liberally construed and applied to promote
its underlying purposes and policies.
(2) Underlying purposes and policies of this Act are
(a) to simplify, clarify and modernize the law governing
commercial transactions;
(b) to permit the continued expansion of commercial
practices through custom, usage and agreement of the parties;
(c) to make uniform the law among the various jurisdictions.
(3) The effect of provisions of this Act may be varied by
agreement, except as otherwise provided in this Act and except
that the obligations of good faith, diligence, reasonableness
and care prescribed by this Act may not be disclaimed by
agreement but the parties may by agreement determine the
standards by which the performance of such obligations is
to be measured if such standards are not manifestly unreasonable.
(4) The presence in certain provisions of this Act of the words
“unless otherwise agreed” or words of similar import does not
imply that the effect of other provisions may not be varied by
agreement under subsection (3).
(5) In this Act unless the context otherwise requires
(a) words in the singular number include the plural, and in
the plural include the singular;
(b) words of the masculine gender include the feminine and
the neuter, and when the sense so indicates words of the neuter
gender may refer to any gender.
§ 1–103. Supplementary General Principles
of Law Applicable.
Unless displaced by the particular provisions of this Act, the
principles of law and equity, including the law merchant and
the law relative to capacity to contract, principal and agent,
estoppel, fraud, misrepresentation, duress, coercion, mistake,
bankruptcy, or other validating or invalidating cause shall sup-
plement its provisions.
§ 1–104. Construction Against Implicit Repeal.
This Act being a general act intended as a unified coverage of its
subject matter, no part of it shall be deemed to be impliedly
repealed by subsequent legislation if such construction can rea-
sonably be avoided.
§ 1–105. Territorial Application of the Act;
Parties’ Power to Choose Applicable
Law.
(1) Except as provided hereafter in this section, when a
transaction bears a reasonable relation to this state and also to
another state or nation the parties may agree that the law
either of this state or of such other state or nation shall
govern their rights and duties. Failing such agreement this
Act applies to transactions bearing an appropriate relation to
this state.
(2) Where one of the following provisions of this Act specifies
the applicable law, that provision governs and a contrary
agreement is effective only to the extent permitted by the law
(including the conflict of laws rules) so specified:
Rights of creditors against sold goods. Section 2–402.
Applicability of the Article on Leases. Sections 2A–105 and
2A–106.
Applicability of the Article on Bank Deposits and Collections.
Section 4–102.
Governing law in the Article on Funds Transfers.
Section 4A–507.
Letters of Credit, Section 5–116.
Bulk sales subject to the Article on Bulk Sales.
Section 6–103.
Applicability of the Article on Investment Securities.
Section 8–106.
B1
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Law governing perfection, the effect of perfection or
nonperfection, and the priority of security interests and
agricultural liens. Sections 9–301 through 9–307.
As amended in 1972, 1987, 1988, 1989, 1994, 1995,
and 1999.
§ 1–106. Remedies to Be Liberally
Administered.
(1) The remedies provided by this Act shall be liberally
administered to the end that the aggrieved party may be put
in as good a position as if the other party had fully performed
but neither consequential or special nor penal damages may
be had except as specifically provided in this Act or by other
rule of law.
(2) Any right or obligation declared by this Act is enforceable by
action unless the provision declaring it specifies a different and
limited effect.
§ 1–107. Waiver or Renunciation of Claim or
Right After Breach.
Any claim or right arising out of an alleged breach can be
discharged in whole or in part without consideration by a written
waiver or renunciation signed and delivered by the aggrieved
party.
§ 1–108. Severability.
If any provision or clause of this Act or application thereof to any
person or circumstances is held invalid, such invalidity shall not
affect other provisions or applications of the Act which can be
given effect without the invalid provision or application, and to
this end the provisions of this Act are declared to be severable.
§ 1–109. Section Captions.
Section captions are parts of this Act.
PART 2 General Definitions and Principles
of Interpretation
§ 1–201. General Definitions.
Subject to additional definitions contained in the subsequent
Articles of this Act which are applicable to specific Articles or
Parts thereof, and unless the context otherwise requires, in
this Act:
(1) “Action” in the sense of a judicial proceeding includes
recoupment, counterclaim, set-off, suit in equity and any other
proceedings in which rights are determined.
(2) “Aggrieved party” means a party entitled to resort to a
remedy.
(3) “Agreement” means the bargain of the parties in fact as
found in their language or by implication from other
circumstances including course of dealing or usage of trade or
course of performance as provided in this Act (Sections 1–205
and 2–208). Whether an agreement has legal consequences
is determined by the provisions of this Act, if applicable;
otherwise by the law of contracts (Section 1–103).
(Compare “Contract”.)
(4) “Bank” means any person engaged in the business of
banking.
(5) “Bearer” means the person in possession of an instrument,
document of title, or certificated security payable to bearer or
indorsed in blank.
(6) “Bill of lading” means a document evidencing the receipt of
goods for shipment issued by a person engaged in the business
of transporting or forwarding goods, and includes an airbill.
“Airbill”means a document serving for air transportation as a bill
of lading does for marine or rail transportation, and includes an
air consignment note or air waybill.
(7) “Branch” includes a separately incorporated foreign branch
of a bank.
(8) “Burden of establishing” a fact means the burden of
persuading the triers of fact that the existence of the fact is more
probable than its non-existence.
(9) “Buyer in ordinary course of business” means a person that
buys goods in good faith, without knowledge that the sale
violates the rights of another person in the goods, and in the
ordinary course from a person, other than a pawnbroker, in the
business of selling goods of that kind. A person buys goods in
the ordinary course if the sale to the person comports with the
usual or customary practices in the kind of business in which
the seller is engaged or with the seller’s own usual or customary
practices. A person that sells oil, gas, or other minerals at the
wellhead or minehead is a person in the business of selling
goods of that kind. A buyer in ordinary course of business may
buy for cash, by exchange of other property, or on secured or
unsecured credit, and may acquire goods or documents of title
under a pre-existing contract for sale. Only a buyer that takes
possession of the goods or has a right to recover the goods from
the seller under Article 2 may be a buyer in ordinary course of
business. A person that acquires goods in a transfer in bulk or as
security for or in total or partial satisfaction of a money debt is
not a buyer in ordinary course of business.
(10) “Conspicuous”: A term or clause is conspicuous when it is
so written that a reasonable person against whom it is to
operate ought to have noticed it. A printed heading in capitals
(as: NON-NEGOTIABLE BILL OF LADING) is conspicuous.
Language in the body of a form is “conspicuous” if it is in larger
or other contrasting type or color. But in a telegram any stated
term is “conspicuous”. Whether a term or clause is
“conspicuous” or not is for decision by the court.
(11) “Contract” means the total legal obligation which results
from the parties’ agreement as affected by this Act and any other
applicable rules of law. (Compare “Agreement”.)
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(12) “Creditor” includes a general creditor, a secured creditor, a
lien creditor and any representative of creditors, including an
assignee for the benefit of creditors, a trustee in bankruptcy, a
receiver in equity and an executor or administrator of an
insolvent debtor’s or assignor’s estate.
(13) “Defendant” includes a person in the position of defendant
in a cross-action or counterclaim.
(14) “Delivery” with respect to instruments, documents of title,
chattel paper, or certificated securities means voluntary transfer
of possession.
(15) “Document of title” includes bill of lading, dock warrant,
dock receipt, warehouse receipt or order for the delivery of
goods, and also any other document which in the regular course
of business or financing is treated as adequately evidencing that
the person in possession of it is entitled to receive, hold and
dispose of the document and the goods it covers. To be a
document of title a document must purport to be issued by or
addressed to a bailee and purport to cover goods in the bailee’s
possession which are either identified or are fungible portions of
an identified mass.
(16) “Fault” means wrongful act, omission or breach.
(17) “Fungible” with respect to goods or securities means goods
or securities of which any unit is, by nature or usage of trade, the
equivalent of any other like unit. Goods which are not fungible
shall be deemed fungible for the purposes of this Act to the
extent that under a particular agreement or document unlike
units are treated as equivalents.
(18) “Genuine” means free of forgery or counterfeiting.
(19) “Good faith” means honesty in fact in the conduct or
transaction concerned.
(20) “Holder” with respect to a negotiable instrument, means
the person in possession if the instrument is payable to bearer or,
in the cases of an instrument payable to an identified person,
if the identified person is in possession. “Holder” with respect
to a document of title means the person in possession if the
goods are deliverable to bearer or to the order of the person in
possession.
(21) To “honor” is to pay or to accept and pay, or where a credit
so engages to purchase or discount a draft complying with the
terms of the credit.
(22) “Insolvency proceedings” includes any assignment for the
benefit of creditors or other proceedings intended to liquidate or
rehabilitate the estate of the person involved.
(23) A person is “insolvent” who either has ceased to pay his
debts in the ordinary course of business or cannot pay his debts
as they become due or is insolvent within the meaning of the
federal bankruptcy law.
(24) “Money” means a medium of exchange authorized or
adopted by a domestic or foreign government and includes
a monetary unit of account established by an intergovern-
mental organization or by agreement between two or more
nations.
(25) A person has “notice” of a fact when
(a) he has actual knowledge of it; or
(b) he has received a notice or notification of it; or
(c) from all the facts and circumstances known to him at the
time in question he has reason to know that it exists.
A person “knows” or has “knowledge” of a fact when he has
actual knowledge of it. “Discover” or “learn” or a word or phrase
of similar import refers to knowledge rather than to reason
to know. The time and circumstances under which a notice or
notification may cease to be effective are not determined by
this Act.
(26) A person “notifies” or “gives” a notice or notification to
another by taking such steps as may be reasonably required to
inform the other in ordinary course whether or not such other
actually comes to know of it. A person “receives” a notice or
notification when
(a) it comes to his attention; or
(b) it is duly delivered at the place of business through
which the contract was made or at any other place held out by
him as the place for receipt of such communications.
(27) Notice, knowledge or a notice or notification received by an
organization is effective for a particular transaction from the time
when it is brought to the attention of the individual conducting
that transaction, and in any event from the time when it would
have been brought to his attention if the organization had
exercised due diligence. An organization exercises due diligence
if it maintains reasonable routines for communicating significant
information to the person conducting the transaction and there
is reasonable compliance with the routines. Due diligence
does not require an individual acting for the organization to
communicate information unless such communication is part
of his regular duties or unless he has reason to know of the
transaction and that the transaction would be materially affected
by the information.
(28) “Organization” includes a corporation, government or
governmental subdivision or agency, business trust, estate, trust,
partnership or association, two or more persons having a joint or
common interest, or any other legal or commercial entity.
(29) “Party”, as distinct from “third party”, means a person
who has engaged in a transaction or made an agreement within
this Act.
(30) “Person” includes an individual or an organization (See
Section 1–102).
(31) “Presumption” or “presumed” means that the trier of fact
must find the existence of the fact presumed unless and until
evidence is introduced which would support a finding of its
non-existence.
(32) “Purchase” includes taking by sale, discount, negotiation,
mortgage, pledge, lien, issue or re-issue, gift or any other
voluntary transaction creating an interest in property.
(33) “Purchaser” means a person who takes by purchase.
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(34) “Remedy” means any remedial right to which an aggrieved
party is entitled with or without resort to a tribunal.
(35) “Representative” includes an agent, an officer of a
corporation or association, and a trustee, executor or
administrator of an estate, or any other person empowered to act
for another.
(36) “Rights” includes remedies.
(37) “Security interest”means an interest in personal property or
fixtures which secures payment or performance of an obligation.
The term also includes any interest of a consignor and a buyer of
accounts, chattel paper, a payment intangible, or a promissory
note in a transaction that is subject to Article 9. The special
property interest of a buyer of goods on identification of those
goods to a contract for sale under Section 2–401 is not a “security
interest”, but a buyer may also acquire a “security interest” by
complying with Article 9. Except as otherwise provided in
Section 2–505, the right of a seller or lessor of goods under
Article 2 or 2A to retain or acquire possession of the goods is not
a “security interest”, but a seller or lessor may also acquire a
“security interest” by complying with Article 9. The retention or
reservation of title by a seller of goods notwithstanding shipment
or delivery to the buyer (Section 2–401) is limited in effect to a
reservation of a “security interest”.
Whether a transaction creates a lease or security interest is
determined by the facts of each case; however, a transaction
creates a security interest if the consideration the lessee is to
pay the lessor for the right to possession and use of the goods is
an obligation for the term of the lease not subject to termination
by the lessee, and
(a) the original term of the lease is equal to or greater than
the remaining economic life of the goods,
(b) the lessee is bound to renew the lease for the remaining
economic life of the goods or is bound to become the owner of
the goods,
(c) the lessee has an option to renew the lease for the
remaining economic life of the goods for no additional
consideration or nominal additional consideration upon
compliance with the lease agreement, or
(d) the lessee has an option to become the owner of the
goods for no additional consideration or nominal additional
consideration upon compliance with the lease agreement.
A transaction does not create a security interest merely because
it provides that
(a) the present value of the consideration the lessee is
obligated to pay the lessor for the right to possession and
use of the goods is substantially equal to or is greater than
the fair market value of the goods at the time the lease is
entered into,
(b) the lessee assumes risk of loss of the goods, or agrees to
pay taxes, insurance, filing, recording, or registration fees, or
service or maintenance costs with respect to the goods,
(c) the lessee has an option to renew the lease or to become
the owner of the goods,
(d) the lessee has an option to renew the lease for a fixed
rent that is equal to or greater than the reasonably predictable
fair market rent for the use of the goods for the term of the
renewal at the time the option is to be performed, or
(e) the lessee has an option to become the owner of the
goods for a fixed price that is equal to or greater than the
reasonably predictable fair market value of the goods at the time
the option is to be performed.
For purposes of this subsection (37):
(x) Additional consideration is not nominal if (i) when the option
to renew the lease is granted to the lessee the rent is stated to be the
fair market rent for the use of the goods for the term of the renewal
determined at the time the option is to be performed, or (ii) when
the option to become the owner of the goods is granted to the lessee
the price is stated to be the fair market value of the goods deter-
mined at the time the option is to be performed. Additional con-
sideration is nominal if it is less than the lessee’s reasonably pre-
dictable cost of performing under the lease agreement if the option is
not exercised;
(y) “Reasonably predictable” and “remaining economic life of the
goods” are to be determined with reference to the facts and circum-
stances at the time the transaction is entered into; and
(z) “Present value” means the amount as of a date certain of one
or more sums payable in the future, discounted to the date certain.
The discount is determined by the interest rate specified by the
parties if the rate is not manifestly unreasonable at the time the
transaction is entered into; otherwise, the discount is determined by
a commercially reasonable rate that takes into account the facts and
circumstances of each case at the time the transaction was entered
into.
(38) “Send” in connection with any writing or notice means to
deposit in the mail or deliver for transmission by any other usual
means of communication with postage or cost of transmission
provided for and properly addressed and in the case of an
instrument to an address specified thereon or otherwise agreed,
or if there be none to any address reasonable under the
circumstances. The receipt of any writing or notice within the
time at which it would have arrived if properly sent has the
effect of a proper sending.
(39) “Signed” includes any symbol executed or adopted by a
party with present intention to authenticate a writing.
(40) “Surety” includes guarantor.
(41) “Telegram” includes a message transmitted by radio, teletype,
cable, any mechanical method of transmission, or the like.
(42) “Term” means that portion of an agreement which relates
to a particular matter.
(43) “Unauthorized” signature means one made without actual,
implied or apparent authority and includes a forgery.
(44) “Value”. Except as otherwise provided with respect to
negotiable instruments and bank collections (Sections 3–303, 4–210
and 4–211) a person gives “value” for rights if he acquires them
(a) in return for a binding commitment to extend credit or
for the extension of immediately available credit whether or not
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drawn upon and whether or not a chargeback is provided for in
the event of difficulties in collection; or
(b) as security for or in total or partial satisfaction of a
pre-existing claim; or
(c) by accepting delivery pursuant to a preexisting contract
for purchase; or
(d) generally, in return for any consideration sufficient to
support a simple contract.
(45) “Warehouse receipt” means a receipt issued by a person
engaged in the business of storing goods for hire.
(46) “Written” or “writing” includes printing, typewriting or any
other intentional reduction to tangible form.
§ 1–202. Prima Facie Evidence by Third Party
Documents.
A document in due form purporting to be a bill of lading,
policy or certificate of insurance, official weigher’s or inspec-
tor’s certificate, consular invoice, or any other document
authorized or required by the contract to be issued by a third
party shall be prima facie evidence of its own authenticity
and genuineness and of the facts stated in the document by
the third party.
§ 1–203. Obligation of Good Faith.
Every contract or duty within this Act imposes an obligation of
good faith in its performance or enforcement.
§ 1–204. Time; Reasonable Time; “Seasonably”.
(1) Whenever this Act requires any action to be taken within a
reasonable time, any time which is not manifestly unreasonable
may be fixed by agreement.
(2) What is a reasonable time for taking any action depends on
the nature, purpose and circumstances of such action.
(3) An action is taken “seasonably”when it is taken at or within the
time agreed or if no time is agreed at or within a reasonable time.
§ 1–205. Course of Dealing and Usage of
Trade.
(1) A course of dealing is a sequence of previous conduct
between the parties to a particular transaction which is fairly to
be regarded as establishing a common basis of understanding for
interpreting their expressions and other conduct.
(2) A usage of trade is any practice or method of dealing having
such regularity of observance in a place, vocation or trade as to
justify an expectation that it will be observed with respect to the
transaction in question. The existence and scope of such a usage
are to be proved as facts. If it is established that such a usage is
embodied in a written trade code or similar writing the
interpretation of the writing is for the court.
(3) A course of dealing between parties and any usage of trade in
the vocation or trade in which they are engaged or of which they
are or should be aware give particular meaning to and
supplement or qualify terms of an agreement.
(4) The express terms of an agreement and an applicable
course of dealing or usage of trade shall be construed wherever
reasonable as consistent with each other; but when such
construction is unreasonable express terms control both course
of dealing and usage of trade and course of dealing controls
usage trade.
(5) An applicable usage of trade in the place where any part of
performance is to occur shall be used in interpreting the
agreement as to that part of the performance.
(6) Evidence of a relevant usage of trade offered by one party is
not admissible unless and until he has given the other party such
notice as the court finds sufficient to prevent unfair surprise to
the latter.
§ 1–206. Statute of Frauds for Kinds of
Personal Property Not Otherwise
Covered.
(1) Except in the cases described in subsection (2) of this section
a contract for the sale of personal property is not enforceable by
way of action or defense beyond five thousand dollars in amount
or value of remedy unless there is some writing which indicates
that a contract for sale has been made between the parties at a
defined or stated price, reasonably identifies the subject matter,
and is signed by the party against whom enforcement is sought
or by his authorized agent.
(2) Subsection (1) of this section does not apply to contracts for
the sale of goods (Section 2–201) nor of securities (Section 8–
113) nor to security agreements (Section 9–203).
As amended in 1994.
§ 1–207. Performance or Acceptance Under
Reservation of Rights.
(1) A party who with explicit reservation of rights performs or
promises performance or assents to performance in a manner
demanded or offered by the other party does not thereby
prejudice the rights reserved. Such words as “without
prejudice”, “under protest” or the like are sufficient.
(2) Subsection (1) does not apply to an accord and satisfaction.
As amended in 1990.
§ 1–208. Option to Accelerate at Will.
A term providing that one party or his successor in interest may
accelerate payment or performance or require collateral or addi-
tional collateral “at will” or “when he deems himself insecure”
or in words of similar import shall be construed to mean that he
shall have power to do so only if he in good faith believes that
the prospect of payment or performance is impaired. The bur-
den of establishing lack of good faith is on the party against
whom the power has been exercised.
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§ 1–209. Subordinated Obligations.
An obligation may be issued as subordinated to payment of
another obligation of the person obligated, or a creditor may
subordinate his right to payment of an obligation by agreement
with either the person obligated or another creditor of the person
obligated. Such a subordination does not create a security inter-
est as against either the common debtor or a subordinated
creditor. This section shall be construed as declaring the law as
it existed prior to the enactment of this section and not as
modifying it. Added 1966.
Note: This new section is proposed as an optional provision to make it
clear that a subordination agreement does not create a security interest
unless so intended.
ARTICLE II
SALES
PART 1 Short Title, General Construction
and Subject Matter
§ 2–101. Short Title.
This Article shall be known and may be cited as Uniform
Commercial Code—Sales.
§ 2–102. Scope; Certain Security and Other
Transactions Excluded From This
Article.
Unless the context otherwise requires, this Article applies to
transactions in goods; it does not apply to any transaction
which although in the form of an unconditional contract to
sell or present sale is intended to operate only as a security
transaction nor does this Article impair or repeal any statute
regulating sales to consumers, farmers or other specified
classes of buyers.
§ 2–103. Definitions and Index of Definitions.
(1) In this Article unless the context otherwise requires
(a) “Buyer” means a person who buys or contracts to buy
goods.
(b) “Good faith” in the case of a merchant means honesty in
fact and the observance of reasonable commercial standards of
fair dealing in the trade.
(c) “Receipt” of goods means taking physical possession of
them.
(d) “Seller” means a person who sells or contracts to sell
goods.
(2) Other definitions applying to this Article or to specified Parts
thereof, and the sections in which they appear are:
“Acceptance”. Section 2–606.
“Banker’s credit”. Section 2–325.
“Between merchants”. Section 2–104.
“Cancellation”. Section 2–106(4).
“Commercial unit”. Section 2–105.
“Confirmed credit”. Section 2–325.
“Conforming to contract”. Section 2–106.
“Contract for sale”. Section 2–106.
“Cover”. Section 2–712.
“Entrusting”. Section 2–403.
“Financing agency”. Section 2–104.
“Future goods”. Section 2–105.
“Goods”. Section 2–105.
“Identification”. Section 2–501.
“Installment contract”. Section 2–612.
“Letter of Credit”. Section 2–325.
“Lot”. Section 2–105
“Merchant”. Section 2–104.
“Overseas”. Section 2–323.
“Person in position of seller”. Section 2–707.
“Present sale”. Section 2–106.
“Sale”. Section 2–106.
“Sale on approval”. Section 2–326.
“Sale or return”. Section 2–326.
“Termination”. Section 2–106.
(3) The following definitions in other Articles apply to this
Article:
“Check”. Section 3–104.
“Consignee”. Section 7–102.
“Consignor”. Section 7–102.
“Consumer goods”. Section 9–109.
“Dishonor”. Section 3–507.
“Draft”. Section 3–104.
(4) In addition Article 1 contains general definitions and
principles of construction and interpretation applicable
throughout this Article.
As amended in 1994 and 1999.
§ 2–104. Definitions: “Merchant”; “Between
Merchants”; “Financing Agency”.
(1) “Merchant” means a person who deals in goods of the kind
or otherwise by his occupation holds himself out as having
knowledge or skill peculiar to the practices or goods involved in
the transaction or to whom such knowledge or skill may be
attributed by his employment of an agent or broker or other
intermediary who by his occupation holds himself out as having
such knowledge or skill.
(2) “Financing agency” means a bank, finance company or other
person who in the ordinary course of business makes advances
against goods or documents of title or who by arrangement with
either the seller or the buyer intervenes in ordinary course to
make or collect payment due or claimed under the contract for
sale, as by purchasing or paying the seller’s draft or making
advances against it or by merely taking it for collection whether
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or not documents of title accompany the draft. “Financing
agency” includes also a bank or other person who similarly
intervenes between persons who are in the position of seller and
buyer in respect to the goods (Section 2–707).
(3) “Between merchants” means in any transaction with respect
to which both parties are chargeable with the knowledge or skill
of merchants.
§ 2–105. Definitions: Transferability; “Goods”;
“Future” Goods; “Lot”; “Commercial
Unit”.
(1) “Goods” means all things (including specially manufactured
goods) which are movable at the time of identification to the
contract for sale other than the money in which the price is to
be paid, investment securities (Article 8) and things in action.
“Goods” also includes the unborn young of animals and
growing crops and other identified things attached to realty as
described in the section on goods to be severed from realty
(Section 2–107).
(2) Goods must be both existing and identified before any
interest in them can pass. Goods which are not both existing and
identified are “future” goods. A purported present sale of future
goods or of any interest therein operates as a contract to sell.
(3) There may be a sale of a part interest in existing identified
goods.
(4) An undivided share in an identified bulk of fungible goods
is sufficiently identified to be sold although the quantity of
the bulk is not determined. Any agreed proportion of such a
bulk or any quantity thereof agreed upon by number, weight
or other measure may to the extent of the seller’s interest
in the bulk be sold to the buyer who then becomes an owner
in common.
(5) “Lot” means a parcel or a single article which is the subject
matter of a separate sale or delivery, whether or not it is
sufficient to perform the contract.
(6) “Commercial unit” means such a unit of goods as by
commercial usage is a single whole for purposes of sale and
division of which materially impairs its character or value on the
market or in use. A commercial unit may be a single article (as a
machine) or a set of articles (as a suite of furniture or an assortment
of sizes) or a quantity (as a bale, gross, or carload) or any other unit
treated in use or in the relevant market as a single whole.
§ 2–106. Definitions: “Contract”; “Agreement”;
“Contract for Sale”; “Sale”; “Present
Sale”; “Conforming” to Contract;
“Termination”; “Cancellation”.
(1) In this Article unless the context otherwise requires
“contract” and “agreement” are limited to those relating to the
present or future sale of goods. “Contract for sale” includes both
a present sale of goods and a contract to sell goods at a future
time. A “sale” consists in the passing of title from the seller to
the buyer for a price (Section 2–401). A “present sale” means a
sale which is accomplished by the making of the contract.
(2) Goods or conduct including any part of a performance are
“conforming” or conform to the contract when they are in
accordance with the obligations under the contract.
(3) “Termination” occurs when either party pursuant to a power
created by agreement or law puts an end to the contract
otherwise than for its breach. On “termination” all obligations
which are still executory on both sides are discharged but any
right based on prior breach or performance survives.
(4) “Cancellation” occurs when either party puts an end to the
contract for breach by the other and its effect is the same as that
of “termination” except that the cancelling party also retains any
remedy for breach of the whole contract or any unperformed
balance.
§ 2–107. Goods to Be Severed From Realty:
Recording.
(1) A contract for the sale of minerals or the like (including oil
and gas) or a structure or its materials to be removed from realty
is a contract for the sale of goods within this Article if they are to
be severed by the seller but until severance a purported present
sale thereof which is not effective as a transfer of an interest in
land is effective only as a contract to sell.
(2) A contract for the sale apart from the land of growing crops or
other things attached to realty and capable of severance without
material harm thereto but not described in subsection (1) or of
timber to be cut is a contract for the sale of goods within this
Article whether the subject matter is to be severed by the buyer
or by the seller even though it forms part of the realty at the time
of contracting, and the parties can by identification effect a
present sale before severance.
(3) The provisions of this section are subject to any third party
rights provided by the law relating to realty records, and the
contract for sale may be executed and recorded as a document
transferring an interest in land and shall then constitute notice to
third parties of the buyer’s rights under the contract for sale.
As amended in 1972.
PART 2 Form, Formation and Readjustment
of Contract
§ 2–201. Formal Requirements; Statute of
Frauds.
(1) Except as otherwise provided in this section a contract for the
sale of goods for the price of $500 or more is not enforceable by
way of action or defense unless there is some writing sufficient
to indicate that a contract for sale has been made between the
parties and signed by the party against whom enforcement is
sought or by his authorized agent or broker. A writing is not
insufficient because it omits or incorrectly states a term agreed
upon but the contract is not enforceable under this paragraph
beyond the quantity of goods shown in such writing.
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(2) Between merchants if within a reasonable time a writing in
confirmation of the contract and sufficient against the sender is
received and the party receiving it has reason to know its
contents, it satisfies the requirements of subsection (1) against
such party unless written notice of objection to its contents is
given within ten days after it is received.
(3) A contract which does not satisfy the requirements of
subsection (1) but which is valid in other respects is enforceable
(a) if the goods are to be specially manufactured for the
buyer and are not suitable for sale to others in the ordinary
course of the seller’s business and the seller, before notice of
repudiation is received and under circumstances which
reasonably indicate that the goods are for the buyer, has made
either a substantial beginning of their manufacture or
commitments for their procurement; or
(b) if the party against whom enforcement is sought admits
in his pleading, testimony or otherwise in court that a contract
for sale was made, but the contract is not enforceable under this
provision beyond the quantity of goods admitted; or
(c) with respect to goods for which payment has been
made and accepted or which have been received and accepted
(Sec. 2–606).
§ 2–202. Final Written Expression: Parol or
Extrinsic Evidence.
Terms with respect to which the confirmatory memoranda of the
parties agree or which are otherwise set forth in a writing intended
by the parties as a final expression of their agreement with respect
to such terms as are included therein may not be contradicted by
evidence of any prior agreement or of a contemporaneous oral
agreement but may be explained or supplemented
(a) by course of dealing or usage of trade (Section 1–205) or
by course of performance (Section 2–208); and
(b) by evidence of consistent additional terms unless the
court finds the writing to have been intended also as a complete
and exclusive statement of the terms of the agreement.
§ 2–203. Seals Inoperative.
The affixing of a seal to a writing evidencing a contract for sale
or an offer to buy or sell goods does not constitute the writing a
sealed instrument and the law with respect to sealed instruments
does not apply to such a contract or offer.
§ 2–204. Formation in General.
(1) A contract for sale of goods may be made in any manner
sufficient to show agreement, including conduct by both parties
which recognizes the existence of such a contract.
(2) An agreement sufficient to constitute a contract for sale may
be found even though the moment of its making is
undetermined.
(3) Even though one or more terms are left open a contract for
sale does not fail for indefiniteness if the parties have intended
to make a contract and there is a reasonably certain basis for
giving an appropriate remedy.
§ 2–205. Firm Offers.
An offer by a merchant to buy or sell goods in a signed writing
which by its terms gives assurance that it will be held open is not
revocable, for lack of consideration, during the time stated or if
no time is stated for a reasonable time, but in no event may such
period of irrevocability exceed three months; but any such term
of assurance on a form supplied by the offeree must be sepa-
rately signed by the offeror.
§ 2–206. Offer and Acceptance in Formation
of Contract.
(1) Unless other unambiguously indicated by the language or
circumstances
(a) an offer to make a contract shall be construed as inviting
acceptance in any manner and by any medium reasonable in the
circumstances;
(b) an order or other offer to buy goods for prompt or
current shipment shall be construed as inviting acceptance
either by a prompt promise to ship or by the prompt or current
shipment of conforming or nonconforming goods, but such a
shipment of non-conforming goods does not constitute an
acceptance if the seller seasonably notifies the buyer that the
shipment is offered only as an accommodation to the buyer.
(2) Where the beginning of a requested performance is a
reasonable mode of acceptance an offeror who is not notified of
acceptance within a reasonable time may treat the offer as
having lapsed before acceptance.
§ 2–207. Additional Terms in Acceptance or
Confirmation.
(1) A definite and seasonable expression of acceptance or a
written confirmation which is sent within a reasonable time
operates as an acceptance even though it states terms additional
to or different from those offered or agreed upon, unless
acceptance is expressly made conditional on assent to the
additional or different terms.
(2) The additional terms are to be construed as proposals for
addition to the contract. Between merchants such terms become
part of the contract unless:
(a) the offer expressly limits acceptance to the terms of the
offer;
(b) they materially alter it; or
(c) notification of objection to them has already been given
or is given within a reasonable time after notice of them is
received.
(3) Conduct by both parties which recognizes the existence of a
contract is sufficient to establish a contract for sale although the
writings of the parties do not otherwise establish a contract. In
such case the terms of the particular contract consist of those
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terms on which the writings of the parties agree, together with
any supplementary terms incorporated under any other
provisions of this Act.
§ 2–208. Course of Performance or Practical
Construction.
(1) Where the contract for sale involves repeated occasions for
performance by either party with knowledge of the nature of the
performance and opportunity for objection to it by the other, any
course of performance accepted or acquiesced in without
objection shall be relevant to determine the meaning of the
agreement.
(2) The express terms of the agreement and any such course of
performance, as well as any course of dealing and usage of trade,
shall be construed whenever reasonable as consistent with each
other; but when such construction is unreasonable, express
terms shall control course of performance and course of
performance shall control both course of dealing and usage of
trade (Section 1–205).
(3) Subject to the provisions of the next section on modification
and waiver, such course of performance shall be relevant to show
a waiver or modification of any term inconsistent with such
course of performance.
§ 2–209. Modification, Rescission and Waiver.
(1) An agreement modifying a contract within this Article needs
no consideration to be binding.
(2) A signed agreement which excludes modification or
rescission except by a signed writing cannot be otherwise
modified or rescinded, but except as between merchants such a
requirement on a form supplied by the merchant must be
separately signed by the other party.
(3) The requirements of the statute of frauds section of this
Article (Section 2–201) must be satisfied if the contract as
modified is within its provisions.
(4) Although an attempt at modification or rescission does not
satisfy the requirements of subsection (2) or (3) it can operate as
a waiver.
(5) A party who has made a waiver affecting an executory portion
of the contract may retract the waiver by reasonable notification
received by the other party that strict performance will be
required of any term waived, unless the retraction would be
unjust in view of a material change of position in reliance on the
waiver.
§ 2–210. Delegation of Performance;
Assignment of Rights.
(1) A party may perform his duty through a delegate unless
otherwise agreed or unless the other party has a substantial
interest in having his original promisor perform or control the
acts required by the contract. No delegation of performance
relieves the party delegating of any duty to perform or any
liability for breach.
(2) Except as otherwise provided in Section 9–406, unless
otherwise agreed, all rights of either seller or buyer can be
assigned except where the assignment would materially change
the duty of the other party, or increase materially the burden or
risk imposed on him by his contract, or impair materially his
chance of obtaining return performance. A right to damages for
breach of the whole contract or a right arising out of the
assignor’s due performance of his entire obligation can be
assigned despite agreement otherwise.
(3) The creation, attachment, perfection, or enforcement of a
security interest in the seller’s interest under a contract is not a
transfer that materially changes the duty of or increases materially
the burden or risk imposed on the buyer or impairs materially the
buyer’s chance of obtaining return performance within the purview
of subsection (2) unless, and then only to the extent that,
enforcement actually results in a delegation of material performance
of the seller. Even in that event, the creation, attachment,
perfection, and enforcement of the security interest remain
effective, but (i) the seller is liable to the buyer for damages caused
by the delegation to the extent that the damages could not
reasonably by prevented by the buyer, and (ii) a court having
jurisdictionmay grant other appropriate relief, including cancellation
of the contract for sale or an injunction against enforcement of the
security interest or consummation of the enforcement.
(4) Unless the circumstances indicate the contrary a prohibition
of assignment of “the contract” is to be construed as barring only
the delegation to the assigness of the assignor’s performance.
(5) An assignment of “the contract” or of “all my rights under
the contract” or an assignment in similar general terms is an
assignment of rights and unless the language or the
circumstances (as in an assignment for security) indicate the
contrary, it is a delegation of performance of the duties of the
assignor and its acceptance by the assignee constitutes a promise
by him to perform those duties. This promise is enforceable by
either the assignor or the other party to the original contract.
(6) The other party may treat any assignment which delegates
performance as creating reasonable grounds for insecurity and
may without prejudice to his rights against the assignor demand
assurances from the assignee (Section 2–609).
As amended in 1999.
PART 3 General Obligation and Construction
of Contract
§ 2–301. General Obligations of Parties.
The obligation of the seller is to transfer and deliver and that of
the buyer is to accept and pay in accordance with the contract.
§ 2–302. Unconscionable Contract or Clause.
(1) If the court as a matter of law finds the contract or any clause
of the contract to have been unconscionable at the time it was
made the court may refuse to enforce the contract, or it may
enforce the remainder of the contract without the
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unconscionable clause, or it may so limit the application of any
unconscionable clause as to avoid any unconscionable result.
(2) When it is claimed or appears to the court that the contract or
any clause thereof may be unconscionable the parties shall be
afforded a reasonable opportunity to present evidence as to its
commercial setting, purpose and effect to aid the court in
making the determination.
§ 2–303. Allocations or Division of Risks.
Where this Article allocates a risk or a burden as between the
parties “unless otherwise agreed”, the agreement may not only
shift the allocation but may also divide the risk or burden.
§ 2–304. Price Payable in Money, Goods,
Realty, or Otherwise.
(1) The price can be made payable in money or otherwise. If it is
payable in whole or in part in goods each party is a seller of the
goods which he is to transfer.
(2) Even though all or part of the price is payable in an interest
in realty the transfer of the goods and the seller’s obligations
with reference to them are subject to this Article, but not the
transfer of the interest in realty or the transferor’s obligations in
connection therewith.
§ 2–305. Open Price Term.
(1) The parties if they so intend can conclude a contract for sale
even though the price is not settled. In such a case the price is a
reasonable price at the time for delivery if
(a) nothing is said as to price; or
(b) the price is left to be agreed by the parties and they fail
to agree; or
(c) the price is to be fixed in terms of some agreed market
or other standard as set or recorded by a third person or agency
and it is not so set or recorded.
(2) A price to be fixed by the seller or by the buyer means a price
for him to fix in good faith.
(3) When a price left to be fixed otherwise than by agreement of
the parties fails to be fixed through fault of one party the other
may at his option treat the contract as cancelled or himself fix a
reasonable price.
(4) Where, however, the parties intend not to be bound unless
the price be fixed or agreed and it is not fixed or agreed there is
no contract. In such a case the buyer must return any goods
already received or if unable so to do must pay their reasonable
value at the time of delivery and the seller must return any
portion of the price paid on account.
§ 2–306. Output, Requirements and Exclusive
Dealings.
(1) A term which measures the quantity by the output of the seller
or the requirements of the buyer means such actual output or
requirements as may occur in good faith, except that no quantity
unreasonably disproportionate to any stated estimate or in the
absence of a stated estimate to any normal or otherwise comparable
prior output or requirements may be tendered or demanded.
(2) A lawful agreement by either the seller or the buyer for
exclusive dealing in the kind of goods concerned imposes unless
otherwise agreed an obligation by the seller to use best efforts to
supply the goods and by the buyer to use best efforts to promote
their sale.
§ 2–307. Delivery in Single Lot or Several
Lots.
Unless otherwise agreed all goods called for by a contract for sale
must be tendered in a single delivery and payment is due only
on such tender but where the circumstances give either party
the right to make or demand delivery in lots the price if it can be
apportioned may be demanded for each lot.
§ 2–308. Absence of Specified Place for
Delivery.
Unless otherwise agreed
(a) the place for delivery of goods is the seller’s place of
business or if he has none his residence; but
(b) in a contract for sale of identified goods which to the
knowledge of the parties at the time of contracting are in some
other place, that place is the place for their delivery; and
(c) documents of title may be delivered through customary
banking channels.
§ 2–309. Absence of Specific Time Provisions;
Notice of Termination.
(1) The time for shipment or delivery or any other action under a
contract if not provided in this Article or agreed upon shall be a
reasonable time.
(2) Where the contract provides for successive performances but
is indefinite in duration it is valid for a reasonable time but
unless otherwise agreed may be terminated at any time by either
party.
(3) Termination of a contract by one party except on the
happening of an agreed event requires that reasonable
notification be received by the other party and an agreement
dispensing with notification is invalid if its operation would be
unconscionable.
§ 2–310. Open Time for Payment or Running
of Credit; Authority to Ship Under
Reservation.
Unless otherwise agreed
(a) payment is due at the time and place at which the buyer
is to receive the goods even though the place of shipment is the
place of delivery; and
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(b) if the seller is authorized to send the goods he may ship
them under reservation, and may tender the documents of title,
but the buyer may inspect the goods after their arrival before
payment is due unless such inspection is inconsistent with the
terms of the contract (Section 2–513); and
(c) if delivery is authorized and made by way of documents
of title otherwise than by subsection (b) then payment is due at
the time and place at which the buyer is to receive the
documents regardless of where the goods are to be received; and
(d) where the seller is required or authorized to ship the
goods on credit the credit period runs from the time of shipment
but post-dating the invoice or delaying its dispatch will
correspondingly delay the starting of the credit period.
§ 2–311. Options and Cooperation Respecting
Performance.
(1) An agreement for sale which is otherwise sufficiently definite
(subsection (3) of Section 2–204) to be a contract is not made
invalid by the fact that it leaves particulars of performance to be
specified by one of the parties. Any such specification must be
made in good faith and within limits set by commercial
reasonableness.
(2) Unless otherwise agreed specifications relating to assortment
of the goods are at the buyer’s option and except as otherwise
provided in subsections (1)(c) and (3) of Section 2–319
specifications or arrangements relating to shipment are at the
seller’s option.
(3) Where such specification would materially affect the other
party’s performance but is not seasonably made or where one
party’s cooperation is necessary to the agreed performance of the
other but is not seasonably forthcoming, the other party in
addition to all other remedies
(a) is excused for any resulting delay in his own
performance; and
(b) may also either proceed to perform in any reasonable
manner or after the time for a material part of his own
performance treat the failure to specify or to cooperate as a
breach by failure to deliver or accept the goods.
§ 2–312. Warranty of Title and Against
Infringement; Buyer’s Obligation
Against Infringement.
(1) Subject to subsection (2) there is in a contract for sale a
warranty by the seller that
(a) the title conveyed shall be good, and its transfer rightful;
and
(b) the goods shall be delivered free from any security
interest or other lien or encumbrance of which the buyer at the
time of contracting has no knowledge.
(2) A warranty under subsection (1) will be excluded or modified
only by specific language or by circumstances which give the
buyer reason to know that the person selling does not claim title
in himself or that he is purporting to sell only such right or title
as he or a third person may have.
(3) Unless otherwise agreed a seller who is a merchant regularly
dealing in goods of the kind warrants that the goods shall be
delivered free of the rightful claim of any third person by way of
infringement or the like but a buyer who furnishes specifications
to the seller must hold the seller harmless against any such claim
which arises out of compliance with the specifications.
§ 2–313. Express Warranties by Affirmation,
Promise, Description, Sample.
(1) Express warranties by the seller are created as follows:
(a) Any affirmation of fact or promise made by the seller to
the buyer which relates to the goods and becomes part of the
basis of the bargain creates an express warranty that the goods
shall conform to the affirmation or promise.
(b) Any description of the goods which is made part of the
basis of the bargain creates an express warranty that the goods
shall conform to the description.
(c) Any sample or model which is made part of the basis of
the bargain creates an express warranty that the whole of the
goods shall conform to the sample or model.
(2) It is not necessary to the creation of an express warranty that
the seller use formal words such as “warrant” or “guarantee” or
that he have a specific intention to make a warranty, but an
affirmation merely of the value of the goods or a statement
purporting to be merely the seller’s opinion or commendation of
the goods does not create a warranty.
§ 2–314. Implied Warranty: Merchantability;
Usage of Trade.
(1) Unless excluded or modified (Section 2–316), a warranty that
the goods shall be merchantable is implied in a contract for their
sale if the seller is a merchant with respect to goods of that kind.
Under this section the serving for value of food or drink to be
consumed either on the premises or elsewhere is a sale.
(2) Goods to be merchantable must be at least such as
(a) pass without objection in the trade under the contract
description; and
(b) in the case of fungible goods, are of fair average quality
within the description; and
(c) are fit for the ordinary purposes for which such goods are
used; and
(d) run, within the variations permitted by the agreement,
of even kind, quality and quantity within each unit and among
all units involved; and
(e) are adequately contained, packaged, and labeled as the
agreement may require; and
(f) conform to the promises or affirmations of fact made on
the container or label if any.
(3) Unless excluded or modified (Section 2–316) other implied
warranties may arise from course of dealing or usage of trade.
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§ 2–315. Implied Warranty: Fitness for
Particular Purpose.
Where the seller at the time of contracting has reason to know
any particular purpose for which the goods are required and that
the buyer is relying on the seller’s skill or judgment to select
or furnish suitable goods, there is unless excluded or modified
under the next section an implied warranty that the goods shall
be fit for such purpose.
§ 2–316. Exclusion or Modification of
Warranties.
(1) Words or conduct relevant to the creation of an express
warranty and words or conduct tending to negate or limit
warranty shall be construed wherever reasonable as consistent
with each other; but subject to the provisions of this Article on
parol or extrinsic evidence (Section 2–202) negation or limitation
is inoperative to the extent that such construction is
unreasonable.
(2) Subject to subsection (3), to exclude or modify the implied
warranty of merchantability or any part of it the language must
mention merchantability and in case of a writing must be
conspicuous, and to exclude or modify any implied warranty of
fitness the exclusion must be by a writing and conspicuous.
Language to exclude all implied warranties of fitness is
sufficient if it states, for example, that “There are no warranties
which extend beyond the description on the face hereof.”
(3) Notwithstanding subsection (2)
(a) unless the circumstances indicate otherwise, all implied
warranties are excluded by expressions like “as is”, “with all
faults” or other language which in common understanding calls
the buyer’s attention to the exclusion of warranties and makes
plain that there is no implied warranty; and
(b) when the buyer before entering into the contract has
examined the goods or the sample or model as fully as he
desired or has refused to examine the goods there is no implied
warranty with regard to defects which an examination ought in
the circumstances to have revealed to him; and
(c) an implied warranty can also be excluded or modified by
course of dealing or course of performance or usage of trade.
(4) Remedies for breach of warranty can be limited in accordance
with the provisions of this Article on liquidation or limitation
of damages and on contractual modification of remedy
(Sections 2–718 and 2–719).
§ 2–317. Cumulation and Conflict of
Warranties Express or Implied.
Warranties whether express or implied shall be construed as
consistent with each other and as cumulative, but if such con-
struction is unreasonable the intention of the parties shall deter-
mine which warranty is dominant. In ascertaining that intention
the following rules apply:
(a) Exact or technical specifications displace an inconsistent
sample or model or general language of description.
(b) A sample from an existing bulk displaces inconsistent
general language of description.
(c) Express warranties displace inconsistent implied
warranties other than an implied warranty of fitness for a
particular purpose.
§ 2–318. Third Party Beneficiaries of
Warranties Express or Implied.
Note: If this Act is introduced in the Congress of the United
States this section should be omitted. (States to select one
alternative.)
Alternative A A seller’s warranty whether express or implied
extends to any natural person who is in the family or household
of his buyer or who is a guest in his home if it is reasonable to
expect that such person may use, consume or be affected by the
goods and who is injured in person by breach of the warranty. A
seller may not exclude or limit the operation of this section.
Alternative B A seller’s warranty whether express or implied
extends to any natural person who may reasonably be expected
to use, consume or be affected by the goods and who is injured
in person by breach of the warranty. A seller may not exclude or
limit the operation of this section.
Alternative C A seller’s warranty whether express or implied
extends to any person who may reasonably be expected to use,
consume or be affected by the goods and who is injured by
breach of the warranty. A seller may not exclude or limit the
operation of this section with respect to injury to the person of
an individual to whom the warranty extends.
As amended 1966.
§ 2–319. F.O.B. and F.A.S. Terms.
(1) Unless otherwise agreed the term F.O.B. (which means “free
on board”) at a named place, even though used only in
connection with the stated price, is a delivery term under which
(a) when the term is F.O.B. the place of shipment, the
seller must at that place ship the goods in the manner provided
in this Article (Section 2–504) and bear the expense and risk of
putting them into the possession of the carrier; or
(b) when the term is F.O.B. the place of destination, the
seller must at his own expense and risk transport the goods to
that place and there tender delivery of them in the manner
provided in this Article (Section 2–503);
(c) when under either (a) or (b) the term is also F.O.B.
vessel, car or other vehicle, the seller must in addition at his own
expense and risk load the goods on board. If the term is F.O.B.
vessel the buyer must name the vessel and in an appropriate
case the seller must comply with the provisions of this Article on
the form of bill of lading (Section 2–323).
(2) Unless otherwise agreed the term F.A.S. vessel (which
means “free alongside”) at a named port, even though used only
in connection with the stated price, is a delivery term under
which the seller must
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(a) at his own expense and risk deliver the goods alongside
the vessel in the manner usual in that port or on a dock
designated and provided by the buyer; and
(b) obtain and tender a receipt for the goods in exchange for
which the carrier is under a duty to issue a bill of lading.
(3) Unless otherwise agreed in any case falling within subsection
(1)(a) or (c) or subsection (2) the buyer must seasonably give any
needed instructions for making delivery, including when the
term is F.A.S. or F.O.B. the loading berth of the vessel and in an
appropriate case its name and sailing date. The seller may treat
the failure of needed instructions as a failure of cooperation
under this Article (Section 2–311). He may also at his option
move the goods in any reasonable manner preparatory to
delivery or shipment.
(4) Under the term F.O.B. vessel or F.A.S. unless otherwise
agreed the buyer must make payment against tender of the
required documents and the seller may not tender nor
the buyer demand delivery of the goods in substitution for the
documents.
§ 2–320. C.I.F. and C. & F. Terms.
(1) The term C.I.F. means that the price includes in a lump sum
the cost of the goods and the insurance and freight to the named
destination. The term C. & F. or C.F. means that the price so
includes cost and freight to the named destination.
(2) Unless otherwise agreed and even though used only in
connection with the stated price and destination, the term C.I.F.
destination or its equivalent requires the seller at his own
expense and risk to
(a) put the goods into the possession of a carrier at the port
for shipment and obtain a negotiable bill or bills of lading
covering the entire transportation to the named destination; and
(b) load the goods and obtain a receipt from the carrier
(which may be contained in the bill of lading) showing that the
freight has been paid or provided for; and
(c) obtain a policy or certificate of insurance, including any
war risk insurance, of a kind and on terms then current at the
port of shipment in the usual amount, in the currency of the
contract, shown to cover the same goods covered by the bill of
lading and providing for payment of loss to the order of the
buyer or for the account of whom it may concern; but the seller
may add to the price the amount of the premium for any such
war risk insurance; and
(d) prepare an invoice of the goods and procure any other
documents required to effect shipment or to comply with the
contract; and
(e) forward and tender with commercial promptness all the
documents in due form and with any indorsement necessary to
perfect the buyer’s rights.
(3) Unless otherwise agreed the term C. & F. or its equivalent
has the same effect and imposes upon the seller the same
obligations and risks as a C.I.F. term except the obligation as
to insurance.
(4) Under the term C.I.F. or C. & F. unless otherwise agreed the
buyer must make payment against tender of the required
documents and the seller may not tender nor the buyer demand
delivery of the goods in substitution for the documents.
§ 2–321. C.I.F. or C. & F.: “Net Landed
Weights”; “Payment on Arrival”;
Warranty of Condition on Arrival.
Under a contract containing a term C.I.F. or C. & F.
(1) Where the price is based on or is to be adjusted according to
“net landed weights”, “delivered weights”, “out turn” quantity
or quality or the like, unless otherwise agreed the seller must
reasonably estimate the price. The payment due on tender of
the documents called for by the contract is the amount so
estimated, but after final adjustment of the price a settlement
must be made with commercial promptness.
(2) An agreement described in subsection (1) or any warranty of
quality or condition of the goods on arrival places upon the seller
the risk of ordinary deterioration, shrinkage and the like in
transportation but has no effect on the place or time of
identification to the contract for sale or delivery or on the passing
of the risk of loss.
(3) Unless otherwise agreed where the contract provides for
payment on or after arrival of the goods the seller must before
payment allow such preliminary inspection as is feasible; but if
the goods are lost delivery of the documents and payment are
due when the goods should have arrived.
§ 2–322. Delivery “Ex-Ship”.
(1) Unless otherwise agreed a term for delivery of goods
“ex-ship” (which means from the carrying vessel) or in
equivalent language is not restricted to a particular ship and
requires delivery from a ship which has reached a place at
the named port of destination where goods of the kind are
usually discharged.
(2) Under such a term unless otherwise agreed
(a) the seller must discharge all liens arising out of the
carriage and furnish the buyer with a direction which puts the
carrier under a duty to deliver the goods; and
(b) the risk of loss does not pass to the buyer until the goods
leave the ship’s tackle or are otherwise properly unloaded.
§ 2–323. Form of Bill of Lading Required in
Overseas Shipment; “Overseas”.
(1) Where the contract contemplates overseas shipment and
contains a term C.I.F. or C. & F. or F.O.B. vessel, the seller
unless otherwise agreed must obtain a negotiable bill of lading
stating that the goods have been loaded on board or, in the case
of a term C.I.F. or C. & F., received for shipment.
(2) Where in a case within subsection (1) a bill of lading has been
issued in a set of parts, unless otherwise agreed if the documents
are not to be sent from abroad the buyer may demand tender of
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the full set; otherwise only one part of the bill of lading need be
tendered. Even if the agreement expressly requires a full set
(a) due tender of a single part is acceptable within the
provisions of this Article on cure of improper delivery
(subsection (1) of Section 2–508); and
(b) even though the full set is demanded, if the documents
are sent from abroad the person tendering an incomplete set
may nevertheless require payment upon furnishing an
indemnity which the buyer in good faith deems adequate.
(3) A shipment by water or by air or a contract contemplating
such shipment is “overseas” insofar as by usage of trade or
agreement it is subject to the commercial, financing or shipping
practices characteristic of international deep water commerce.
§ 2–324. “No Arrival, No Sale” Term.
Under a term “no arrival, no sale” or terms of like meaning,
unless otherwise agreed,
(a) the seller must properly ship conforming goods and if
they arrive by any means he must tender them on arrival but he
assumes no obligation that the goods will arrive unless he has
caused the non-arrival; and
(b) where without fault of the seller the goods are in part
lost or have so deteriorated as no longer to conform to the
contract or arrive after the contract time, the buyer may proceed
as if there had been casualty to identified goods (Section 2–613).
§ 2–325. “Letter of Credit” Term; “Confirmed
Credit”.
(1) Failure of the buyer seasonably to furnish an agreed letter of
credit is a breach of the contract for sale.
(2) The delivery to seller of a proper letter of credit suspends the
buyer’s obligation to pay. If the letter of credit is dishonored, the
seller may on seasonable notification to the buyer require
payment directly from him.
(3) Unless otherwise agreed the term “letter of credit” or
“banker’s credit” in a contract for sale means an irrevocable
credit issued by a financing agency of good repute and, where
the shipment is overseas, of good international repute. The term
“confirmed credit” means that the credit must also carry the
direct obligation of such an agency which does business in the
seller’s financial market.
§ 2–326. Sale on Approval and Sale or Return;
Rights of Creditors.
(1) Unless otherwise agreed, if delivered goods may be returned
by the buyer even though they conform to the contract, the
transaction is
(a) a “sale on approval” if the goods are delivered primarily
for use, and
(b) a “sale or return” if the goods are delivered primarily
for resale.
(2) Goods held on approval are not subject to the claims of the
buyer’s creditors until acceptance; goods held on sale or return
are subject to such claims while in the buyer’s possession.
(3) Any “or return” term of a contract for sale is to be treated as a
separate contract for sale within the statute of frauds section of
this Article (Section 2–201) and as contradicting the sale aspect
of the contract within the provisions of this Article or on parol or
extrinsic evidence (Section 2–202).
As amended in 1999.
§ 2–327. Special Incidents of Sale on Approval
and Sale or Return.
(1) Under a sale on approval unless otherwise agreed
(a) although the goods are identified to the contract the risk
of loss and the title do not pass to the buyer until acceptance; and
(b) use of the goods consistent with the purpose of trial is not
acceptance but failure seasonably to notify the seller of election to
return the goods is acceptance, and if the goods conform to the
contract acceptance of any part is acceptance of the whole; and
(c) after due notification of election to return, the return is
at the seller’s risk and expense but a merchant buyer must
follow any reasonable instructions.
(2) Under a sale or return unless otherwise agreed
(a) the option to return extends to the whole or any
commercial unit of the goods while in substantially their original
condition, but must be exercised seasonably; and
(b) the return is at the buyer’s risk and expense.
§ 2–328. Sale by Auction.
(1) In a sale by auction if goods are put up in lots each lot is the
subject of a separate sale.
(2) A sale by auction is complete when the auctioneer so
announces by the fall of the hammer or in other customary
manner. Where a bid is made while the hammer is falling in
acceptance of a prior bid the auctioneer may in his discretion
reopen the bidding or declare the goods sold under the bid on
which the hammer was falling.
(3) Such a sale is with reserve unless the goods are in explicit
terms put up without reserve. In an auction with reserve the
auctioneer may withdraw the goods at any time until he
announces completion of the sale. In an auction without reserve,
after the auctioneer calls for bids on an article or lot, that article
or lot cannot be withdrawn unless no bid is made within a
reasonable time. In either case a bidder may retract his bid until
the auctioneer’s announcement of completion of the sale, but a
bidder’s retraction does not revive any previous bid.
(4) If the auctioneer knowingly receives a bid on the seller’s
behalf or the seller makes or procures such as bid, and notice has
not been given that liberty for such bidding is reserved, the
buyer may at his option avoid the sale or take the goods at the
price of the last good faith bid prior to the completion of the sale.
This subsection shall not apply to any bid at a forced sale.
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PART 4 Title, Creditors and Good Faith
Purchasers
§ 2–401. Passing of Title; Reservation for
Security; Limited Application of This
Section.
Each provision of this Article with regard to the rights, obliga-
tions and remedies of the seller, the buyer, purchasers or other
third parties applies irrespective of title to the goods except
where the provision refers to such title. Insofar as situations are
not covered by the other provisions of this Article and matters
concerning title became material the following rules apply:
(1) Title to goods cannot pass under a contract for sale prior to
their identification to the contract (Section 2–501), and unless
otherwise explicitly agreed the buyer acquires by their
identification a special property as limited by this Act. Any
retention or reservation by the seller of the title (property) in
goods shipped or delivered to the buyer is limited in effect to
a reservation of a security interest. Subject to these provisions
and to the provisions of the Article on Secured Transactions
(Article 9), title to goods passes from the seller to the buyer in any
manner and on any conditions explicitly agreed on by the parties.
(2) Unless otherwise explicitly agreed title passes to the buyer at
the time and place at which the seller completes his
performance with reference to the physical delivery of the
goods, despite any reservation of a security interest and even
though a document of title is to be delivered at a different time
or place; and in particular and despite any reservation of a
security interest by the bill of lading
(a) if the contract requires or authorizes the seller to send
the goods to the buyer but does not require him to deliver them
at destination, title passes to the buyer at the time and place of
shipment; but
(b) if the contract requires delivery at destination, title
passes on tender there.
(3) Unless otherwise explicitly agreed where delivery is to be
made without moving the goods,
(a) if the seller is to deliver a document of title, title passes
at the time when and the place where he delivers such
documents; or
(b) if the goods are at the time of contracting already
identified and no documents are to be delivered, title passes at
the time and place of contracting.
(4) A rejection or other refusal by the buyer to receive or retain
the goods, whether or not justified, or a justified revocation of
acceptance revests title to the goods in the seller. Such revesting
occurs by operation of law and is not a “sale”.
§ 2–402. Rights of Seller’s Creditors Against
Sold Goods.
(1) Except as provided in subsections (2) and (3), rights of
unsecured creditors of the seller with respect to goods which
have been identified to a contract for sale are subject to the
buyer’s rights to recover the goods under this Article (Sections
2–502 and 2–716).
(2) A creditor of the seller may treat a sale or an identification of
goods to a contract for sale as void if as against him a retention
of possession by the seller is fraudulent under any rule of law of
the state where the goods are situated, except that retention
of possession in good faith and current course of trade by a
merchant-seller for a commercially reasonable time after a sale or
identification is not fraudulent.
(3) Nothing in this Article shall be deemed to impair the rights
of creditors of the seller
(a) under the provisions of the Article on Secured
Transactions (Article 9); or
(b) where identification to the contract or delivery is made
not in current course of trade but in satisfaction of or as security
for a pre-existing claim for money, security or the like and is
made under circumstances which under any rule of law of the
state where the goods are situated would apart from this Article
constitute the transaction a fraudulent transfer or voidable
preference.
§ 2–403. Power to Transfer; Good Faith
Purchase of Goods; “Entrusting”.
(1) A purchaser of goods acquires all title which his transferor
had or had power to transfer except that a purchaser of a limited
interest acquires rights only to the extent of the interest
purchased. A person with voidable title has power to transfer a
good title to a good faith purchaser for value. When goods have
been delivered under a transaction of purchase the purchaser has
such power even though
(a) the transferor was deceived as to the identity of the
purchaser, or
(b) the delivery was in exchange for a check which is later
dishonored, or
(c) it was agreed that the transaction was to be a “cash
sale”, or
(d) the delivery was procured through fraud punishable as
larcenous under the criminal law.
(2) Any entrusting of possession of goods to a merchant who
deals in goods of that kind gives him power to transfer all rights
of the entruster to a buyer in ordinary course of business.
(3) “Entrusting” includes any delivery and any acquiescence in
retention of possession regardless of any condition expressed
between the parties to the delivery or acquiescence and
regardless of whether the procurement of the entrusting or the
possessor’s disposition of the goods have been such as to be
larcenous under the criminal law.
(4) The rights of other purchasers of goods and of lien
creditors are governed by the Articles on Secured Transactions
(Article 9), Bulk Transfers (Article 6) and Documents of Title
(Article 7).
As amended in 1988.
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PART 5 Performance
§ 2–501. Insurable Interest in Goods; Manner
of Identification of Goods.
(1) The buyer obtains a special property and an insurable
interest in goods by identification of existing goods as goods to
which the contract refers even though the goods so identified are
non-conforming and he has an option to return or reject them.
Such identification can be made at any time and in any manner
explicitly agreed to by the parties. In the absence of explicit
agreement identification occurs
(a) when the contract is made if it is for the sale of goods
already existing and identified;
(b) if the contract is for the sale of future goods other than
those described in paragraph (c), when goods are shipped,
marked or otherwise designated by the seller as goods to which
the contract refers;
(c) when the crops are planted or otherwise become
growing crops or the young are conceived if the contract is for
the sale of unborn young to be born within twelve months after
contracting or for the sale of crops to be harvested within twelve
months or the next normal harvest season after contracting
whichever is longer.
(2) The seller retains an insurable interest in goods so long as
title to or any security interest in the goods remains in him
and where the identification is by the seller alone he may until
default or insolvency or notification to the buyer that the
identification is final substitute other goods for those
identified.
(3) Nothing in this section impairs any insurable interest
recognized under any other statute or rule of law.
§ 2–502. Buyer’s Right to Goods on Seller’s
Insolvency.
(1) Subject to subsections (2) and (3) and even though the goods
have not been shipped a buyer who has paid a part or all of the
price of goods in which he has a special property under the
provisions of the immediately preceding section may on making
and keeping good a tender of any unpaid portion of their price
recover them from the seller if:
(a) in the case of goods bought for personal, family, or
household purposes, the seller repudiates or fails to deliver as
required by the contract; or
(b) in all cases, the seller becomes insolvent within ten days
after receipt of the first installment on their price.
(2) The buyer’s right to recover the goods under subsection (1)
(a) vests upon acquisition of a special property, even if the seller
had not then repudiated or failed to deliver.
(3) If the identification creating his special property has been
made by the buyer he acquires the right to recover the goods
only if they conform to the contract for sale.
As amended in 1999.
§ 2–503. Manner of Seller’s Tender of
Delivery.
(1) Tender of delivery requires that the seller put and hold
conforming goods at the buyer’s disposition and give the buyer
any notification reasonably necessary to enable him to take
delivery. The manner, time and place for tender are determined
by the agreement and this Article, and in particular
(a) tender must be at a reasonable hour, and if it is of goods
they must be kept available for the period reasonably necessary
to enable the buyer to take possession; but
(b) unless otherwise agreed the buyer must furnish facilities
reasonably suited to the receipt of the goods.
(2) Where the case is within the next section respecting
shipment tender requires that the seller comply with its
provisions.
(3) Where the seller is required to deliver at a particular
destination tender requires that he comply with subsection (1)
and also in any appropriate case tender documents as described
in subsections (4) and (5) of this section.
(4) Where goods are in the possession of a bailee and are to be
delivered without being moved
(a) tender requires that the seller either tender a negotiable
document of title covering such goods or procure acknowledgment
by the bailee of the buyer’s right to possession of the goods; but
(b) tender to the buyer of a non-negotiable document of
title or of a written direction to the bailee to deliver is sufficient
tender unless the buyer seasonably objects, and receipt by the
bailee of notification of the buyer’s rights fixes those rights
as against the bailee and all third persons; but risk of loss of
the goods and of any failure by the bailee to honor the
non-negotiable document of title or to obey the direction
remains on the seller until the buyer has had a reasonable time
to present the document or direction, and a refusal by the
bailee to honor the document or to obey the direction defeats
the tender.
(5) Where the contract requires the seller to deliver
documents
(a) he must tender all such documents in correct form,
except as provided in this Article with respect to bills of lading in
a set (subsection (2) of Section 2–323); and
(b) tender through customary banking channels is sufficient
and dishonor of a draft accompanying the documents constitutes
non-acceptance or rejection.
§ 2–504. Shipment by Seller.
Where the seller is required or authorized to send the goods to
the buyer and the contract does not require him to deliver them
at a particular destination, then unless otherwise agreed he must
(a) put the goods in the possession of such a carrier and
make such a contract for their transportation as may be
reasonable having regard to the nature of the goods and other
circumstances of the case; and
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(b) obtain and promptly deliver or tender in due form any
document necessary to enable the buyer to obtain possession of
the goods or otherwise required by the agreement or by usage
of trade; and
(c) promptly notify the buyer of the shipment.
Failure to notify the buyer under paragraph (c) or to make a
proper contract under paragraph (a) is a ground for rejection only
if material delay or loss ensues.
§ 2–505. Seller’s Shipment under
Reservation.
(1) Where the seller has identified goods to the contract by or
before shipment:
(a) his procurement of a negotiable bill of lading to his
own order or otherwise reserves in him a security interest in
the goods. His procurement of the bill to the order of a
financing agency or of the buyer indicates in addition only
the seller’s expectation of transferring that interest to the
person named.
(b) a non-negotiable bill of lading to himself or his nominee
reserves possession of the goods as security but except in a
case of conditional delivery (subsection (2) of Section 2–507)
a non-negotiable bill of lading naming the buyer as consignee
reserves no security interest even though the seller retains
possession of the bill of lading.
(2) When shipment by the seller with reservation of a security
interest is in violation of the contract for sale it constitutes an
improper contract for transportation within the preceding section
but impairs neither the rights given to the buyer by shipment
and identification of the goods to the contract nor the seller’s
powers as a holder of a negotiable document.
§ 2–506. Rights of Financing Agency.
(1) A financing agency by paying or purchasing for value a
draft which relates to a shipment of goods acquires to the
extent of the payment or purchase and in addition to its own
rights under the draft and any document of title securing it
any rights of the shipper in the goods including the right to
stop delivery and the shipper’s right to have the draft
honored by the buyer.
(2) The right to reimbursement of a financing agency which has
in good faith honored or purchased the draft under commitment
to or authority from the buyer is not impaired by subsequent
discovery of defects with reference to any relevant document
which was apparently regular on its face.
§ 2–507. Effect of Seller’s Tender; Delivery on
Condition.
(1) Tender of delivery is a condition to the buyer’s duty to
accept the goods and, unless otherwise agreed, to his duty to pay
for them. Tender entitles the seller to acceptance of the goods
and to payment according to the contract.
(2) Where payment is due and demanded on the delivery to the
buyer of goods or documents of title, his right as against the
seller to retain or dispose of them is conditional upon his making
the payment due.
§ 2–508. Cure by Seller of Improper Tender
or Delivery; Replacement.
(1) Where any tender or delivery by the seller is rejected because
non-conforming and the time for performance has not yet expired,
the seller may seasonably notify the buyer of his intention to cure
and may then within the contract time make a conforming delivery.
(2) Where the buyer rejects a non-conforming tender which the
seller had reasonable grounds to believe would be acceptable
with or without money allowance the seller may if he seasonably
notifies the buyer have a further reasonable time to substitute a
conforming tender.
§ 2–509. Risk of Loss in the Absence of Breach.
(1) Where the contract requires or authorizes the seller to ship
the goods by carrier
(a) if it does not require him to deliver them at a particular
destination, the risk of loss passes to the buyer when the goods
are duly delivered to the carrier even though the shipment is
under reservation (Section 2–505); but
(b) if it does require him to deliver them at a particular
destination and the goods are there duly tendered while in the
possession of the carrier, the risk of loss passes to the buyer
when the goods are there duly so tendered as to enable the
buyer to take delivery.
(2) Where the goods are held by a bailee to be delivered without
being moved, the risk of loss passes to the buyer
(a) on his receipt of a negotiable document of title covering
the goods; or
(b) on acknowledgment by the bailee of the buyer’s right to
possession of the goods; or
(c) after his receipt of a non-negotiable document of title or
other written direction to deliver, as provided in subsection (4)
(b) of Section 2–503.
(3) In any case not within subsection (1) or (2), the risk of loss passes
to the buyer on his receipt of the goods if the seller is a merchant;
otherwise the risk passes to the buyer on tender of delivery.
(4) The provisions of this section are subject to contrary
agreement of the parties and to the provisions of this Article on
sale on approval (Section 2–327) and on effect of breach on risk
of loss (Section 2–510).
§ 2–510. Effect of Breach on Risk of Loss.
(1) Where a tender or delivery of goods so fails to conform to the
contract as to give a right of rejection the risk of their loss
remains on the seller until cure or acceptance.
(2) Where the buyer rightfully revokes acceptance he may
to the extent of any deficiency in his effective insurance
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B17
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coverage treat the risk of loss as having rested on the seller from
the beginning.
(3) Where the buyer as to conforming goods already identified
to the contract for sale repudiates or is otherwise in breach
before risk of their loss has passed to him, the seller may to the
extent of any deficiency in his effective insurance coverage
treat the risk of loss as resting on the buyer for a commercially
reasonable time.
§ 2–511. Tender of Payment by Buyer;
Payment by Check.
(1) Unless otherwise agreed tender of payment is a condition to
the seller’s duty to tender and complete any delivery.
(2) Tender of payment is sufficient when made by any means or
in any manner current in the ordinary course of business unless
the seller demands payment in legal tender and gives any
extension of time reasonably necessary to procure it.
(3) Subject to the provisions of this Act on the effect of an
instrument on an obligation (Section 3–310), payment by check
is conditional and is defeated as between the parties by dishonor
of the check on due presentment.
As amended in 1994.
§ 2–512. Payment by Buyer Before Inspection.
(1) Where the contract requires payment before inspection non-
conformity of the goods does not excuse the buyer from so
making payment unless
(a) the non-conformity appears without inspection; or
(b) despite tender of the required documents the
circumstances would justify injunction against honor under this
Act (Section 5–109(b)).
(2) Payment pursuant to subsection (1) does not constitute an
acceptance of goods or impair the buyer’s right to inspect or any
of his remedies.
As amended in 1995.
§ 2–513. Buyer’s Right to Inspection of Goods.
(1) Unless otherwise agreed and subject to subsection (3), where
goods are tendered or delivered or identified to the contract for
sale, the buyer has a right before payment or acceptance to
inspect them at any reasonable place and time and in any
reasonable manner. When the seller is required or authorized to
send the goods to the buyer, the inspection may be after their
arrival.
(2) Expenses of inspection must be borne by the buyer but may
be recovered from the seller if the goods do not conform and are
rejected.
(3) Unless otherwise agreed and subject to the provisions of this
Article on C.I.F. contracts (subsection (3) of Section 2–321), the
buyer is not entitled to inspect the goods before payment of the
price when the contract provides
(a) for delivery “C.O.D.” or on other like terms; or
(b) for payment against documents of title, except where
such payment is due only after the goods are to become
available for inspection.
(4) A place or method of inspection fixed by the parties is
presumed to be exclusive but unless otherwise expressly agreed
it does not postpone identification or shift the place for delivery
or for passing the risk of loss. If compliance becomes impossible,
inspection shall be as provided in this section unless the place or
method fixed was clearly intended as an indispensable condition
failure of which avoids the contract.
§ 2–514. When Documents Deliverable on
Acceptance; When on Payment.
Unless otherwise agreed documents against which a draft is
drawn are to be delivered to the drawee on acceptance of the
draft if it is payable more than three days after presentment;
otherwise, only on payment.
§ 2–515. Preserving Evidence of Goods in
Dispute.
In furtherance of the adjustment of any claim or dispute
(a) either party on reasonable notification to the other and for
the purpose of ascertaining the facts and preserving evidence has
the right to inspect, test and sample the goods including such of
them as may be in the possession or control of the other; and
(b) the parties may agree to a third party inspection or
survey to determine the conformity or condition of the goods
and may agree that the findings shall be binding upon them in
any subsequent litigation or adjustment.
PART 6 Breach, Repudiation and Excuse
§ 2–601. Buyer’s Rights on Improper Delivery.
Subject to the provisions of this Article on breach in installment
contracts (Section 2–612) and unless otherwise agreed under the
sections on contractual limitations of remedy (Sections 2–718
and 2–719), if the goods or the tender of delivery fail in any
respect to conform to the contract, the buyer may
(a) reject the whole; or
(b) accept the whole; or
(c) accept any commercial unit or units and reject the rest.
§ 2–602. Manner and Effect of Rightful
Rejection.
(1) Rejection of goods must be within a reasonable time after
their delivery or tender. It is ineffective unless the buyer
seasonably notifies the seller.
(2) Subject to the provisions of the two following sections on
rejected goods (Sections 2–603 and 2–604),
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(a) after rejection any exercise of ownership by the buyer
with respect to any commercial unit is wrongful as against the
seller; and
(b) if the buyer has before rejection taken physical
possession of goods in which he does not have a security interest
under the provisions of this Article (subsection (3) of Section 2–711),
he is under a duty after rejection to hold them with reasonable care
at the seller’s disposition for a time sufficient to permit the seller to
remove them; but
(c) the buyer has no further obligations with regard to goods
rightfully rejected.
(3) The seller’s rights with respect to goods wrongfully rejected
are governed by the provisions of this Article on Seller’s
remedies in general (Section 2–703).
§ 2–603. Merchant Buyer’s Duties as to
Rightfully Rejected Goods.
(1) Subject to any security interest in the buyer (subsection (3)
of Section 2–711), when the seller has no agent or place of
business at the market of rejection a merchant buyer is under a
duty after rejection of goods in his possession or control to follow
any reasonable instructions received from the seller with respect
to the goods and in the absence of such instructions to make
reasonable efforts to sell them for the seller’s account if they are
perishable or threaten to decline in value speedily. Instructions
are not reasonable if on demand indemnity for expenses is not
forthcoming.
(2) When the buyer sells goods under subsection (1), he is entitled
to reimbursement from the seller or out of the proceeds for
reasonable expenses of caring for and selling them, and if the
expenses include no selling commission then to such commission
as is usual in the trade or if there is none to a reasonable sum not
exceeding ten per cent on the gross proceeds.
(3) In complying with this section the buyer is held only to good
faith and good faith conduct hereunder is neither acceptance nor
conversion nor the basis of an action for damages.
§ 2–604. Buyer’s Options as to Salvage of
Rightfully Rejected Goods.
Subject to the provisions of the immediately preceding section
on perishables if the seller gives no instructions within a reason-
able time after notification of rejection the buyer may store the
rejected goods for the seller’s account or reship them to him or
resell them for the seller’s account with reimbursement as pro-
vided in the preceding section. Such action is not acceptance or
conversion.
§ 2–605. Waiver of Buyer’s Objections by
Failure to Particularize.
(1) The buyer’s failure to state in connection with rejection a
particular defect which is ascertainable by reasonable inspection
precludes him from relying on the unstated defect to justify
rejection or to establish breach
(a) where the seller could have cured it if stated seasonably;
or
(b) between merchants when the seller has after rejection
made a request in writing for a full and final written statement of
all defects on which the buyer proposes to rely.
(2) Payment against documents made without reservation of
rights precludes recovery of the payment for defects apparent on
the face of the documents.
§ 2–606. What Constitutes Acceptance
of Goods.
(1) Acceptance of goods occurs when the buyer
(a) after a reasonable opportunity to inspect the goods
signifies to the seller that the goods are conforming or that he
will take or retain them in spite of their nonconformity; or
(b) fails to make an effective rejection (subsection (1) of
Section 2–602), but such acceptance does not occur until the
buyer has had a reasonable opportunity to inspect them; or
(c) does any act inconsistent with the seller’s ownership; but
if such act is wrongful as against the seller it is an acceptance
only if ratified by him.
(2) Acceptance of a part of any commercial unit is acceptance of
that entire unit.
§ 2–607. Effect of Acceptance; Notice of
Breach; Burden of Establishing
Breach After Acceptance; Notice
of Claim or Litigation to Person
Answerable Over.
(1) The buyer must pay at the contract rate for any goods
accepted.
(2) Acceptance of goods by the buyer precludes rejection of the
goods accepted and if made with knowledge of a non-conformity
cannot be revoked because of it unless the acceptance was on
the reasonable assumption that the non-conformity would be
seasonably cured but acceptance does not of itself impair any
other remedy provided by this Article for non-conformity.
(3) Where a tender has been accepted
(a) the buyer must within a reasonable time after he
discovers or should have discovered any breach notify the seller
of breach or be barred from any remedy; and
(b) if the claim is one for infringement or the like
(subsection (3) of Section 2–312) and the buyer is sued as a
result of such a breach he must so notify the seller within a
reasonable time after he receives notice of the litigation or be
barred from any remedy over for liability established by the
litigation.
(4) The burden is on the buyer to establish any breach with
respect to the goods accepted.
(5) Where the buyer is sued for breach of a warranty or other
obligation for which his seller is answerable over
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B19
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(a) he may give his seller written notice of the litigation.
If the notice states that the seller may come in and defend
and that if the seller does not do so he will be bound in any
action against him by his buyer by any determination of fact
common to the two litigations, then unless the seller after
seasonable receipt of the notice does come in and defend he
is so bound.
(b) if the claim is one for infringement or the like
(subsection (3) of Section 2–312) the original seller may
demand in writing that his buyer turn over to him control of
the litigation including settlement or else be barred from any
remedy over and if he also agrees to bear all expense and to
satisfy any adverse judgment, then unless the buyer after
seasonable receipt of the demand does turn over control the
buyer is so barred.
(6) The provisions of subsections (3), (4) and (5) apply to any
obligation of a buyer to hold the seller harmless against
infringement or the like (subsection (3) of Section 2–312).
§ 2–608. Revocation of Acceptance in Whole
or in Part.
(1) The buyer may revoke his acceptance of a lot or commercial
unit whose non-conformity substantially impairs its value to him
if he has accepted it
(a) on the reasonable assumption that its nonconformity
would be cured and it has not been seasonably cured; or
(b) without discovery of such non-conformity if his
acceptance was reasonably induced either by the difficulty of
discovery before acceptance or by the seller’s assurances.
(2) Revocation of acceptance must occur within a reasonable
time after the buyer discovers or should have discovered the
ground for it and before any substantial change in condition of
the goods which is not caused by their own defects. It is not
effective until the buyer notifies the seller of it.
(3) A buyer who so revokes has the same rights and duties with
regard to the goods involved as if he had rejected them.
§ 2–609. Right to Adequate Assurance of
Performance.
(1) A contract for sale imposes an obligation on each party that
the other’s expectation of receiving due performance will not be
impaired. When reasonable grounds for insecurity arise with
respect to the performance of either party the other may in
writing demand adequate assurance of due performance and
until he receives such assurance may if commercially reasonable
suspend any performance for which he has not already received
the agreed return.
(2) Between merchants the reasonableness of grounds for
insecurity and the adequacy of any assurance offered shall be
determined according to commercial standards.
(3) Acceptance of any improper delivery or payment does not
prejudice the party’s right to demand adequate assurance of
future performance.
(4) After receipt of a justified demand failure to provide within a
reasonable time not exceeding thirty days such assurance of due
performance as is adequate under the circumstances of the
particular case is a repudiation of the contract.
§ 2–610. Anticipatory Repudiation.
When either party repudiates the contract with respect to a perfor-
mance not yet due the loss of which will substantially impair the
value of the contract to the other, the aggrieved party may
(a) for a commercially reasonable time await performance by
the repudiating party; or
(b) resort to any remedy for breach (Section 2–703 or Sec-
tion 2–711), even though he has notified the repudiating party
that he would await the latter’s performance and has urged
retraction; and
(c) in either case suspend his own performance or proceed
in accordance with the provisions of this Article on the seller’s
right to identify goods to the contract notwithstanding breach or
to salvage unfinished goods (Section 2–704).
§ 2–611. Retraction of Anticipatory
Repudiation.
(1) Until the repudiating party’s next performance is due he can
retract his repudiation unless the aggrieved party has since the
repudiation cancelled or materially changed his position or
otherwise indicated that he considers the repudiation final.
(2) Retraction may be by any method which clearly indicates to
the aggrieved party that the repudiating party intends to
perform, but must include any assurance justifiably demanded
under the provisions of this Article (Section 2–609).
(3) Retraction reinstates the repudiating party’s rights under the
contract with due excuse and allowance to the aggrieved party
for any delay occasioned by the repudiation.
§ 2–612. “Installment Contract”; Breach.
(1) An “installment contract” is one which requires or authorizes
the delivery of goods in separate lots to be separately accepted,
even though the contract contains a clause “each delivery is a
separate contract” or its equivalent.
(2) The buyer may reject any installment which is non-
conforming if the non-conformity substantially impairs the value
of that installment and cannot be cured or if the non-conformity
is a defect in the required documents; but if the non-conformity
does not fall within subsection (3) and the seller gives adequate
assurance of its cure the buyer must accept that installment.
(3) Whenever non-conformity or default with respect to one or
more installments substantially impairs the value of the whole
contract there is a breach of the whole. But the aggrieved party
reinstates the contract if he accepts a non-conforming
installment without seasonably notifying of cancellation or if he
brings an action with respect only to past installments or
demands performance as to future installments.
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§ 2–613. Casualty to Identified Goods.
Where the contract requires for its performance goods identi-
fied when the contract is made, and the goods suffer casualty
without fault of either party before the risk of loss passes to the
buyer, or in a proper case under a “no arrival, no sale” term
(Section 2–324) then
(a) if the loss is total the contract is avoided; and
(b) if the loss is partial or the goods have so deteriorated as
no longer to conform to the contract the buyer may nevertheless
demand inspection and at his option either treat the contract as
voided or accept the goods with due allowance from the contract
price for the deterioration or the deficiency in quantity but
without further right against the seller.
§ 2–614. Substituted Performance.
(1) Where without fault of either party the agreed berthing,
loading, or unloading facilities fail or an agreed type of carrier
becomes unavailable or the agreed manner of delivery otherwise
becomes commercially impracticable but a commercially
reasonable substitute is available, such substitute performance
must be tendered and accepted.
(2) If the agreed means or manner of payment fails because of
domestic or foreign governmental regulation, the seller may
withhold or stop delivery unless the buyer provides a means or
manner of payment which is commercially a substantial
equivalent. If delivery has already been taken, payment by the
means or in the manner provided by the regulation discharges
the buyer’s obligation unless the regulation is discriminatory,
oppressive or predatory.
§ 2–615. Excuse by Failure of Presupposed
Conditions.
Except so far as a seller may have assumed a greater obligation
and subject to the preceding section on substituted performance:
(a) Delay in delivery or non-delivery in whole or in part
by a seller who complies with paragraphs (b) and (c) is not a
breach of his duty under a contract for sale if performance as
agreed has been made impracticable by the occurrence of a
contingency the nonoccurrence of which was a basic
assumption on which the contract was made or by compliance
in good faith with any applicable foreign or domestic
governmental regulation or order whether or not it later
proves to be invalid.
(b) Where the causes mentioned in paragraph (a) affect only
a part of the seller’s capacity to perform, he must allocate
production and deliveries among his customers but may at his
option include regular customers not then under contract as well
as his own requirements for further manufacture. He may so
allocate in any manner which is fair and reasonable.
(c) The seller must notify the buyer seasonably that there
will be delay or non-delivery and, when allocation is required
under paragraph (b), of the estimated quota thus made available
for the buyer.
§ 2–616. Procedure on Notice Claiming
Excuse.
(1) Where the buyer receives notification of a material or
indefinite delay or an allocation justified under the preceding
section he may by written notification to the seller as to any
delivery concerned, and where the prospective deficiency
substantially impairs the value of the whole contract under the
provisions of this Article relating to breach of installment
contracts (Section 2–612), then also as to the whole,
(a) terminate and thereby discharge any unexecuted portion
of the contract; or
(b) modify the contract by agreeing to take his available
quota in substitution.
(2) If after receipt of such notification from the seller the buyer
fails so to modify the contract within a reasonable time not
exceeding thirty days the contract lapses with respect to any
deliveries affected.
(3) The provisions of this section may not be negated by
agreement except in so far as the seller has assumed a greater
obligation under the preceding section.
PART 7 Remedies
§ 2–701. Remedies for Breach of Collateral
Contracts Not Impaired.
Remedies for breach of any obligation or promise collateral or
ancillary to a contract for sale are not impaired by the provisions
of this Article.
§ 2–702. Seller’s Remedies on Discovery of
Buyer’s Insolvency.
(1) Where the seller discovers the buyer to be insolvent he may
refuse delivery except for cash including payment for all goods
theretofore delivered under the contract, and stop delivery
under this Article (Section 2–705).
(2) Where the seller discovers that the buyer has received goods on
credit while insolvent he may reclaim the goods upon demand
made within ten days after the receipt, but if misrepresentation of
solvency has been made to the particular seller in writing within
threemonths before delivery the ten day limitation does not apply.
Except as provided in this subsection the seller may not base a
right to reclaim goods on the buyer’s fraudulent or innocent
misrepresentation of solvency or of intent to pay.
(3) The seller’s right to reclaim under subsection (2) is subject to
the rights of a buyer in ordinary course or other good faith purchaser
under this Article (Section 2–403). Successful reclamation of goods
excludes all other remedies with respect to them.
§ 2–703. Seller’s Remedies in General.
Where the buyer wrongfully rejects or revokes acceptance of
goods or fails to make a payment due on or before delivery or
repudiates with respect to a part or the whole, then with respect
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B21
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to any goods directly affected and, if the breach is of the whole
contract (Section 2–612), then also with respect to the whole
undelivered balance, the aggrieved seller may
(a) withhold delivery of such goods;
(b) stop delivery by any bailee as hereafter provided
(Section 2–705);
(c) proceed under the next section respecting goods still
unidentified to the contract;
(d) resell and recover damages as hereafter provided
(Section 2–706);
(e) recover damages for non-acceptance (Section 2–708) or
in a proper case the price (Section 2–709);
(f) cancel.
§ 2–704. Seller’s Right to Identify Goods to
the Contract Notwithstanding
Breach or to Salvage Unfinished
Goods.
(1) An aggrieved seller under the preceding section may
(a) identify to the contract conforming goods not already
identified if at the time he learned of the breach they are in his
possession or control;
(b) treat as the subject of resale goods which have
demonstrably been intended for the particular contract even
though those goods are unfinished.
(2) Where the goods are unfinished an aggrieved seller may in
the exercise of reasonable commercial judgment for the
purposes of avoiding loss and of effective realization either
complete the manufacture and wholly identify the goods to the
contract or cease manufacture and resell for scrap or salvage
value or proceed in any other reasonable manner.
§ 2–705. Seller’s Stoppage of Delivery in
Transit or Otherwise.
(1) The seller may stop delivery of goods in the possession of a
carrier or other bailee when he discovers the buyer to be
insolvent (Section 2–702) and may stop delivery of carload,
truckload, planeload or larger shipments of express or freight
when the buyer repudiates or fails to make a payment due
before delivery or if for any other reason the seller has a right to
withhold or reclaim the goods.
(2) As against such buyer the seller may stop delivery until
(a) receipt of the goods by the buyer; or
(b) acknowledgment to the buyer by any bailee of the
goods except a carrier that the bailee holds the goods for the
buyer; or
(c) such acknowledgment to the buyer by a carrier by
reshipment or as warehouseman; or
(d) negotiation to the buyer of any negotiable document of
title covering the goods.
(3) (a) To stop delivery the seller must so notify as to enable the
bailee by reasonable diligence to prevent delivery of the goods.
(b) After such notification the bailee must hold and deliver
the goods according to the directions of the seller but the seller
is liable to the bailee for any ensuing charges or damages.
(c) If a negotiable document of title has been issued for
goods the bailee is not obliged to obey a notification to stop until
surrender of the document.
(d) A carrier who has issued a non-negotiable bill of lading is
not obliged to obey a notification to stop received from a person
other than the consignor.
§ 2–706. Seller’s Resale Including Contract
for Resale.
(1) Under the conditions stated in Section 2–703 on seller’s
remedies, the seller may resell the goods concerned or the
undelivered balance thereof. Where the resale is made in good
faith and in a commercially reasonable manner the seller may
recover the difference between the resale price and the contract
price together with any incidental damages allowed under the
provisions of this Article (Section 2–710), but less expenses
saved in consequence of the buyer’s breach.
(2) Except as otherwise provided in subsection (3) or unless
otherwise agreed resale may be at public or private sale
including sale by way of one or more contracts to sell or of
identification to an existing contract of the seller. Sale may be as
a unit or in parcels and at any time and place and on any terms
but every aspect of the sale including the method, manner, time,
place and terms must be commercially reasonable. The resale
must be reasonably identified as referring to the broken contract,
but it is not necessary that the goods be in existence or that any
or all of them have been identified to the contract before the
breach.
(3) Where the resale is at private sale the seller must give the
buyer reasonable notification of his intention to resell.
(4) Where the resale is at public sale
(a) only identified goods can be sold except where there is a
recognized market for a public sale of futures in goods of the
kind; and
(b) it must be made at a usual place or market for public sale
if one is reasonably available and except in the case of goods
which are perishable or threaten to decline in value speedily the
seller must give the buyer reasonable notice of the time and
place of the resale; and
(c) if the goods are not to be within the view of those
attending the sale the notification of sale must state the place
where the goods are located and provide for their reasonable
inspection by prospective bidders; and
(d) the seller may buy.
(5) A purchaser who buys in good faith at a resale takes the
goods free of any rights of the original buyer even though the
seller fails to comply with one or more of the requirements of
this section.
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(6) The seller is not accountable to the buyer for any profit made
on any resale. A person in the position of a seller (Section 2–707)
or a buyer who has rightfully rejected or justifiably revoked
acceptance must account for any excess over the amount of his
security interest, as hereinafter defined (subsection (3) of
Section 2–711).
§ 2–707. “Person in the Position of a Seller”.
(1) A “person in the position of a seller” includes as against a
principal an agent who has paid or become responsible for the
price of goods on behalf of his principal or anyone who otherwise
holds a security interest or other right in goods similar to that of
a seller.
(2) A person in the position of a seller may as provided in this
Article withhold or stop delivery (Section 2–705) and resell
(Section 2–706) and recover incidental damages (Section 2–710).
§ 2–708. Seller’s Damages for Non-
Acceptance or Repudiation.
(1) Subject to subsection (2) and to the provisions of this Article
with respect to proof of market price (Section 2–723), the
measure of damages for non-acceptance or repudiation by the
buyer is the difference between the market price at the time and
place for tender and the unpaid contract price together with any
incidental damages provided in this Article (Section 2–710), but
less expenses saved in consequence of the buyer’s breach.
(2) If the measure of damages provided in subsection (1) is
inadequate to put the seller in as good a position as performance
would have done then the measure of damages is the profit
(including reasonable overhead) which the seller would have
made from full performance by the buyer, together with any
incidental damages provided in this Article (Section 2–710), due
allowance for costs reasonably incurred and due credit for
payments or proceeds of resale.
§ 2–709. Action for the Price.
(1) When the buyer fails to pay the price as it becomes due the
seller may recover, together with any incidental damages under
the next section, the price
(a) of goods accepted or of conforming goods lost or
damaged within a commercially reasonable time after risk of
their loss has passed to the buyer; and
(b) of goods identified to the contract if the seller is unable
after reasonable effort to resell them at a reasonable price or the
circumstances reasonably indicate that such effort will be
unavailing.
(2) Where the seller sues for the price he must hold for the buyer
any goods which have been identified to the contract and are
still in his control except that if resale becomes possible he may
resell them at any time prior to the collection of the judgment.
The net proceeds of any such resale must be credited to the
buyer and payment of the judgment entitles him to any goods
not resold.
(3) After the buyer has wrongfully rejected or revoked
acceptance of the goods or has failed to make a payment due or
has repudiated (Section 2–610), a seller who is held not entitled
to the price under this section shall nevertheless be awarded
damages for non-acceptance under the preceding section.
§ 2–710. Seller’s Incidental Damages.
Incidental damages to an aggrieved seller include any commer-
cially reasonable charges, expenses or commissions incurred in
stopping delivery, in the transportation, care and custody of
goods after the buyer’s breach, in connection with return or
resale of the goods or otherwise resulting from the breach.
§ 2–711. Buyer’s Remedies in General; Buyer’s
Security Interest in Rejected Goods.
(1) Where the seller fails to make delivery or repudiates or the
buyer rightfully rejects or justifiably revokes acceptance then
with respect to any goods involved, and with respect to the
whole if the breach goes to the whole contract (Section 2–612),
the buyer may cancel and whether or not he has done so may in
addition to recovering so much of the price as has been paid
(a) “cover” and have damages under the next section as to
all the goods affected whether or not they have been identified
to the contract; or
(b) recover damages for non-delivery as provided in this
Article (Section 2–713).
(2) Where the seller fails to deliver or repudiates the buyer may
also
(a) if the goods have been identified recover them as
provided in this Article (Section 2–502); or
(b) in a proper case obtain specific performance or replevy
the goods as provided in this Article (Section 2–716).
(3) On rightful rejection or justifiable revocation of acceptance a
buyer has a security interest in goods in his possession or control
for any payments made on their price and any expenses
reasonably incurred in their inspection, receipt, transportation,
care and custody and may hold such goods and resell them in
like manner as an aggrieved seller (Section 2–706).
§ 2–712. “Cover”; Buyer’s Procurement of
Substitute Goods.
(1) After a breach within the preceding section the buyer may
“cover” by making in good faith and without unreasonable delay
any reasonable purchase of or contract to purchase goods in
substitution for those due from the seller.
(2) The buyer may recover from the seller as damages the
difference between the cost of cover and the contract price
together with any incidental or consequential damages as
hereinafter defined (Section 2–715), but less expenses saved in
consequence of the seller’s breach.
(3) Failure of the buyer to effect cover within this section does
not bar him from any other remedy.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B23
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§ 2–713. Buyer’s Damages for Non-Delivery or
Repudiation.
(1) Subject to the provisions of this Article with respect to proof
of market price (Section 2–723), the measure of damages for
non-delivery or repudiation by the seller is the difference between
the market price at the time when the buyer learned of the
breach and the contract price together with any incidental and
consequential damages provided in this Article (Section 2–715),
but less expenses saved in consequence of the seller’s breach.
(2) Market price is to be determined as of the place for tender or,
in cases of rejection after arrival or revocation of acceptance, as of
the place of arrival.
§ 2–714. Buyer’s Damages for Breach in
Regard to Accepted Goods.
(1) Where the buyer has accepted goods and given notification
(subsection (3) of Section 2–607) he may recover as damages for
any non-conformity of tender the loss resulting in the ordinary
course of events from the seller’s breach as determined in any
manner which is reasonable.
(2) The measure of damages for breach of warranty is the
difference at the time and place of acceptance between the
value of the goods accepted and the value they would have had
if they had been as warranted, unless special circumstances show
proximate damages of a different amount.
(3) In a proper case any incidental and consequential damages
under the next section may also be recovered.
§ 2–715. Buyer’s Incidental and Consequential
Damages.
(1) Incidental damages resulting from the seller’s breach include
expenses reasonably incurred in inspection, receipt,
transportation and care and custody of goods rightfully rejected,
any commercially reasonable charges, expenses or commissions
in connection with effecting cover and any other reasonable
expense incident to the delay or other breach.
(2) Consequential damages resulting from the seller’s breach
include
(a) any loss resulting from general or particular
requirements and needs of which the seller at the time of
contracting had reason to know and which could not reasonably
be prevented by cover or otherwise; and
(b) injury to person or property proximately resulting from
any breach of warranty.
§ 2–716. Buyer’s Right to Specific
Performance or Replevin.
(1) Specific performance may be decreed where the goods are
unique or in other proper circumstances.
(2) The decree for specific performance may include such terms
and conditions as to payment of the price, damages, or other
relief as the court may deem just.
(3) The buyer has a right of replevin for goods identified to the
contract if after reasonable effort he is unable to effect cover for
such goods or the circumstances reasonably indicate that such
effort will be unavailing or if the goods have been shipped under
reservation and satisfaction of the security interest in them has
been made or tendered. In the case of goods bought for
personal, family, or household purposes, the buyer’s right of
replevin vests upon acquisition of a special property, even if the
seller had not then repudiated or failed to deliver.
As amended in 1999.
§ 2–717. Deduction of Damages From the
Price.
The buyer on notifying the seller of his intention to do so may
deduct all or any part of the damages resulting from any breach
of the contract from any part of the price still due under the
same contract.
§ 2–718. Liquidation or Limitation of
Damages; Deposits.
(1) Damages for breach by either party may be liquidated in the
agreement but only at an amount which is reasonable in the light
of the anticipated or actual harm caused by the breach, the
difficulties of proof of loss, and the inconvenience or nonfeasibility
of otherwise obtaining an adequate remedy. A term fixing
unreasonably large liquidated damages is void as a penalty.
(2) Where the seller justifiably withholds delivery of goods
because of the buyer’s breach, the buyer is entitled to restitution
of any amount by which the sum of his payments exceeds
(a) the amount to which the seller is entitled by virtue of
terms liquidating the seller’s damages in accordance with
subsection (1), or
(b) in the absence of such terms, twenty per cent of the
value of the total performance for which the buyer is obligated
under the contract or $500, whichever is smaller.
(3) The buyer’s right to restitution under subsection (2) is
subject to offset to the extent that the seller establishes
(a) a right to recover damages under the provisions of this
Article other than subsection (1), and
(b) the amount or value of any benefits received by the
buyer directly or indirectly by reason of the contract.
(4) Where a seller has received payment in goods their reasonable
value or the proceeds of their resale shall be treated as payments
for the purposes of subsection (2); but if the seller has notice of the
buyer’s breach before reselling goods received in part
performance, his resale is subject to the conditions laid down in
this Article on resale by an aggrieved seller (Section 2–706).
§ 2–719. Contractual Modification or
Limitation of Remedy.
(1) Subject to the provisions of subsections (2) and (3) of this
section and of the preceding section on liquidation and
limitation of damages,
B24 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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(a) the agreement may provide for remedies in addition to
or in substitution for those provided in this Article and may limit
or alter the measure of damages recoverable under this Article,
as by limiting the buyer’s remedies to return of the goods and
repayment of the price or to repair and replacement of
nonconforming goods or parts; and
(b) resort to a remedy as provided is optional unless the
remedy is expressly agreed to be exclusive, in which case it is
the sole remedy.
(2) Where circumstances cause an exclusive or limited remedy to
fail of its essential purpose, remedy may be had as provided in
this Act.
(3) Consequential damages may be limited or excluded unless
the limitation or exclusion is unconscionable. Limitation of
consequential damages for injury to the person in the case of
consumer goods is prima facie unconscionable but limitation of
damages where the loss is commercial is not.
§ 2–720. Effect of “Cancellation” or
“Rescission” on Claims for
Antecedent Breach.
Unless the contrary intention clearly appears, expressions of
“cancellation” or “rescission” of the contract or the like shall
not be construed as a renunciation or discharge of any claim in
damages for an antecedent breach.
§ 2–721. Remedies for Fraud.
Remedies for material misrepresentation or fraud include all
remedies available under this Article for non-fraudulent breach.
Neither rescission or a claim for rescission of the contract for sale
nor rejection or return of the goods shall bar or be deemed
inconsistent with a claim for damages or other remedy.
§ 2–722. Who Can Sue Third Parties for Injury
to Goods.
Where a third party so deals with goods which have been
identified to a contract for sale as to cause actionable injury to
a party to that contract
(a) a right of action against the third party is in either party
to the contract for sale who has title to or a security interest or a
special property or an insurable interest in the goods; and if the
goods have been destroyed or converted a right of action is also
in the party who either bore the risk of loss under the contract
for sale or has since the injury assumed that risk as against the
other;
(b) if at the time of the injury the party plaintiff did not bear
the risk of loss as against the other party to the contract for sale
and there is no arrangement between them for disposition of the
recovery, his suit or settlement is, subject to his own interest, as
a fiduciary for the other party to the contract;
(c) either party may with the consent of the other sue for
the benefit of whom it may concern.
§ 2–723. Proof of Market Price: Time and
Place.
(1) If an action based on anticipatory repudiation comes to trial
before the time for performance with respect to some or all of
the goods, any damages based on market price (Section 2–708 or
Section 2–713) shall be determined according to the price of
such goods prevailing at the time when the aggrieved party
learned of the repudiation.
(2) If evidence of a price prevailing at the times or places
described in this Article is not readily available the price
prevailing within any reasonable time before or after the time
described or at any other place which in commercial judgment or
under usage of trade would serve as a reasonable substitute for
the one described may be used, making any proper allowance for
the cost of transporting the goods to or from such other place.
(3) Evidence of a relevant price prevailing at a time or place
other than the one described in this Article offered by one party
is not admissible unless and until he has given the other party
such notice as the court finds sufficient to prevent unfair
surprise.
§ 2–724. Admissibility of Market Quotations.
Whenever the prevailing price or value of any goods regularly
bought and sold in any established commodity market is in
issue, reports in official publications or trade journals or in news-
papers or periodicals of general circulation published as the
reports of such market shall be admissible in evidence. The
circumstances of the preparation of such a report may be shown
to affect its weight but not its admissibility.
§ 2–725. Statute of Limitations in Contracts
for Sale.
(1) An action for breach of any contract for sale must be
commenced within four years after the cause of action has
accrued. By the original agreement the parties may reduce the
period of limitation to not less than one year but may not extend
it.
(2) A cause of action accrues when the breach occurs, regardless
of the aggrieved party’s lack of knowledge of the breach. A
breach of warranty occurs when tender of delivery is made,
except that where a warranty explicitly extends to future
performance of the goods and discovery of the breach must await
the time of such performance the cause of action accrues when
the breach is or should have been discovered.
(3) Where an action commenced within the time limited by
subsection (1) is so terminated as to leave available a remedy by
another action for the same breach such other action may be
commenced after the expiration of the time limited and within
six months after the termination of the first action unless the
termination resulted from voluntary discontinuance or from
dismissal for failure or neglect to prosecute.
(4) This section does not alter the law on tolling of the statute of
limitations nor does it apply to causes of action which have
accrued before this Act becomes effective.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B25
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REVISED ARTICLE IX
SECURED TRANSACTIONS
PART 1 General Provisions
[Subpart 1. Short Title, Definitions, and General
Concepts]
§ 9–101. Short Title.
This article may be cited as Uniform Commercial Code—
Secured Transactions.
§ 9–102. Definitions and Index of Definitions.
(a) In this article:
(1) “Accession” means goods that are physically united with
other goods in such a manner that the identity of the original
goods is not lost.
(2) “Account”, except as used in “account for”, means a right
to payment of a monetary obligation, whether or not earned
by performance, (i) for property that has been or is to be sold,
leased, licensed, assigned, or otherwise disposed of, (ii) for
services rendered or to be rendered, (iii) for a policy of
insurance issued or to be issued, (iv) for a secondary
obligation incurred or to be incurred, (v) for energy provided
or to be provided, (vi) for the use or hire of a vessel under a
charter or other contract, (vii) arising out of the use of a credit
or charge card or information contained on or for use with the
card, or (viii) as winnings in a lottery or other game of chance
operated or sponsored by a State, governmental unit of a
State, or person licensed or authorized to operate the game
by a State or governmental unit of a State. The term includes
health-care insurance receivables. The term does not include
(i) rights to payment evidenced by chattel paper or an
instrument, (ii) commercial tort claims, (iii) deposit accounts,
(iv) investment property, (v) letter-of-credit rights or letters
of credit, or (vi) rights to payment for money or funds
advanced or sold, other than rights arising out of the use of
a credit or charge card or information contained on or for
use with the card.
(3) “Account debtor” means a person obligated on an account,
chattel paper, or general intangible. The term does not include
persons obligated to pay a negotiable instrument, even if the
instrument constitutes part of chattel paper.
(4) “Accounting”, except as used in “accounting for”,means a record:
(A) authenticated by a secured party;
(B) indicating the aggregate unpaid secured obligations as of a
date not more than 35 days earlier or 35 days later than the date of
the record; and
(C) identifying the components of the obligations in
reasonable detail.
(5) “Agricultural lien” means an interest, other than a security
interest, in farm products:
(A) which secures payment or performance of an obligation for:
(i) goods or services furnished in connection with a debtor’s
farming operation; or
(ii) rent on real property leased by a debtor in connection
with its farming operation;
(B) which is created by statute in favor of a person that:
(i) in the ordinary course of its business furnished goods
or services to a debtor in connection with a debtor’s farming
operation; or
(ii) leased real property to a debtor in connection with the
debtor’s farming operation; and
(C) whose effectiveness does not depend on the person’s
possession of the personal property.
(6) “As-extracted collateral” means:
(A) oil, gas, or other minerals that are subject to a security
interest that:
(i) is created by a debtor having an interest in the minerals
before extraction; and
(ii) attaches to the minerals as extracted; or
(B) accounts arising out of the sale at the wellhead or
minehead of oil, gas, or other minerals in which the debtor had an
interest before extraction.
(7) “Authenticate” means:
(A) to sign; or
(B) to execute or otherwise adopt a symbol, or encrypt or
similarly process a record in whole or in part, with the present intent
of the authenticating person to identify the person and adopt or
accept a record.
(8) “Bank” means an organization that is engaged in the
business of banking. The term includes savings banks,
savings and loan associations, credit unions, and trust
companies.
(9) “Cash proceeds” means proceeds that are money, checks,
deposit accounts, or the like.
(10) “Certificate of title” means a certificate of title with respect
to which a statute provides for the security interest in question
to be indicated on the certificate as a condition or result of the
security interest’s obtaining priority over the rights of a lien
creditor with respect to the collateral.
(11) “Chattel paper” means a record or records that evidence
both a monetary obligation and a security interest in specific
goods, a security interest in specific goods and software used in
the goods, a security interest in specific goods and license of
software used in the goods, a lease of specific goods, or a lease of
specific goods and license of software used in the goods. In this
paragraph, “monetary obligation” means a monetary obligation
secured by the goods or owed under a lease of the goods and
includes a monetary obligation with respect to software used in
B26 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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the goods. The term does not include (i) charters or other
contracts involving the use or hire of a vessel or (ii) records that
evidence a right to payment arising out of the use of a credit or
charge card or information contained on or for use with the card.
If a transaction is evidenced by records that include an
instrument or series of instruments, the group of records taken
together constitutes chattel paper.
(12) “Collateral” means the property subject to a security
interest or agricultural lien. The term includes:
(A) proceeds to which a security interest attaches;
(B) accounts, chattel paper, payment intangibles, and
promissory notes that have been sold; and
(C) goods that are the subject of a consignment.
(13) “Commercial tort claim” means a claim arising in tort with
respect to which:
(A) the claimant is an organization; or
(B) the claimant is an individual and the claim:
(i) arose in the course of the claimant’s business or
profession; and
(ii) does not include damages arising out of personal injury
to or the death of an individual.
(14) “Commodity account” means an account maintained by a
commodity intermediary in which a commodity contract is
carried for a commodity customer.
(15) “Commodity contract”means a commodity futures contract,
an option on a commodity futures contract, a commodity option,
or another contract if the contract or option is:
(A) traded on or subject to the rules of a board of trade that has
been designated as a contract market for such a contract pursuant to
federal commodities laws; or
(B) traded on a foreign commodity board of trade, exchange,
or market, and is carried on the books of a commodity intermediary
for a commodity customer.
(16) “Commodity customer” means a person for which a
commodity intermediary carries a commodity contract on its books.
(17) “Commodity intermediary” means a person that:
(A) is registered as a futures commission merchant under
federal commodities law; or
(B) in the ordinary course of its business provides clearance or
settlement services for a board of trade that has been designated as a
contract market pursuant to federal commodities law.
(18) “Communicate” means:
(A) to send a written or other tangible record;
(B) to transmit a record by any means agreed upon by the
persons sending and receiving the record; or
(C) in the case of transmission of a record to or by a filing
office, to transmit a record by any means prescribed by filing-
office rule.
(19) “Consignee” means a merchant to which goods are
delivered in a consignment.
(20) “Consignment” means a transaction, regardless of its form,
in which a person delivers goods to a merchant for the purpose
of sale and:
(A) the merchant:
(i) deals in goods of that kind under a name other than the
name of the person making delivery;
(ii) is not an auctioneer; and
(iii) is not generally known by its creditors to be substantially
engaged in selling the goods of others;
(B) with respect to each delivery, the aggregate value of the
goods is $1,000 or more at the time of delivery;
(C) the goods are not consumer goods immediately before
delivery; and
(D) the transaction does not create a security interest that
secures an obligation.
(21) “Consignor” means a person that delivers goods to a
consignee in a consignment.
(22) “Consumer debtor” means a debtor in a consumer
transaction.
(23) “Consumer goods” means goods that are used or bought for
use primarily for personal, family, or household purposes.
(24) “Consumer goods transaction” means a consumer
transaction in which:
(A) an individual incurs an obligation primarily for personal,
family, or household purposes; and
(B) a security interest in consumer goods secures the
obligation.
(25) “Consumer obligor” means an obligor who is an individual
and who incurred the obligation as part of a transaction entered
into primarily for personal, family, or household purposes.
(26) “Consumer transaction” means a transaction in which (i) an
individual incurs an obligation primarily for personal, family, or
household purposes, (ii) a security interest secures the obligation,
and (iii) the collateral is held or acquired primarily for personal,
family, or household purposes. The term includes consumer-goods
transactions.
(27) “Continuation statement” means an amendment of a
financing statement which:
(A) identifies, by its file number, the initial financing
statement to which it relates; and
(B) indicates that it is a continuation statement for, or that it is
filed to continue the effectiveness of, the identified financing statement.
(28) “Debtor” means:
(A) a person having an interest, other than a security interest
or other lien, in the collateral, whether or not the person is an
obligor;
(B) a seller of accounts, chattel paper, payment intangibles, or
promissory notes; or
(C) a consignee.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B27
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(29) “Deposit account”means a demand, time, savings, passbook, or
similar account maintained with a bank. The term does not include
investment property or accounts evidenced by an instrument.
(30) “Document” means a document of title or a receipt of the
type described in Section 7–201(2).
(31) “Electronic chattel paper” means chattel paper evidenced
by a record or records consisting of information stored in an
electronic medium.
(32) “Encumbrance” means a right, other than an ownership
interest, in real property. The term includes mortgages and other
liens on real property.
(33) “Equipment” means goods other than inventory, farm
products, or consumer goods.
(34) “Farm products” means goods, other than standing timber,
with respect to which the debtor is engaged in a farming
operation and which are:
(A) crops grown, growing, or to be grown, including:
(i) crops produced on trees, vines, and bushes; and
(ii) aquatic goods produced in aquacultural operations;
(B) livestock, born or unborn, including aquatic goods
produced in aquacultural operations;
(C) supplies used or produced in a farming operation; or
(D) products of crops or livestock in their unmanufactured
states.
(35) “Farming operation” means raising, cultivating,
propagating, fattening, grazing, or any other farming, livestock,
or aquacultural operation.
(36) “File number” means the number assigned to an initial
financing statement pursuant to Section 9–519(a).
(37) “Filing office” means an office designated in Section 9–501
as the place to file a financing statement.
(38) “Filing-office rule” means a rule adopted pursuant to
Section 9–526.
(39) “Financing statement” means a record or records composed
of an initial financing statement and any filed record relating to
the initial financing statement.
(40) “Fixture filing” means the filing of a financing statement
covering goods that are or are to become fixtures and satisfying
Section 9–502(a) and (b). The term includes the filing of a
financing statement covering goods of a transmitting utility
which are or are to become fixtures.
(41) “Fixtures” means goods that have become so related to
particular real property that an interest in them arises under real
property law.
(42) “General intangible” means any personal property,
including things in action, other than accounts, chattel paper,
commercial tort claims, deposit accounts, documents, goods,
instruments, investment property, letter-of-credit rights,
letters of credit, money, and oil, gas, or other minerals before
extraction. The term includes payment intangibles and
software.
(43) “Good faith” means honesty in fact and the observance of
reasonable commercial standards of fair dealing.
(44) “Goods” means all things that are movable when a security
interest attaches. The term includes (i) fixtures, (ii) standing timber
that is to be cut and removed under a conveyance or contract for
sale, (iii) the unborn young of animals, (iv) crops grown, growing, or
to be grown, even if the crops are produced on trees, vines, or
bushes, and (v) manufactured homes. The term also includes a
computer program embedded in goods and any supporting
information provided in connection with a transaction relating to
the program if (i) the program is associated with the goods in such a
manner that it customarily is considered part of the goods, or (ii) by
becoming the owner of the goods, a person acquires a right to use
the program in connection with the goods. The term does not
include a computer program embedded in goods that consist solely
of the medium in which the program is embedded. The term
also does not include accounts, chattel paper, commercial tort
claims, deposit accounts, documents, general intangibles,
instruments, investment property, letter-of-credit rights, letters of
credit, money, or oil, gas, or other minerals before extraction.
(45) “Governmental unit” means a subdivision, agency,
department, county, parish, municipality, or other unit of the
government of the United States, a State, or a foreign country. The
term includes an organization having a separate corporate existence
if the organization is eligible to issue debt on which interest is
exempt from income taxation under the laws of the United States.
(46) “Health-care-insurance receivable” means an interest in or
claim under a policy of insurance which is a right to payment of a
monetary obligation for health-care goods or servies provided.
(47) “Instrument” means a negotiable instrument or any other
writing that evidences a right to the payment of a monetary
obligation, is not itself a security agreement or lease, and is of a
type that in ordinary course of business is transferred by delivery
with any necessary indorsement or assignment. The term does
not include (i) investment property, (ii) letters of credit, or
(iii) writings that evidence a right to payment arising out of the use
of a credit or charge card or information contained on or for use
with the card.
(48) “Inventory” means goods, other than farm products, which:
(A) are leased by a person as lessor;
(B) are held by a person for sale or lease or to be furnished
under a contract of service;
(C) are furnished by a person under a contract of service; or
(D) consist of raw materials, work in process, or materials used
or consumed in a business.
(49) “Investment property” means a security, whether
certificated or uncertificated, security entitlement, securities
account, commodity contract, or commodity account.
(50) “Jurisdiction of organization”, with respect to a registered
organization, means the jurisdiction under whose law the
organization is organized.
(51) “Letter-of-credit right” means a right to payment or
performance under a letter of credit, whether or not the
beneficiary has demanded or is at the time entitled to demand
B28 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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payment or performance. The term does not include the right of
a beneficiary to demand payment or performance under a letter
of credit.
(52) “Lien creditor” means:
(A) a creditor that has acquired a lien on the property involved
by attachment, levy, or the like;
(B) an assignee for benefit of creditors from the time of
assignment;
(C) a trustee in bankruptcy from the date of the filing of the
petition; or
(D) a receiver in equity from the time of appointment.
(53) “Manufactured home” means a structure, transportable in
one or more sections, which, in the traveling mode, is eight
body feet or more in width or 40 body feet or more in length,
or, when erected on site, is 320 or more square feet, and
which is built on a permanent chassis and designed to be
used as a dwelling with or without a permanent foundation
when connected to the required utilities, and includes the
plumbing, heating, air-conditioning, and electrical systems
contained therein. The term includes any structure that
meets all of the requirements of this paragraph except the
size requirements and with respect to which the manufacturer
voluntarily files a certification required by the United States
Secretary of Housing and Urban Development and complies
with the standards established under Title 42 of the United
States Code.
(54) “Manufactured-home transaction” means a secured
transaction:
(A) that creates a purchase-money security interest in a
manufactured home, other than a manufactured home held as
inventory; or
(B) in which a manufactured home, other than a manufactured
home held as inventory, is the primary collateral.
(55) “Mortgage” means a consensual interest in real property,
including fixtures, which secures payment or performance of an
obligation.
(56) “New debtor” means a person that becomes bound as
debtor under Section 9–203(d) by a security agreement
previously entered into by another person.
(57) “New value” means (i) money, (ii) money’s worth in
property, services, or new credit, or (iii) release by a transferee of
an interest in property previously transferred to the transferee.
The term does not include an obligation substituted for another
obligation.
(58) “Noncash proceeds” means proceeds other than cash
proceeds.
(59) “Obligor” means a person that, with respect to an
obligation secured by a security interest in or an agricultural
lien on the collateral, (i) owes payment or other performance
of the obligation, (ii) has provided property other than the
collateral to secure payment or other performance of the
obligation, or (iii) is otherwise accountable in whole or in part
for payment or other performance of the obligation. The term
does not include issuers or nominated persons under a letter
of credit.
(60) “Original debtor”, except as used in Section 9–310(c),
means a person that, as debtor, entered into a security
agreement to which a new debtor has become bound under
Section 9–203(d).
(61) “Payment intangible” means a general intangible under
which the account debtor’s principal obligation is a monetary
obligation.
(62) “Person related to”, with respect to an individual, means:
(A) the spouse of the individual;
(B) a brother, brother-in-law, sister, or sister-in-law of the
individual;
(C) an ancestor or lineal descendant of the individual or the
individual’s spouse; or
(D) any other relative, by blood or marriage, of the individual or
the individual’s spouse who shares the same home with the individual.
(63) “Person related to”, with respect to an organization, means:
(A) a person directly or indirectly controlling, controlled by, or
under common control with the organization;
(B) an officer or director of, or a person performing similar
functions with respect to, the organization;
(C) an officer or director of, or a person performing
similar functions with respect to, a person described in
subparagraph (A);
(D) the spouse of an individual described in subparagraph (A),
(B), or (C); or
(E) an individual who is related by blood or marriage to an
individual described in subparagraph (A), (B), (C), or (D) and
shares the same home with the individual.
(64) “Proceeds”, except as used in Section 9–609(b), means the
following property:
(A) whatever is acquired upon the sale, lease, license, exchange,
or other disposition of collateral;
(B) whatever is collected on, or distributed on account of,
collateral;
(C) rights arising out of collateral;
(D) to the extent of the value of collateral, claims arising out of
the loss, nonconformity, or interference with the use of, defects or
infringement of rights in, or damage to, the collateral; or (E) to the
extent of the value of collateral and to the extent payable to the
debtor or the secured party, insurance payable by reason of the loss
or nonconformity of, defects or infringement of rights in, or damage
to, the collateral.
(65) “Promissory note” means an instrument that evidences a
promise to pay a monetary obligation, does not evidence an order
to pay, and does not contain an acknowledgment by a bank that
the bank has received for deposit a sum of money or funds.
(66) “Proposal” means a record authenticated by a secured party
which includes the terms on which the secured party is willing to
accept collateral in full or partial satisfaction of the obligation it
secures pursuant to Sections 9–620, 9–621, and 9–622.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B29
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(67) “Public-finance transaction” means a secured transaction in
connection with which:
(A) debt securities are issued;
(B) all or a portion of the securities issued have an initial stated
maturity of at least 20 years; and
(C) the debtor, obligor, secured party, account debtor or other
person obligated on collateral, assignor or assignee of a secured
obligation, or assignor or assignee of a security interest is a State or a
governmental unit of a State.
(68) “Pursuant to commitment”, with respect to an advance
made or other value given by a secured party, means pursuant to
the secured party’s obligation, whether or not a subsequent
event of default or other event not within the secured party’s
control has relieved or may relieve the secured party from its
obligation.
(69) “Record”, except as used in “for record”, “of record”, “record
or legal title”, and “record owner”, means information that is
inscribed on a tangible medium or which is stored in an electronic
or other medium and is retrievable in perceivable form.
(70) “Registered organization” means an organization organized
solely under the law of a single State or the United States and as
to which the State or the United States must maintain a public
record showing the organization to have been organized.
(71) “Secondary obligor” means an obligor to the extent that:
(A) the obligor’s obligation is secondary; or
(B) the obligor has a right of recourse with respect to an
obligation secured by collateral against the debtor, another obligor,
or property of either.
(72) “Secured party” means:
(A) a person in whose favor a security interest is created or
provided for under a security agreement, whether or not any
obligation to be secured is outstanding;
(B) a person that holds an agricultural lien;
(C) a consignor;
(D) a person to which accounts, chattel paper, payment
intangibles, or promissory notes have been sold;
(E) a trustee, indenture trustee, agent, collateral agent, or other
representative in whose favor a security interest or agricultural lien is
created or provided for; or
(F) a person that holds a security interest arising under Section
2–401, 2–505, 2–711(3), 2A–508(5), 4–210, or 5–118.
(73) “Security agreement” means an agreement that creates or
provides for a security interest.
(74) “Send”, in connection with a record or notification,
means:
(A) to deposit in the mail, deliver for transmission, or transmit
by any other usual means of communication, with postage or cost of
transmission provided for, addressed to any address reasonable
under the circumstances; or
(B) to cause the record or notification to be received within the
timce that it would have been received if properly sent under
subparagraph (A).
(75) “Software” means a computer program and any supporting
information provided in connection with a transaction relating to
the program. The term does not include a computer program
that is included in the definition of goods.
(76) “State” means a State of the United States, the District of
Columbia, Puerto Rico, the United States Virgin Islands, or any
territory or insular possession subject to the jurisdiction of the
United States.
(77) “Supporting obligation” means a letter-of-credit right or
secondary obligation that supports the payment or performance
of an account, chattel paper, a document, a general intangible, an
instrument, or investment property.
(78) “Tangible chattel paper” means chattel paper evidenced by
a record or records consisting of information that is inscribed on a
tangible medium.
(79) “Termination statement” means an amendment of a
financing statement which:
(A) identifies, by its file number, the initial financing
statement to which it relates; and
(B) indicates either that it is a termination statement or that
the identified financing statement is no longer effective.
(80) “Transmitting utility” means a person primarily engaged in
the business of:
(A) operating a railroad, subway, street railway, or trolley bus;
(B) transmitting communications electrically,
electromagnetically, or by light;
(C) transmitting goods by pipeline or sewer; or
(D) transmitting or producing and transmitting electricity,
steam, gas, or water.
(b) The following definitions in other articles apply to this
article:
“Applicant.” Section 5–102
“Beneficiary.” Section 5–102
“Broker.” Section 8–102
“Certificated security.” Section 8–102
“Check.” Section 3–104
“Clearing corporation.” Section 8–102
“Contract for sale.” Section 2–106
“Customer.” Section 4–104
“Entitlement holder.” Section 8–102
“Financial asset.” Section 8–102
“Holder in due course.” Section 3–302
“Issuer” (with respect to a letter of credit or letter-of-credit
right). Section 5–102
“Issuer” (with respect to a security). Section 8–201
“Lease.” Section 2A–103
“Lease agreement.” Section 2A–103
B30 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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“Lease contract.” Section 2A–103
“Leasehold interest.” Section 2A–103
“Lessee.” Section 2A–103
“Lessee in ordinary course of business.” Section 2A–103
“Lessor.” Section 2A–103
“Lessor’s residual interest.” Section 2A–103
“Letter of credit.” Section 5–102
“Merchant.” Section 2–104
“Negotiable instrument.” Section 3–104
“Nominated person.” Section 5–102
“Note.” Section 3–104
“Proceeds of a letter of credit.” Section 5–114
“Prove.” Section 3–103
“Sale.” Section 2–106
“Securities account.” Section 8–501
“Securities intermediary.” Section 8–102
“Security.” Section 8–102
“Security certificate.” Section 8–102
“Security entitlement.” Section 8–102
“Uncertificated security.” Section 8–102
(c) Article 1 contains general definitions and principles of
construction and interpretation applicable throughout this article.
Amended in 1999 and 2000.
§ 9–103. Purchase-Money Security Interest;
Application of Payments; Burden of
Establishing.
(a) In this section:
(1) “purchase-money collateral” means goods or software that
secures a purchase-money obligation incurred with respect to
that collateral; and
(2) “purchase-money obligation” means an obligation of an
obligor incurred as all or part of the price of the collateral or for
value given to enable the debtor to acquire rights in or the use of
the collateral if the value is in fact so used.
(b) A security interest in goods is a purchase-money security
interest:
(1) to the extent that the goods are purchase-money collateral
with respect to that security interest;
(2) if the security interest is in inventory that is or was purchase-
money collateral, also to the extent that the security interest
secures a purchase-money obligation incurred with respect to
other inventory in which the secured party holds or held a
purchase-money security interest; and
(3) also to the extent that the security interest secures a
purchase-money obligation incurred with respect to software
in which the secured party holds or held a purchase-money
security interest.
(c) A security interest in software is a purchase-money
security interest to the extent that the security interest also
secures a purchase-money obligation incurred with respect to
goods in which the secured party holds or held a purchase-
money security interest if:
(1) the debtor acquired its interest in the software in an
integrated transaction in which it acquired an interest in the
goods; and
(2) the debtor acquired its interest in the software for the
principal purpose of using the software in the goods.
(d) The security interest of a consignor in goods that are the
subject of a consignment is a purchase-money security interest
in inventory.
(e) In a transaction other than a consumer-goods transaction,
if the extent to which a security interest is a purchase-money
security interest depends on the application of a payment to a
particular obligation, the payment must be applied:
(1) in accordance with any reasonable method of application to
which the parties agree;
(2) in the absence of the parties’ agreement to a reasonable
method, in accordance with any intention of the obligor
manifested at or before the time of payment; or
(3) in the absence of an agreement to a reasonable method and
a timely manifestation of the obligor’s intention, in the following
order:
(A) to obligations that are not secured; and
(B) if more than one obligation is secured, to obligations
secured by purchase-money security interests in the order in which
those obligations were incurred.
(f) In a transaction other than a consumer-goods transaction,
a purchase-money security interest does not lose its status as
such, even if:
(1) the purchase-money collateral also secures an obligation that
is not a purchase-money obligation;
(2) collateral that is not purchase-money collateral also secures
the purchase-money obligation; or
(3) the purchase-money obligation has been renewed,
refinanced, consolidated, or restructured.
(g) In a transaction other than a consumer-goods transaction,
a secured party claiming a purchase-money security interest has
the burden of establishing the extent to which the security
interest is a purchase-money security interest.
(h) The limitation of the rules in subsections (e), (f ), and
(g) to transactions other than consumer-goods transactions is
intended to leave to the court the determination of the proper
rules in consumer-goods transactions. The court may not infer
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B31
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from that limitation the nature of the proper rule in consumer-
goods transactions and may continue to apply established
approaches.
§ 9–104. Control of Deposit Account.
(a) A secured party has control of a deposit account if:
(1) the secured party is the bank with which the deposit account
is maintained;
(2) the debtor, secured party, and bank have agreed in an
authenticated record that the bank will comply with
instructions originated by the secured party directing
disposition of the funds in the deposit account without
further consent by the debtor; or
(3) the secured party becomes the bank’s customer with respect
to the deposit account.
(b) A secured party that has satisfied subsection (a) has
control, even if the debtor retains the right to direct the
disposition of funds from the deposit account.
§ 9–105. Control of Electronic Chattel
Paper.
A secured party has control of electronic chattel paper if the
record or records comprising the chattel paper are created,
stored, and assigned in such a manner that:
(1) a single authoritative copy of the record or records exists
which is unique, identifiable and, except as otherwise provided
in paragraphs (4), (5), and (6), unalterable;
(2) the authoritative copy identifies the secured party as the
assignee of the record or records;
(3) the authoritative copy is communicated to and maintained by
the secured party or its designated custodian;
(4) copies or revisions that add or change an identified assignee
of the authoritative copy can be made only with the participation
of the secured party;
(5) each copy of the authoritative copy and any copy of a copy
is readily identifiable as a copy that is not the authoritative
copy; and
(6) any revision of the authoritative copy is readily identifiable as
an authorized or unauthorized revision.
§ 9–106. Control of Investment Property.
(a) A person has control of a certificated security,
uncertificated security, or security entitlement as provided in
Section 8–106.
(b) A secured party has control of a commodity contract if:
(1) the secured party is the commodity intermediary with which
the commodity contract is carried; or
(2) the commodity customer, secured party, and commodity
intermediary have agreed that the commodity intermediary will
apply any value distributed on account of the commodity
contract as directed by the secured party without further consent
by the commodity customer.
(c) A secured party having control of all security
entitlements or commodity contracts carried in a securities
account or commodity account has control over the securities
account or commodity account.
§ 9–107. Control of Letter-of-Credit Right.
A secured party has control of a letter-of-credit right to the
extent of any right to payment or performance by the issuer
or any nominated person if the issuer or nominated person
has consented to an assignment of proceeds of the letter of
credit under Section 5–114(c) or otherwise applicable law or
practice.
§ 9–108. Sufficiency of Description.
(a) Except as otherwise provided in subsections (c), (d),
and (e), a description of personal or real property is sufficient,
whether or not it is specific, if it reasonably identifies what is
described.
(b) Except as otherwise provided in subsection (d), a
description of collateral reasonably identifies the collateral if it
identifies the collateral by:
(1) specific listing;
(2) category;
(3) except as otherwise provided in subsection (e), a type of
collateral defined in [the Uniform Commercial Code];
(4) quantity;
(5) computational or allocational formula or procedure; or
(6) except as otherwise provided in subsection (c), any
other method, if the identity of the collateral is objectively
determinable.
(c) A description of collateral as “all the debtor’s assets” or
“all the debtor’s personal property” or using words of similar
import does not reasonably identify the collateral.
(d) Except as otherwise provided in subsection (e), a
description of a security entitlement, securities account, or
commodity account is sufficient if it describes:
(1) the collateral by those terms or as investment property; or
(2) the underlying financial asset or commodity contract.
(e) A description only by type of collateral defined in
[the Uniform Commercial Code] is an insufficient description of:
(1) a commercial tort claim; or
(2) in a consumer transaction, consumer goods, a security
entitlement, a securities account, or a commodity account.
B32 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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[Subpart 2. Applicability of Article]
§ 9–109. Scope.
(a) Except as otherwise provided in subsections (c) and (d),
this article applies to:
(1) a transaction, regardless of its form, that creates a security
interest in personal property or fixtures by contract;
(2) an agricultural lien;
(3) a sale of accounts, chattel paper, payment intangibles, or
promissory notes;
(4) a consignment;
(5) a security interest arising under Section 2–401, 2–505, 2–711
(3), or 2A–508(5), as provided in Section 9–110; and
(6) a security interest arising under Section 4–210 or 5–118.
(b) The application of this article to a security interest in a
secured obligation is not affected by the fact that the obligation
is itself secured by a transaction or interest to which this article
does not apply.
(c) This article does not apply to the extent that:
(1) a statute, regulation, or treaty of the United States preempts
this article;
(2) another statute of this State expressly governs the creation,
perfection, priority, or enforcement of a security interest created
by this State or a governmental unit of this State;
(3) a statute of another State, a foreign country, or a governmental
unit of another State or a foreign country, other than a statute
generally applicable to security interests, expressly governs
creation, perfection, priority, or enforcement of a security interest
created by the State, country, or governmental unit; or
(4) the rights of a transferee beneficiary or nominated person
under a letter of credit are independent and superior under
Section 5–114.
(d) This article does not apply to:
(1) a landlord’s lien, other than an agricultural lien;
(2) a lien, other than an agricultural lien, given by statute or
other rule of law for services or materials, but Section 9–333
applies with respect to priority of the lien;
(3) an assignment of a claim for wages, salary, or other
compensation of an employee;
(4) a sale of accounts, chattel paper, payment intangibles, or
promissory notes as part of a sale of the business out of which
they arose;
(5) an assignment of accounts, chattel paper, payment
intangibles, or promissory notes which is for the purpose of
collection only;
(6) an assignment of a right to payment under a contract to
an assignee that is also obligated to perform under the contract;
(7) an assignment of a single account, payment intangible, or
promissory note to an assignee in full or partial satisfaction of a
preexisting indebtedness;
(8) a transfer of an interest in or an assignment of a
claim under a policy of insurance, other than an
assignment by or to a health-care provider of a health-
care-insurance receivable and any subsequent assignment
of the right to payment, but Sections 9–315 and 9–322
apply with respect to proceeds and priorities in
proceeds;
(9) an assignment of a right represented by a judgment,
other than a judgment taken on a right to payment that was
collateral;
(10) a right of recoupment or set-off, but:
(A) Section 9–340 applies with respect to the effectiveness
of rights of recoupment or set-off against deposit accounts;
and
(B) Section 9–404 applies with respect to defenses or claims of
an account debtor;
(11) the creation or transfer of an interest in or lien on real
property, including a lease or rents thereunder, except to the
extent that provision is made for:
(A) liens on real property in Sections 9–203 and 9–308;
(B) fixtures in Section 9–334;
(C) fixture filings in Sections 9–501, 9–502, 9–512, 9–516,
and 9–519; and
(D) security agreements covering personal and real property in
Section 9–604;
(12) an assignment of a claim arising in tort, other than a
commercial tort claim, but Sections 9–315 and 9–322 apply with
respect to proceeds and priorities in proceeds; or
(13) an assignment of a deposit account in a consumer
transaction, but Sections 9–315 and 9–322 apply with respect to
proceeds and priorities in proceeds.
§ 9–110. Security Interests Arising under
Article 2 or 2A.
A security interest arising under Section 2–401, 2–505, 2–711(3),
or 2A–508(5) is subject to this article. However, until the debtor
obtains possession of the goods:
(1) the security interest is enforceable, even if Section 9–203(b)
(3) has not been satisfied;
(2) filing is not required to perfect the security interest;
(3) the rights of the secured party after default by the debtor are
governed by Article 2 or 2A; and
(4) the security interest has priority over a conflicting security
interest created by the debtor.
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PART 2 Effectiveness of Security
Agreement; Attachment of Security
Interest; Rights of Parties to
Security Agreement
[Subpart 1. Effectiveness and Attachment]
§ 9–201. General Effectiveness of Security
Agreement.
(a) Except as otherwise provided in [the Uniform
Commercial Code], a security agreement is effective according
to its terms between the parties, against purchasers of the
collateral, and against creditors.
(b) A transaction subject to this article is subject to any
applicable rule of law which establishes a different rule for
consumers and [insert reference to (i) any other statute or
regulation that regulates the rates, charges, agreements, and
practices for loans, credit sales, or other extensions of credit and
(ii) any consumer-protection statute or regulation].
(c) In case of conflict between this article and a rule of law,
statute, or regulation described in subsection (b), the rule of law,
statute, or regulation controls. Failure to comply with a statute or
regulation described in subsection (b) has only the effect the
statute or regulation specifies.
(d) This article does not:
(1) validate any rate, charge, agreement, or practice that
violates a rule of law, statute, or regulation described in
subsection (b); or
(2) extend the application of the rule of law, statute, or
regulation to a transaction not otherwise subject to it.
§ 9–202. Title to Collateral Immaterial.
Except as otherwise provided with respect to consignments or
sales of accounts, chattel paper, payment intangibles, or promis-
sory notes, the provisions of this article with regard to rights and
obligations apply whether title to collateral is in the secured
party or the debtor.
§ 9–203. Attachment and Enforceability of
Security Interest; Proceeds;
Supporting Obligations; Formal
Requisites.
(a) A security interest attaches to collateral when it becomes
enforceable against the debtor with respect to the collateral, unless
an agreement expressly postpones the time of attachment.
(b) Except as otherwise provided in subsections (c) through
(i), a security interest is enforceable against the debtor and third
parties with respect to the collateral only if:
(1) value has been given;
(2) the debtor has rights in the collateral or the power to transfer
rights in the collateral to a secured party; and
(3) one of the following conditions is met:
(A) the debtor has authenticated a security agreement
that provides a description of the collateral and, if the security
interest covers timber to be cut, a description of the land
concerned;
(B) the collateral is not a certificated security and is in the
possession of the secured party under Section 9–313 pursuant to the
debtor’s security agreement;
(C) the collateral is a certificated security in registered
form and the security certificate has been delivered to the secured
party under Section 8–301 pursuant to the debtor’s security
agreement; or
(D) the collateral is deposit accounts, electronic chattel paper,
investment property, or letter-of-credit rights, and the secured party
has control under Section 9–104, 9–105, 9–106, or 9–107 pursuant
to the debtor’s security agreement.
(c) Subsection (b) is subject to Section 4–210 on the
security interest of a collecting bank, Section 5–118 on the
security interest of a letter-of-credit issuer or nominated
person, Section 9–110 on a security interest arising under
Article 2 or 2A, and Section 9–206 on security interests in
investment property.
(d) A person becomes bound as debtor by a security
agreement entered into by another person if, by operation of law
other than this article or by contract:
(1) the security agreement becomes effective to create a security
interest in the person’s property; or
(2) the person becomes generally obligated for the
obligations of the other person, including the obligation
secured under the security agreement, and acquires or
succeeds to all or substantially all of the assets of the other
person.
(e) If a new debtor becomes bound as debtor by a security
agreement entered into by another person:
(1) the agreement satisfies subsection (b)(3) with respect to
existing or after-acquired property of the new debtor to the
extent the property is described in the agreement; and
(2) another agreement is not necessary to make a security
interest in the property enforceable.
(f) The attachment of a security interest in collateral
gives the secured party the rights to proceeds provided by
Section 9–315 and is also attachment of a security interest in a
supporting obligation for the collateral.
(g) The attachment of a security interest in a right to
payment or performance secured by a security interest or
other lien on personal or real property is also attachment of
a security interest in the security interest, mortgage, or other
lien.
(h) The attachment of a security interest in a securities
account is also attachment of a security interest in the security
entitlements carried in the securities account.
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(i) The attachment of a security interest in a commodity
account is also attachment of a security interest in the
commodity contracts carried in the commodity account.
§ 9–204. After-Acquired Property; Future
Advances.
(a) Except as otherwise provided in subsection (b), a
security agreement may create or provide for a security interest
in after-acquired collateral.
(b) A security interest does not attach under a term
constituting an after-acquired property clause to:
(1) consumer goods, other than an accession when given as
additional security, unless the debtor acquires rights in them
within 10 days after the secured party gives value; or
(2) a commercial tort claim.
(c) A security agreement may provide that collateral
secures, or that accounts, chattel paper, payment intangibles, or
promissory notes are sold in connection with, future advances
or other value, whether or not the advances or value are given
pursuant to commitment.
§ 9–205. Use or Disposition of Collateral
Permissible.
(a) A security interest is not invalid or fraudulent against
creditors solely because:
(1) the debtor has the right or ability to:
(A) use, commingle, or dispose of all or part of the collateral,
including returned or repossessed goods;
(B) collect, compromise, enforce, or otherwise deal with
collateral;
(C) accept the return of collateral or make repossessions; or
(D) use, commingle, or dispose of proceeds; or
(2) the secured party fails to require the debtor to account for
proceeds or replace collateral.
(b) This section does not relax the requirements of
possession if attachment, perfection, or enforcement of a
security interest depends upon possession of the collateral by
the secured party.
§ 9–206. Security Interest Arising in
Purchase or Delivery of Financial
Asset.
(a) A security interest in favor of a securities intermediary
attaches to a person’s security entitlement if:
(1) the person buys a financial asset through the securities
intermediary in a transaction in which the person is obligated to
pay the purchase price to the securities intermediary at the time
of the purchase; and
(2) the securities intermediary credits the financial asset to the
buyer’s securities account before the buyer pays the securities
intermediary.
(b) The security interest described in subsection (a) secures
the person’s obligation to pay for the financial asset.
(c) A security interest in favor of a person that delivers a
certificated security or other financial asset represented by a
writing attaches to the security or other financial asset if:
(1) the security or other financial asset:
(A) in the ordinary course of business is transferred by delivery
with any necessary indorsement or assignment; and
(B) is delivered under an agreement between persons in
the business of dealing with such securities or financial assets;
and
(2) the agreement calls for delivery against payment.
(d) The security interest described in subsection (c) secures
the obligation to make payment for the delivery.
[Subpart 2. Rights and Duties]
§ 9–207. Rights and Duties of Secured Party
Having Possession or Control of
Collateral.
(a) Except as otherwise provided in subsection (d),
a secured party shall use reasonable care in the custody and
preservation of collateral in the secured party’s possession.
In the case of chattel paper or an instrument, reasonable care
includes taking necessary steps to preserve rights against prior
parties unless otherwise agreed.
(b) Except as otherwise provided in subsection (d), if a
secured party has possession of collateral:
(1) reasonable expenses, including the cost of insurance and
payment of taxes or other charges, incurred in the custody,
preservation, use, or operation of the collateral are chargeable
to the debtor and are secured by the collateral;
(2) the risk of accidental loss or damage is on the debtor
to the extent of a deficiency in any effective insurance
coverage;
(3) the secured party shall keep the collateral identifiable, but
fungible collateral may be commingled; and
(4) the secured party may use or operate the collateral:
(A) for the purpose of preserving the collateral or its value;
(B) as permitted by an order of a court having competent
jurisdiction; or
(C) except in the case of consumer goods, in the manner and
to the extent agreed by the debtor.
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(c) Except as otherwise provided in subsection (d), a
secured party having possession of collateral or control of
collateral under Section 9–104, 9–105, 9–106, or 9–107:
(1) may hold as additional security any proceeds, except money
or funds, received from the collateral;
(2) shall apply money or funds received from the collateral to
reduce the secured obligation, unless remitted to the debtor;
and
(3) may create a security interest in the collateral.
(d) If the secured party is a buyer of accounts, chattel paper,
payment intangibles, or promissory notes or a consignor:
(1) subsection (a) does not apply unless the secured party is
entitled under an agreement:
(A) to charge back uncollected collateral; or
(B) otherwise to full or limited recourse against the
debtor or a secondary obligor based on the nonpayment or other
default of an account debtor or other obligor on the
collateral; and
(2) subsections (b) and (c) do not apply.
§ 9–208. Additional Duties of Secured Party
Having Control of Collateral.
(a) This section applies to cases in which there is no
outstanding secured obligation and the secured party is not
committed to make advances, incur obligations, or otherwise
give value.
(b) Within 10 days after receiving an authenticated demand
by the debtor:
(1) a secured party having control of a deposit account
under Section 9–104(a)(2) shall send to the bank with which
the deposit account is maintained an authenticated
statement that releases the bank from any further
obligation to comply with instructions originated by the
secured party;
(2) a secured party having control of a deposit account under
Section 9–104(a)(3) shall:
(A) pay the debtor the balance on deposit in the deposit
account; or
(B) transfer the balance on deposit into a deposit account in
the debtor’s name;
(3) a secured party, other than a buyer, having control of
electronic chattel paper under Section 9–105 shall:
(A) communicate the authoritative copy of the
electronic chattel paper to the debtor or its designated
custodian;
(B) if the debtor designates a custodian that is the
designated custodian with which the authoritative copy of the
electronic chattel paper is maintained for the secured party,
communicate to the custodian an authenticated record releasing
the designated custodian from any further obligation to comply
with instructions originated by the secured party and instructing
the custodian to comply with instructions originated by the
debtor; and
(C) take appropriate action to enable the debtor or its
designated custodian to make copies of or revisions to the
authoritative copy which add or change an identified assignee
of the authoritative copy without the consent of the secured
party;
(4) a secured party having control of investment property under
Section 8–106(d)(2) or 9–106(b) shall send to the securities
intermediary or commodity intermediary with which the security
entitlement or commodity contract is maintained an
authenticated record that releases the securities intermediary or
commodity intermediary from any further obligation to comply
with entitlement orders or directions originated by the secured
party; and
(5) a secured party having control of a letter-of-credit right under
Section 9–107 shall send to each person having an unfulfilled
obligation to pay or deliver proceeds of the letter of credit to
the secured party an authenticated release from any further
obligation to pay or deliver proceeds of the letter of credit to the
secured party.
§ 9–209. Duties of Secured Party If Account
Debtor Has Been Notified of
Assignment.
(a) Except as otherwise provided in subsection (c), this
section applies if:
(1) there is no outstanding secured obligation; and
(2) the secured party is not committed to make advances, incur
obligations, or otherwise give value.
(b) Within 10 days after receiving an authenticated demand
by the debtor, a secured party shall send to an account debtor
that has received notification of an assignment to the secured
party as assignee under Section 9–406(a) an authenticated record
that releases the account debtor from any further obligation to
the secured party.
(c) This section does not apply to an assignment constituting
the sale of an account, chattel paper, or payment intangible.
§ 9–210. Request for Accounting; Request
Regarding List of Collateral or
Statement of Account.
(a) In this section:
(1) “Request” means a record of a type described in paragraph
(2), (3), or (4).
(2) “Request for an accounting” means a record authenticated
by a debtor requesting that the recipient provide an accounting
of the unpaid obligations secured by collateral and reasonably
identifying the transaction or relationship that is the subject of
the request.
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(3) “Request regarding a list of collateral” means a record
authenticated by a debtor requesting that the recipient
approve or correct a list of what the debtor believes to be
the collateral securing an obligation and reasonably
identifying the transaction or relationship that is the subject
of the request.
(4) “Request regarding a statement of account” means a
record authenticated by a debtor requesting that the recipient
approve or correct a statement indicating what the debtor
believes to be the aggregate amount of unpaid obligations
secured by collateral as of a specified date and reasonably
identifying the transaction or relationship that is the subject of
the request.
(b) Subject to subsections (c), (d), (e), and (f), a secured
party, other than a buyer of accounts, chattel paper, payment
intangibles, or promissory notes or a consignor, shall comply with
a request within 14 days after receipt:
(1) in the case of a request for an accounting, by authenticating
and sending to the debtor an accounting; and
(2) in the case of a request regarding a list of collateral or a
request regarding a statement of account, by authenticating and
sending to the debtor an approval or correction.
(c) A secured party that claims a security interest in all of a
particular type of collateral owned by the debtor may comply
with a request regarding a list of collateral by sending to the
debtor an authenticated record including a statement to that
effect within 14 days after receipt.
(d) A person that receives a request regarding a list of
collateral, claims no interest in the collateral when it
receives the request, and claimed an interest in the collateral
at an earlier time shall comply with the request within 14
days after receipt by sending to the debtor an authenticated
record:
(1) disclaiming any interest in the collateral; and
(2) if known to the recipient, providing the name and mailing
address of any assignee of or successor to the recipient’s interest
in the collateral.
(e) A person that receives a request for an accounting
or a request regarding a statement of account, claims no
interest in the obligations when it receives the request,
and claimed an interest in the obligations at an earlier time
shall comply with the request within 14 days after receipt by
sending to the debtor an authenticated record:
(1) disclaiming any interest in the obligations; and
(2) if known to the recipient, providing the name and mailing
address of any assignee of or successor to the recipient’s interest
in the obligations.
(f) A debtor is entitled without charge to one response to a
request under this section during any six-month period. The
secured party may require payment of a charge not exceeding
$25 for each additional response.
As amended in 1999.
PART 3 Perfection and Priority
[Subpart 1. Law Governing Perfection and
Priority]
§ 9–301. Law Governing Perfection and
Priority of Security Interests.
Except as otherwise provided in Sections 9–303 through 9–306,
the following rules determine the law governing perfection, the
effect of perfection or nonperfection, and the priority of a secur-
ity interest in collateral:
(1) Except as otherwise provided in this section, while a debtor
is located in a jurisdiction, the local law of that jurisdiction
governs perfection, the effect of perfection or nonperfection, and
the priority of a security interest in collateral.
(2) While collateral is located in a jurisdiction, the local law of
that jurisdiction governs perfection, the effect of perfection or
nonperfection, and the priority of a possessory security interest
in that collateral.
(3) Except as otherwise provided in paragraph (4), while
negotiable documents, goods, instruments, money, or tangible
chattel paper is located in a jurisdiction, the local law of that
jurisdiction governs:
(A) perfection of a security interest in the goods by filing a fixture
filing;
(B) perfection of a security interest in timber to be cut; and
(C) the effect of perfection or nonperfection and the priority of a
nonpossessory security interest in the collateral.
(4) The local law of the jurisdiction in which the wellhead or
minehead is located governs perfection, the effect of perfection
or nonperfection, and the priority of a security interest in as-
extracted collateral.
§ 9–302. Law Governing Perfection and
Priority of Agricultural Liens.
While farm products are located in a jurisdiction, the local law of
that jurisdiction governs perfection, the effect of perfection or
nonperfection, and the priority of an agricultural lien on the farm
products.
§ 9–303. Law Governing Perfection and
Priority of Security Interests in
Goods Covered by a Certificate of
Title.
(a) This section applies to goods covered by a certificate of
title, even if there is no other relationship between the
jurisdiction under whose certificate of title the goods are covered
and the goods or the debtor.
(b) Goods become covered by a certificate of title when a
valid application for the certificate of title and the applicable fee
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are delivered to the appropriate authority. Goods cease to be
covered by a certificate of title at the earlier of the time the
certificate of title ceases to be effective under the law of the
issuing jurisdiction or the time the goods become covered
subsequently by a certificate of title issued by another
jurisdiction.
(c) The local law of the jurisdiction under whose certificate
of title the goods are covered governs perfection, the effect of
perfection or nonperfection, and the priority of a security interest
in goods covered by a certificate of title from the time the goods
become covered by the certificate of title until the goods cease
to be covered by the certificate of title.
§ 9–304. Law Governing Perfection and
Priority of Security Interests in
Deposit Accounts.
(a) The local law of a bank’s jurisdiction governs
perfection, the effect of perfection or nonperfection, and the
priority of a security interest in a deposit account maintained
with that bank.
(b) The following rules determine a bank’s jurisdiction for
purposes of this part:
(1) If an agreement between the bank and the debtor governing
the deposit account expressly provides that a particular
jurisdiction is the bank’s jurisdiction for purposes of this part,
this article, or [the Uniform Commercial Code], that jurisdiction
is the bank’s jurisdiction.
(2) If paragraph (1) does not apply and an agreement between
the bank and its customer governing the deposit account
expressly provides that the agreement is governed by the law
of a particular jurisdiction, that jurisdiction is the bank’s
jurisdiction.
(3) If neither paragraph (1) nor paragraph (2) applies and an
agreement between the bank and its customer governing the
deposit account expressly provides that the deposit account is
maintained at an office in a particular jurisdiction, that
jurisdiction is the bank’s jurisdiction.
(4) If none of the preceding paragraphs applies, the bank’s
jurisdiction is the jurisdiction in which the office identified in
an account statement as the office serving the customer’s
account is located.
(5) If none of the preceding paragraphs applies, the bank’s
jurisdiction is the jurisdiction in which the chief executive office
of the bank is located.
§ 9–305. Law Governing Perfection and
Priority of Security Interests in
Investment Property.
(a) Except as otherwise provided in subsection (c), the
following rules apply:
(1) While a security certificate is located in a jurisdiction,
the local law of that jurisdiction governs perfection, the
effect of perfection or nonperfection, and the priority of
a security interest in the certificated security represented
thereby.
(2) The local law of the issuer’s jurisdiction as specified in
Section 8–110(d) governs perfection, the effect of perfection or
nonperfection, and the priority of a security interest in an
uncertificated security.
(3) The local law of the securities intermediary’s jurisdiction
as specified in Section 8–110(e) governs perfection, the
effect of perfection or nonperfection, and the priority of
a security interest in a security entitlement or securities
account.
(4) The local law of the commodity intermediary’s jurisdiction
governs perfection, the effect of perfection or nonperfection, and
the priority of a security interest in a commodity contract or
commodity account.
(b) The following rules determine a commodity
intermediary’s jurisdiction for purposes of this part:
(1) If an agreement between the commodity intermediary and
commodity customer governing the commodity account
expressly provides that a particular jurisdiction is the commodity
intermediary’s jurisdiction for purposes of this part, this article,
or [the Uniform Commercial Code], that jurisdiction is the
commodity intermediary’s jurisdiction.
(2) If paragraph (1) does not apply and an agreement between
the commodity intermediary and commodity customer
governing the commodity account expressly provides that
the agreement is governed by the law of a particular
jurisdiction, that jurisdiction is the commodity intermediary’s
jurisdiction.
(3) If neither paragraph (1) nor paragraph (2) applies and an
agreement between the commodity intermediary and
commodity customer governing the commodity account
expressly provides that the commodity account is maintained
at an office in a particular jurisdiction, that jurisdiction is the
commodity intermediary’s jurisdiction.
(4) If none of the preceding paragraphs applies, the commodity
intermediary’s jurisdiction is the jurisdiction in which the office
identified in an account statement as the office serving the
commodity customer’s account is located.
(5) If none of the preceding paragraphs applies, the
commodity intermediary’s jurisdiction is the jurisdiction in
which the chief executive office of the commodity
intermediary is located.
(c) The local law of the jurisdiction in which the debtor is
located governs:
(1) perfection of a security interest in investment property by
filing;
(2) automatic perfection of a security interest in investment
property created by a broker or securities intermediary; and
(3) automatic perfection of a security interest in a commodity
contract or commodity account created by a commodity
intermediary.
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§ 9–306. Law Governing Perfection and
Priority of Security Interests in
Letter-of-Credit Rights.
(a) Subject to subsection (c), the local law of the issuer’s
jurisdiction or a nominated person’s jurisdiction governs
perfection, the effect of perfection or nonperfection, and
the priority of a security interest in a letter-of-credit right
if the issuer’s jurisdiction or nominated person’s jurisdiction is
a State.
(b) For purposes of this part, an issuer’s jurisdiction or
nominated person’s jurisdiction is the jurisdiction whose law
governs the liability of the issuer or nominated person
with respect to the letter-of-credit right as provided in
Section 5–116.
(c) This section does not apply to a security interest that is
perfected only under Section 9–308(d).
§ 9–307. Location of Debtor.
(a) In this section, “place of business” means a place where
a debtor conducts its affairs.
(b) Except as otherwise provided in this section, the
following rules determine a debtor’s location:
(1) A debtor who is an individual is located at the individual’s
principal residence.
(2) A debtor that is an organization and has only one place of
business is located at its place of business.
(3) A debtor that is an organization and has more than one place
of business is located at its chief executive office.
(c) Subsection (b) applies only if a debtor’s residence, place
of business, or chief executive office, as applicable, is located
in a jurisdiction whose law generally requires information
concerning the existence of a nonpossessory security interest to
be made generally available in a filing, recording, or registration
system as a condition or result of the security interest’s obtaining
priority over the rights of a lien creditor with respect to the
collateral. If subsection (b) does not apply, the debtor is located
in the District of Columbia.
(d) A person that ceases to exist, have a residence, or have a
place of business continues to be located in the jurisdiction
specified by subsections (b) and (c).
(e) A registered organization that is organized under the law
of a State is located in that State.
(f) Except as otherwise provided in subsection (i), a
registered organization that is organized under the law of the
United Statesand a branch or agency of a bank that is not
organized under the law of the United States or a State are
located:
(1) in the State that the law of the United States designates,
if the law designates a State of location;
(2) in the State that the registered organization, branch, or
agency designates, if the law of the United States authorizes the
registered organization, branch, or agency to designate its State
of location; or
(3) in the District of Columbia, if neither paragraph (1) nor
paragraph (2) applies.
(g) A registered organization continues to be located
in the jurisdiction specified by subsection (e) or (f)
notwithstanding:
(1) the suspension, revocation, forfeiture, or lapse of the
registered organization’s status as such in its jurisdiction of
organization; or
(2) the dissolution, winding up, or cancellation of the existence
of the registered organization.
(h) The United States is located in the District of
Columbia.
(i) A branch or agency of a bank that is not organized
under the law of the United States or a State is located in
the State in which the branch or agency is licensed, if all
branches and agencies of the bank are licensed in only
one State.
(j) A foreign air carrier under the Federal Aviation Act of
1958, as amended, is located at the designated office of the
agent upon which service of process may be made on behalf of
the carrier.
(k) This section applies only for purposes of this part.
[Subpart 2. Perfection]
§ 9–308. When Security Interest or
Agricultural Lien Is Perfected;
Continuity of Perfection.
(a) Except as otherwise provided in this section and
Section 9–309, a security interest is perfected if it has
attached and all of the applicable requirements for perfection
in Sections 9–310 through 9–316 have been satisfied.
A security interest is perfected when it attaches if the
applicable requirements are satisfied before the security
interest attaches.
(b) An agricultural lien is perfected if it has become
effective and all of the applicable requirements for perfection
in Section 9–310 have been satisfied. An agricultural lien is
perfected when it becomes effective if the applicable
requirements are satisfied before the agricultural lien becomes
effective.
(c) A security interest or agricultural lien is perfected
continuously if it is originally perfected by one method under
this article and is later perfected by another method under
this article, without an intermediate period when it was
unperfected.
(d) Perfection of a security interest in collateral also
perfects a security interest in a supporting obligation for the
collateral.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B39
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(e) Perfection of a security interest in a right to payment or
performance also perfects a security interest in a security
interest, mortgage, or other lien on personal or real property
securing the right.
(f) Perfection of a security interest in a securities account
also perfects a security interest in the security entitlements
carried in the securities account.
(g) Perfection of a security interest in a commodity account
also perfects a security interest in the commodity contracts
carried in the commodity account.
Legislative Note: Any statute conflicting with subsection (e) must be
made expressly subject to that subsection.
§ 9–309. Security Interest Perfected upon
Attachment.
The following security interests are perfected when they attach:
(1) a purchase-money security interest in consumer goods,
except as otherwise provided in Section 9–311(b) with respect to
consumer goods that are subject to a statute or treaty described
in Section 9–311(a);
(2) an assignment of accounts or payment intangibles which
does not by itself or in conjunction with other assignments to
the same assignee transfer a significant part of the assignor’s
outstanding accounts or payment intangibles;
(3) a sale of a payment intangible;
(4) a sale of a promissory note;
(5) a security interest created by the assignment of a health-care-
insurance receivable to the provider of the health-care goods or
services;
(6) a security interest arising under Section 2–401, 2–505, 2–711
(3), or 2A–508(5), until the debtor obtains possession of the
collateral;
(7) a security interest of a collecting bank arising under
Section 4–210;
(8) a security interest of an issuer or nominated person arising
under Section 5–118;
(9) a security interest arising in the delivery of a financial asset
under Section 9–206(c);
(10) a security interest in investment property created by a
broker or securities intermediary;
(11) a security interest in a commodity contract or a commodity
account created by a commodity intermediary;
(12) an assignment for the benefit of all creditors of the
transferor and subsequent transfers by the assignee thereunder;
and
(13) a security interest created by an assignment of a beneficial
interest in a decedent’s estate; and
(14) a sale by an individual of an account that is a right to
payment of winnings in a lottery or other game of chance.
§ 9–310. When Filing Required to Perfect
Security Interest or Agricultural
Lien; Security Interests and
Agricultural Liens to Which Filing
Provisions Do Not Apply.
(a) Except as otherwise provided in subsection (b) and
Section 9–312(b), a financing statement must be filed to perfect
all security interests and agricultural liens.
(b) The filing of a financing statement is not necessary to
perfect a security interest:
(1) that is perfected under Section 9–308(d), (e), (f), or (g);
(2) that is perfected under Section 9–309 when it attaches;
(3) in property subject to a statute, regulation, or treaty described
in Section 9–311(a);
(4) in goods in possession of a bailee which is perfected under
Section 9–312(d)(1) or (2);
(5) in certificated securities, documents, goods, or instruments
which is perfected without filing or possession under
Section 9–312(e), (f), or (g);
(6) in collateral in the secured party’s possession under
Section 9–313;
(7) in a certificated security which is perfected by delivery
of the security certificate to the secured party under
Section 9–313;
(8) in deposit accounts, electronic chattel paper, investment
property, or letter-of-credit rights which is perfected by control
under Section 9–314;
(9) in proceeds which is perfected under Section 9–315; or
(10) that is perfected under Section 9–316.
(c) If a secured party assigns a perfected security
interest or agricultural lien, a filing under this article is not
required to continue the perfected status of the security
interest against creditors of and transferees from the original
debtor.
§ 9–311. Perfection of Security Interests in
Property Subject to Certain
Statutes, Regulations, and Treaties.
(a) Except as otherwise provided in subsection (d), the
filing of a financing statement is not necessary or effective to
perfect a security interest in property subject to:
(1) a statute, regulation, or treaty of the United States whose
requirements for a security interest’s obtaining priority over the
rights of a lien creditor with respect to the property preempt
Section 9–310(a);
(2) [list any certificate-of-title statute covering automobiles,
trailers, mobile homes, boats, farm tractors, or the like, which
provides for a security interest to be indicated on the certificate
as a condition or result of perfection, and any non-Uniform
Commercial Code central filing statute]; or
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(3) a certificate-of-title statute of another jurisdiction which
provides for a security interest to be indicated on the certificate
as a condition or result of the security interest’s obtaining
priority over the rights of a lien creditor with respect to the
property.
(b) Compliance with the requirements of a statute,
regulation, or treaty described in subsection (a) for obtaining
priority over the rights of a lien creditor is equivalent to the
filing of a financing statement under this article. Except as
otherwise provided in subsection (d) and Sections 9–313
and 9–316(d) and (e) for goods covered by a certificate of
title, a security interest in property subject to a statute,
regulation, or treaty described in subsection (a) may be
perfected only by compliance with those requirements,
and a security interest so perfected remains perfected
notwithstanding a change in the use or transfer of possession
of the collateral.
(c) Except as otherwise provided in subsection (d) and
Section 9–316(d) and (e), duration and renewal of perfection
of a security interest perfected by compliance with the
requirements prescribed by a statute, regulation, or treaty
described in subsection (a) are governed by the statute,
regulation, or treaty. In other respects, the security interest is
subject to this article.
(d) During any period in which collateral subject to a statute
specified in subsection (a)(2) is inventory held for sale or lease
by a person or leased by that person as lessor and that person
is in the business of selling goods of that kind, this section
does not apply to a security interest in that collateral created by
that person.
Legislative Note: This Article contemplates that perfection of a security
interest in goods covered by a certificate of title occurs upon receipt by
appropriate State officials of a properly tendered application for a
certificate of title on which the security interest is to be indicated, without
a relation back to an earlier time. States whose certificate-of-title statutes
provide for perfection at a different time or contain a relation-back
provision should amend the statutes accordingly.
§ 9–312. Perfection of Security Interests in
Chattel Paper, Deposit Accounts,
Documents, Goods Covered by
Documents, Instruments,
Investment Property, Letter-of-
Credit Rights, and Money;
Perfection by Permissive Filing;
Temporary Perfection without
Filing or Transfer of Possession.
(a) A security interest in chattel paper, negotiable documents,
instruments, or investment property may be perfected by filing.
(b) Except as otherwise provided in Section 9–315(c) and
(d) for proceeds:
(1) a security interest in a deposit account may be perfected only
by control under Section 9–314;
(2) and except as otherwise provided in Section 9–308(d), a
security interest in a letter-of-credit right may be perfected only
by control under Section 9–314; and
(3) a security interest in money may be perfected only by the
secured party’s taking possession under Section 9–313.
(c) While goods are in the possession of a bailee that has
issued a negotiable document covering the goods:
(1) a security interest in the goods may be perfected by
perfecting a security interest in the document; and
(2) a security interest perfected in the document has priority
over any security interest that becomes perfected in the goods
by another method during that time.
(d) While goods are in the possession of a bailee that has
issued a nonnegotiable document covering the goods, a security
interest in the goods may be perfected by:
(1) issuance of a document in the name of the secured party;
(2) the bailee’s receipt of notification of the secured party’s
interest; or
(3) filing as to the goods.
(e) A security interest in certificated securities, negotiable
documents, or instruments is perfected without filing or the
taking of possession for a period of 20 days from the time it
attaches to the extent that it arises for new value given under an
authenticated security agreement.
(f) A perfected security interest in a negotiable document
or goods in possession of a bailee, other than one that has issued
a negotiable document for the goods, remains perfected for
20 days without filing if the secured party makes available to
the debtor the goods or documents representing the goods for
the purpose of:
(1) ultimate sale or exchange; or
(2) loading, unloading, storing, shipping, transshipping,
manufacturing, processing, or otherwise dealing with them in a
manner preliminary to their sale or exchange.
(g) A perfected security interest in a certificated security or
instrument remains perfected for 20 days without filing if the
secured party delivers the security certificate or instrument to
the debtor for the purpose of:
(1) ultimate sale or exchange; or
(2) presentation, collection, enforcement, renewal, or registration
of transfer.
(h) After the 20-day period specified in subsection (e), (f),
or (g) expires, perfection depends upon compliance with this
article.
§ 9–313. When Possession by or Delivery to
Secured Party Perfects Security
Interest without Filing.
(a) Except as otherwise provided in subsection (b), a
secured party may perfect a security interest in negotiable
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B41
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documents, goods, instruments, money, or tangible chattel
paper by taking possession of the collateral. A secured party
may perfect a security interest in certificated securities
by taking delivery of the certificated securities under
Section 8–301.
(b) With respect to goods covered by a certificate of
title issued by this State, a secured party may perfect a
security interest in the goods by taking possession of
the goods only in the circumstances described in
Section 9–316(d).
(c) With respect to collateral other than certificated
securities and goods covered by a document, a secured party
takes possession of collateral in the possession of a person other
than the debtor, the secured party, or a lessee of the collateral
from the debtor in the ordinary course of the debtor’s business,
when:
(1) the person in possession authenticates a record acknow-
ledging that it holds possession of the collateral for the secured
party’s benefit; or
(2) the person takes possession of the collateral after having
authenticated a record acknowledging that it will hold
possession of collateral for the secured party’s benefit.
(d) If perfection of a security interest depends upon
possession of the collateral by a secured party, perfection
occurs no earlier than the time the secured party takes
possession and continues only while the secured party retains
possession.
(e) A security interest in a certificated security in registered
form is perfected by delivery when delivery of the certificated
security occurs under Section 8–301 and remains perfected by
delivery until the debtor obtains possession of the security
certificate.
(f) A person in possession of collateral is not required to
acknowledge that it holds possession for a secured party’s
benefit.
(g) If a person acknowledges that it holds possession for the
secured party’s benefit:
(1) the acknowledgment is effective under subsection (c) or
Section 8–301(a), even if the acknowledgment violates the rights
of a debtor; and
(2) unless the person otherwise agrees or law other than this
article otherwise provides, the person does not owe any duty to
the secured party and is not required to confirm the
acknowledgment to another person.
(h) A secured party having possession of collateral does not
relinquish possession by delivering the collateral to a person
other than the debtor or a lessee of the collateral from the
debtor in the ordinary course of the debtor’s business if the
person was instructed before the delivery or is instructed
contemporaneously with the delivery:
(1) to hold possession of the collateral for the secured party’s
benefit; or
(2) to redeliver the collateral to the secured party.
(i) A secured party does not relinquish possession, even if
a delivery under subsection (h) violates the rights of a debtor.
A person to which collateral is delivered under subsection
(h) does not owe any duty to the secured party and is not
required to confirm the delivery to another person unless the
person otherwise agrees or law other than this article otherwise
provides.
§ 9–314. Perfection by Control.
(a) A security interest in investment property, deposit
accounts, letter-of-credit rights, or electronic chattel paper may
be perfected by control of the collateral under Section 9–104,
9–105, 9–106, or 9–107.
(b) A security interest in deposit accounts, electronic chattel
paper, or letter-of-credit rights is perfected by control under
Section 9–104, 9–105, or 9–107 when the secured party obtains
control and remains perfected by control only while the secured
party retains control.
(c) A security interest in investment property is perfected
by control under Section 9–106 from the time the secured party
obtains control and remains perfected by control until:
(1) the secured party does not have control; and
(2) one of the following occurs:
(A) if the collateral is a certificated security, the debtor has or
acquires possession of the security certificate;
(B) if the collateral is an uncertificated security, the
issuer has registered or registers the debtor as the registered
owner; or
(C) if the collateral is a security entitlement, the debtor is or
becomes the entitlement holder.
§ 9–315. Secured Party’s Rights on
Disposition of Collateral and in
Proceeds.
(a) Except as otherwise provided in this article and in
Section 2–403(2):
(1) a security interest or agricultural lien continues in
collateral notwithstanding sale, lease, license, exchange, or
other disposition thereof unless the secured party authorized
the disposition free of the security interest or agricultural
lien; and
(2) a security interest attaches to any identifiable proceeds of
collateral.
(b) Proceeds that are commingled with other property are
identifiable proceeds:
(1) if the proceeds are goods, to the extent provided by
Section 9–336; and
(2) if the proceeds are not goods, to the extent that the secured
party identifies the proceeds by a method of tracing, including
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application of equitable principles, that is permitted under law
other than this article with respect to commingled property of
the type involved.
(c) A security interest in proceeds is a perfected security
interest if the security interest in the original collateral was
perfected.
(d) A perfected security interest in proceeds becomes
unperfected on the 21st day after the security interest attaches to
the proceeds unless:
(1) the following conditions are satisfied:
(A) a filed financing statement covers the original
collateral;
(B) the proceeds are collateral in which a security interest may
be perfected by filing in the office in which the financing statement
has been filed; and
(C) the proceeds are not acquired with cash proceeds;
(2) the proceeds are identifiable cash proceeds; or
(3) the security interest in the proceeds is perfected other than
under subsection (c) when the security interest attaches to the
proceeds or within 20 days thereafter.
(e) If a filed financing statement covers the original
collateral, a security interest in proceeds which remains
perfected under subsection (d)(1) becomes unperfected at the
later of:
(1) when the effectiveness of the filed financing statement lapses
under Section 9–515 or is terminated under Section 9–513; or
(2) the 21st day after the security interest attaches to the
proceeds.
§ 9–316. Continued Perfection of Security
Interest Following Change in
Governing Law.
(a) A security interest perfected pursuant to the law of the
jurisdiction designated in Section 9–301(1) or 9–305(c) remains
perfected until the earliest of:
(1) the time perfection would have ceased under the law of that
jurisdiction;
(2) the expiration of four months after a change of the debtor’s
location to another jurisdiction; or
(3) the expiration of one year after a transfer of collateral to a
person that thereby becomes a debtor and is located in another
jurisdiction.
(b) If a security interest described in subsection (a) becomes
perfected under the law of the other jurisdiction before the
earliest time or event described in that subsection, it remains
perfected thereafter. If the security interest does not become
perfected under the law of the other jurisdiction before the
earliest time or event, it becomes unperfected and is deemed
never to have been perfected as against a purchaser of the
collateral for value.
(c) A possessory security interest in collateral, other than
goods covered by a certificate of title and as-extracted collateral
consisting of goods, remains continuously perfected if:
(1) the collateral is located in one jurisdiction and subject
to a security interest perfected under the law of that
jurisdiction;
(2) thereafter the collateral is brought into another jurisdiction;
and
(3) upon entry into the other jurisdiction, the security interest is
perfected under the law of the other jurisdiction.
(d) Except as otherwise provided in subsection (e),
a security interest in goods covered by a certificate of title
which is perfected by any method under the law of
another jurisdiction when the goods become covered by a
certificate of title from this State remains perfected until
the security interest would have become unperfected under
the law of the other jurisdiction had the goods not become
so covered.
(e) A security interest described in subsection (d) becomes
unperfected as against a purchaser of the goods for value and is
deemed never to have been perfected as against a purchaser
of the goods for value if the applicable requirements for
perfection under Section 9–311(b) or 9–313 are not satisfied
before the earlier of:
(1) the time the security interest would have become
unperfected under the law of the other jurisdiction had the
goods not become covered by a certificate of title from this
State; or
(2) the expiration of four months after the goods had become so
covered.
(f) A security interest in deposit accounts, letter-of-credit
rights, or investment property which is perfected under the
law of the bank’s jurisdiction, the issuer’s jurisdiction, a
nominated person’s jurisdiction, the securities intermediary’s
jurisdiction, or the commodity intermediary’s jurisdiction, as
applicable, remains perfected until the earlier of:
(1) the time the security interest would have become
unperfected under the law of that jurisdiction; or
(2) the expiration of four months after a change of the applicable
jurisdiction to another jurisdiction.
(g) If a security interest described in subsection (f)
becomes perfected under the law of the other jurisdiction
before the earlier of the time or the end of the period
described in that subsection, it remains perfected thereafter.
If the security interest does not become perfected under the
law of the other jurisdiction before the earlier of that time or
the end of that period, it becomes unperfected and is deemed
never to have been perfected as against a purchaser of the
collateral for value.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B43
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[Subpart 3. Priority]
§ 9–317. Interests That Take Priority over or
Take Free of Security Interest or
Agricultural Lien.
(a) A security interest or agricultural lien is subordinate to
the rights of:
(1) a person entitled to priority under Section 9–322; and
(2) except as otherwise provided in subsection (e), a person that
becomes a lien creditor before the earlier of the time:
(A) the security interest or agricultural lien is perfected; or
(B) one of the conditions specified in Section 9–203(b)(3) is
met and a financing statement covering the collateral is filed.
(b) Except as otherwise provided in subsection (e), a
buyer, other than a secured party, of tangible chattel paper,
documents, goods, instruments, or a security certificate takes
free of a security interest or agricultural lien if the buyer
gives value and receives delivery of the collateral without
knowledge of the security interest or agricultural lien and
before it is perfected.
(c) Except as otherwise provided in subsection (e), a lessee
of goods takes free of a security interest or agricultural lien if the
lessee gives value and receives delivery of the collateral without
knowledge of the security interest or agricultural lien and before
it is perfected.
(d) A licensee of a general intangible or a buyer, other than
a secured party, of accounts, electronic chattel paper, general
intangibles, or investment property other than a certificated
security takes free of a security interest if the licensee or buyer
gives value without knowledge of the security interest and
before it is perfected.
(e) Except as otherwise provided in Sections 9–320 and
9–321, if a person files a financing statement with respect to a
purchase-money security interest before or within 20 days after
the debtor receives delivery of the collateral, the security
interest takes priority over the rights of a buyer, lessee, or lien
creditor which arise between the time the security interest
attaches and the time of filing.
As amended in 2000.
§ 9–318. No Interest Retained in Right to
Payment That Is Sold; Rights and
Title of Seller of Account or Chattel
Paper with Respect to Creditors and
Purchasers.
(a) A debtor that has sold an account, chattel paper,
payment intangible, or promissory note does not retain a legal or
equitable interest in the collateral sold.
(b) For purposes of determining the rights of creditors of,
and purchasers for value of an account or chattel paper from, a
debtor that has sold an account or chattel paper, while the
buyer’s security interest is unperfected, the debtor is deemed to
have rights and title to the account or chattel paper identical to
those the debtor sold.
§ 9–319. Rights and Title of Consignee with
Respect to Creditors and
Purchasers.
(a) Except as otherwise provided in subsection (b), for
purposes of determining the rights of creditors of, and
purchasers for value of goods from, a consignee, while the
goods are in the possession of the consignee, the consignee
is deemed to have rights and title to the goods identical to
those the consignor had or had power to transfer.
(b) For purposes of determining the rights of a creditor of
a consignee, law other than this article determines the rights
and title of a consignee while goods are in the consignee’s
possession if, under this part, a perfected security interest
held by the consignor would have priority over the rights of
the creditor.
§ 9–320. Buyer of Goods.
(a) Except as otherwise provided in subsection (e), a buyer
in ordinary course of business, other than a person buying farm
products from a person engaged in farming operations, takes free
of a security interest created by the buyer’s seller, even if the
security interest is perfected and the buyer knows of its
existence.
(b) Except as otherwise provided in subsection (e),
a buyer of goods from a person who used or bought the goods
for use primarily for personal, family, or household purposes
takes free of a security interest, even if perfected, if the
buyer buys:
(1) without knowledge of the security interest;
(2) for value;
(3) primarily for the buyer’s personal, family, or household
purposes; and
(4) before the filing of a financing statement covering the goods.
(c) To the extent that it affects the priority of a security
interest over a buyer of goods under subsection (b), the
period of effectiveness of a filing made in the jurisdiction in
which the seller is located is governed by Section 9–316(a)
and (b).
(d) A buyer in ordinary course of business buying oil, gas, or
other minerals at the wellhead or minehead or after extraction
takes free of an interest arising out of an encumbrance.
(e) Subsections (a) and (b) do not affect a security
interest in goods in the possession of the secured party under
Section 9–313.
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§ 9–321. Licensee of General Intangible and
Lessee of Goods in Ordinary Course
of Business.
(a) In this section, “licensee in ordinary course of business”
means a person that becomes a licensee of a general intangible
in good faith, without knowledge that the license violates the
rights of another person in the general intangible, and in the
ordinary course from a person in the business of licensing
general intangibles of that kind. A person becomes a licensee in
the ordinary course if the license to the person comports with
the usual or customary practices in the kind of business in which
the licensor is engaged or with the licensor’s own usual or
customary practices.
(b) A licensee in ordinary course of business takes its
rights under a nonexclusive license free of a security interest
in the general intangible created by the licensor, even if the
security interest is perfected and the licensee knows of its
existence.
(c) A lessee in ordinary course of business takes its
leasehold interest free of a security interest in the goods created
by the lessor, even if the security interest is perfected and the
lessee knows of its existence.
§ 9–322. Priorities among Conflicting Security
Interests in and Agricultural Liens on
Same Collateral.
(a) Except as otherwise provided in this section, priority
among conflicting security interests and agricultural liens in
the same collateral is determined according to the following
rules:
(1) Conflicting perfected security interests and agricultural liens
rank according to priority in time of filing or perfection. Priority
dates from the earlier of the time a filing covering the collateral
is first made or the security interest or agricultural lien is first
perfected, if there is no period thereafter when there is neither
filing nor perfection.
(2) A perfected security interest or agricultural lien has priority
over a conflicting unperfected security interest or agricultural
lien.
(3) The first security interest or agricultural lien to attach or
become effective has priority if conflicting security interests and
agricultural liens are unperfected.
(b) For the purposes of subsection (a)(1):
(1) the time of filing or perfection as to a security interest in
collateral is also the time of filing or perfection as to a security
interest in proceeds; and
(2) the time of filing or perfection as to a security interest in
collateral supported by a supporting obligation is also the time of
filing or perfection as to a security interest in the supporting
obligation.
(c) Except as otherwise provided in subsection (f), a
security interest in collateral which qualifies for priority over a
conflicting security interest under Section 9–327, 9–328, 9–329,
9–330, or 9–331 also has priority over a conflicting security
interest in:
(1) any supporting obligation for the collateral; and
(2) proceeds of the collateral if:
(A) the security interest in proceeds is perfected;
(B) the proceeds are cash proceeds or of the same type as the
collateral; and
(C) in the case of proceeds that are proceeds of proceeds, all
intervening proceeds are cash proceeds, proceeds of the same type as
the collateral, or an account relating to the collateral.
(d) Subject to subsection (e) and except as otherwise
provided in subsection (f), if a security interest in chattel paper,
deposit accounts, negotiable documents, instruments,
investment property, or letter-of-credit rights is perfected by a
method other than filing, conflicting perfected security interests
in proceeds of the collateral rank according to priority in time
of filing.
(e) Subsection (d) applies only if the proceeds of the
collateral are not cash proceeds, chattel paper, negotiable
documents, instruments, investment property, or letter-of-credit
rights.
(f) Subsections (a) through (e) are subject to:
(1) subsection (g) and the other provisions of this part;
(2) Section 4–210 with respect to a security interest of a
collecting bank;
(3) Section 5–118 with respect to a security interest of an issuer
or nominated person; and
(4) Section 9–110 with respect to a security interest arising under
Article 2 or 2A.
(g) A perfected agricultural lien on collateral has priority
over a conflicting security interest in or agricultural lien on the
same collateral if the statute creating the agricultural lien so
provides.
§ 9–323. Future Advances.
(a) Except as otherwise provided in subsection (c), for
purposes of determining the priority of a perfected security
interest under Section 9–322(a)(1), perfection of the security
interest dates from the time an advance is made to the extent
that the security interest secures an advance that:
(1) is made while the security interest is perfected only:
(A) under Section 9–309 when it attaches; or
(B) temporarily under Section 9–312(e), (f), or (g); and
(2) is not made pursuant to a commitment entered into before or
while the security interest is perfected by a method other than
under Section 9–309 or 9–312(e), (f), or (g).
(b) Except as otherwise provided in subsection (c), a
security interest is subordinate to the rights of a person that
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becomes a lien creditor to the extent that the security interest
secures an advance made more than 45 days after the person
becomes a lien creditor unless the advance is made:
(1) without knowledge of the lien; or
(2) pursuant to a commitment entered into without knowledge
of the lien.
(c) Subsections (a) and (b) do not apply to a security
interest held by a secured party that is a buyer of accounts,
chattel paper, payment intangibles, or promissory notes or a
consignor.
(d) Except as otherwise provided in subsection (e), a buyer
of goods other than a buyer in ordinary course of business takes
free of a security interest to the extent that it secures advances
made after the earlier of:
(1) the time the secured party acquires knowledge of the buyer’s
purchase; or
(2) 45 days after the purchase.
(e) Subsection (d) does not apply if the advance is made
pursuant to a commitment entered into without knowledge of
the buyer’s purchase and before the expiration of the 45-day
period.
(f) Except as otherwise provided in subsection (g), a lessee
of goods, other than a lessee in ordinary course of business, takes
the leasehold interest free of a security interest to the extent that
it secures advances made after the earlier of:
(1) the time the secured party acquires knowledge of the lease; or
(2) 45 days after the lease contract becomes enforceable.
(g) Subsection (f) does not apply if the advance is made
pursuant to a commitment entered into without knowledge of
the lease and before the expiration of the 45-day period.
As amended in 1999.
§ 9–324. Priority of Purchase-Money Security
Interests.
(a) Except as otherwise provided in subsection (g), a
perfected purchase-money security interest in goods other
than inventory or livestock has priority over a conflicting
security interest in the same goods, and, except as otherwise
provided in Section 9–327, a perfected security interest in its
identifiable proceeds also has priority, if the purchase-money
security interest is perfected when the debtor receives
possession of the collateral or within 20 days thereafter.
(b) Subject to subsection (c) and except as otherwise
provided in subsection (g), a perfected purchase-money
security interest in inventory has priority over a conflicting
security interest in the same inventory, has priority over a
conflicting security interest in chattel paper or an instrument
constituting proceeds of the inventory and in proceeds of the
chattel paper, if so provided in Section 9–330, and, except as
otherwise provided in Section 9–327, also has priority in
identifiable cash proceeds of the inventory to the extent the
identifiable cash proceeds are received on or before the
delivery of the inventory to a buyer, if:
(1) the purchase-money security interest is perfected when the
debtor receives possession of the inventory;
(2) the purchase-money secured party sends an authenticated
notification to the holder of the conflicting security interest;
(3) the holder of the conflicting security interest receives the
notification within five years before the debtor receives
possession of the inventory; and
(4) the notification states that the person sending the
notification has or expects to acquire a purchase-money
security interest in inventory of the debtor and describes
the inventory.
(c) Subsections (b)(2) through (4) apply only if the holder of
the conflicting security interest had filed a financing statement
covering the same types of inventory:
(1) if the purchase-money security interest is perfected by filing,
before the date of the filing; or
(2) if the purchase-money security interest is temporarily
perfected without filing or possession under Section 9–312(f),
before the beginning of the 20-day period thereunder.
(d) Subject to subsection (e) and except as otherwise
provided in subsection (g), a perfected purchase-money
security interest in livestock that are farm products has
priority over a conflicting security interest in the same
livestock, and, except as otherwise provided in Section 9–327,
a perfected security interest in their identifiable proceeds
and identifiable products in their unmanufactured states also
has priority, if:
(1) the purchase-money security interest is perfected when the
debtor receives possession of the livestock;
(2) the purchase-money secured party sends an authenticated
notification to the holder of the conflicting security interest;
(3) the holder of the conflicting security interest receives the
notification within six months before the debtor receives
possession of the livestock; and
(4) the notification states that the person sending the
notification has or expects to acquire a purchase-money
security interest in livestock of the debtor and describes
the livestock.
(e) Subsections (d)(2) through (4) apply only if the holder of
the conflicting security interest had filed a financing statement
covering the same types of livestock:
(1) if the purchase-money security interest is perfected by filing,
before the date of the filing; or
(2) if the purchase-money security interest is temporarily
perfected without filing or possession under Section 9–312(f),
before the beginning of the 20-day period thereunder.
(f) Except as otherwise provided in subsection (g), a
perfected purchase-money security interest in software has
priority over a conflicting security interest in the same
B46 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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collateral, and, except as otherwise provided in Section 9–327,
a perfected security interest in its identifiable proceeds also
has priority, to the extent that the purchase-money security
interest in the goods in which the software was acquired for
use has priority in the goods and proceeds of the goods under
this section.
(g) If more than one security interest qualifies for priority in
the same collateral under subsection (a), (b), (d), or (f):
(1) a security interest securing an obligation incurred as all or
part of the price of the collateral has priority over a security
interest securing an obligation incurred for value given to enable
the debtor to acquire rights in or the use of collateral; and
(2) in all other cases, Section 9–322(a) applies to the qualifying
security interests.
§ 9–325. Priority of Security Interests in
Transferred Collateral.
(a) Except as otherwise provided in subsection (b),
a security interest created by a debtor is subordinate to a
security interest in the same collateral created by another
person if:
(1) the debtor acquired the collateral subject to the security
interest created by the other person;
(2) the security interest created by the other person was
perfected when the debtor acquired the collateral; and
(3) there is no period thereafter when the security interest is
unperfected.
(b) Subsection (a) subordinates a security interest only if the
security interest:
(1) otherwise would have priority solely under Section 9–322(a)
or 9–324; or
(2) arose solely under Section 2–711(3) or 2A–508(5).
§ 9–326. Priority of Security Interests
Created by New Debtor.
(a) Subject to subsection (b), a security interest created by a
new debtor which is perfected by a filed financing statement
that is effective solely under Section 9–508 in collateral in which
a new debtor has or acquires rights is subordinate to a security
interest in the same collateral which is perfected other than by
a filed financing statement that is effective solely under
Section 9–508.
(b) The other provisions of this part determine the priority
among conflicting security interests in the same collateral
perfected by filed financing statements that are effective solely
under Section 9–508. However, if the security agreements to
which a new debtor became bound as debtor were not entered
into by the same original debtor, the conflicting security
interests rank according to priority in time of the new debtor’s
having become bound.
§ 9–327. Priority of Security Interests in
Deposit Account.
The following rules govern priority among conflicting security
interests in the same deposit account:
(1) A security interest held by a secured party having control
of the deposit account under Section 9–104 has priority over a
conflicting security interest held by a secured party that does
not have control.
(2) Except as otherwise provided in paragraphs (3) and (4),
security interests perfected by control under Section 9–314 rank
according to priority in time of obtaining control.
(3) Except as otherwise provided in paragraph (4), a security
interest held by the bank with which the deposit account is
maintained has priority over a conflicting security interest held
by another secured party.
(4) A security interest perfected by control under Section 9–104
(a)(3) has priority over a security interest held by the bank with
which the deposit account is maintained.
§ 9–328. Priority of Security Interests in
Investment Property.
The following rules govern priority among conflicting security
interests in the same investment property:
(1) A security interest held by a secured party having control
of investment property under Section 9–106 has priority over a
security interest held by a secured party that does not have
control of the investment property.
(2) Except as otherwise provided in paragraphs (3) and (4),
conflicting security interests held by secured parties each of
which has control under Section 9–106 rank according to
priority in time of:
(A) if the collateral is a security, obtaining control;
(B) if the collateral is a security entitlement carried in a securities
account and:
(i) if the secured party obtained control under Section 8–106(d)(1),
the secured party’s becoming the person for which the securities
account is maintained;
(ii) if the secured party obtained control under Section
8–106(d)(2), the securities intermediary’s agreement to comply
with the secured party’s entitlement orders with respect to
security entitlements carried or to be carried in the securities
account; or
(iii) if the secured party obtained control through another
person under Section 8–106(d)(3), the time on which priority would
be based under this paragraph if the other person were the secured
party; or
(C) if the collateral is a commodity contract carried with a
commodity intermediary, the satisfaction of the requirement
for control specified in Section 9–106(b)(2) with respect to
commodity contracts carried or to be carried with the commodity
intermediary.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B47
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(3) A security interest held by a securities intermediary in a
security entitlement or a securities account maintained with the
securities intermediary has priority over a conflicting security
interest held by another secured party.
(4) A security interest held by a commodity intermediary
in a commodity contract or a commodity account
maintained with the commodity intermediary has priority over a
conflicting security interest held by another secured party.
(5) A security interest in a certificated security in registered form
which is perfected by taking delivery under Section 9–313(a) and
not by control under Section 9–314 has priority over a conflicting
security interest perfected by a method other than control.
(6) Conflicting security interests created by a broker,
securities intermediary, or commodity intermediary which
are perfected without control under Section 9–106 rank
equally.
(7) In all other cases, priority among conflicting security
interests in investment property is governed by Sections 9–322
and 9–323.
§ 9–329. Priority of Security Interests in
Letter-of-Credit Right.
The following rules govern priority among conflicting security
interests in the same letter-of-credit right:
(1) A security interest held by a secured party having control of
the letter-of-credit right under Section 9–107 has priority to the
extent of its control over a conflicting security interest held by a
secured party that does not have control.
(2) Security interests perfected by control under Section 9–314
rank according to priority in time of obtaining control.
§ 9–330. Priority of Purchaser of Chattel
Paper or Instrument.
(a) A purchaser of chattel paper has priority over a security
interest in the chattel paper which is claimed merely as proceeds
of inventory subject to a security interest if:
(1) in good faith and in the ordinary course of the purchaser’s
business, the purchaser gives new value and takes possession of
the chattel paper or obtains control of the chattel paper under
Section 9–105; and
(2) the chattel paper does not indicate that it has been assigned
to an identified assignee other than the purchaser.
(b) A purchaser of chattel paper has priority over a
security interest in the chattel paper which is claimed other
than merely as proceeds of inventory subject to a security
interest if the purchaser gives new value and takes possession
of the chattel paper or obtains control of the chattel paper
under Section 9–105 in good faith, in the ordinary course of
the purchaser’s business, and without knowledge that the
purchase violates the rights of the secured party.
(c) Except as otherwise provided in Section 9–327, a
purchaser having priority in chattel paper under subsection (a) or
(b) also has priority in proceeds of the chattel paper to the extent
that:
(1) Section 9–322 provides for priority in the proceeds; or
(2) the proceeds consist of the specific goods covered by
the chattel paper or cash proceeds of the specific goods,
even if the purchaser’s security interest in the proceeds is
unperfected.
(d) Except as otherwise provided in Section 9–331(a),
a purchaser of an instrument has priority over a security
interest in the instrument perfected by a method other than
possession if the purchaser gives value and takes possession
of the instrument in good faith and without knowledge that
the purchase violates the rights of the secured party.
(e) For purposes of subsections (a) and (b), the holder
of a purchase-money security interest in inventory gives
new value for chattel paper constituting proceeds of the
inventory.
(f) For purposes of subsections (b) and (d), if chattel
paper or an instrument indicates that it has been assigned
to an identified secured party other than the purchaser,
a purchaser of the chattel paper or instrument has
knowledge that the purchase violates the rights of the
secured party.
§ 9–331. Priority of Rights of Purchasers of
Instruments, Documents, and
Securities under Other Articles;
Priority of Interests in Financial
Assets and Security Entitlements
under Article 8.
(a) This article does not limit the rights of a holder in due
course of a negotiable instrument, a holder to which a negotiable
document of title has been duly negotiated, or a protected
purchaser of a security. These holders or purchasers take priority
over an earlier security interest, even if perfected, to the extent
provided in Articles 3, 7, and 8.
(b) This article does not limit the rights of or impose
liability on a person to the extent that the person is protected
against the assertion of a claim under Article 8.
(c) Filing under this article does not constitute notice of a
claim or defense to the holders, or purchasers, or persons
described in subsections (a) and (b).
§ 9–332. Transfer of Money; Transfer of
Funds from Deposit Account.
(a) A transferee of money takes the money free of a security
interest unless the transferee acts in collusion with the debtor in
violating the rights of the secured party.
B48 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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(b) A transferee of funds from a deposit account takes the
funds free of a security interest in the deposit account unless the
transferee acts in collusion with the debtor in violating the rights
of the secured party.
§ 9–333. Priority of Certain Liens Arising by
Operation of Law.
(a) In this section, “possessory lien” means an interest,
other than a security interest or an agricultural lien:
(1) which secures payment or performance of an obligation for
services or materials furnished with respect to goods by a person
in the ordinary course of the person’s business;
(2) which is created by statute or rule of law in favor of the
person; and
(3) whose effectiveness depends on the person’s possession of
the goods.
(b) A possessory lien on goods has priority over a security
interest in the goods unless the lien is created by a statute that
expressly provides otherwise.
§ 9–334. Priority of Security Interests in
Fixtures and Crops.
(a) A security interest under this article may be created in
goods that are fixtures or may continue in goods that become
fixtures. A security interest does not exist under this article in
ordinary building materials incorporated into an improvement
on land.
(b) This article does not prevent creation of an
encumbrance upon fixtures under real property law.
(c) In cases not governed by subsections (d) through (h), a
security interest in fixtures is subordinate to a conflicting interest
of an encumbrancer or owner of the related real property other
than the debtor.
(d) Except as otherwise provided in subsection (h), a
perfected security interest in fixtures has priority over a
conflicting interest of an encumbrancer or owner of the real
property if the debtor has an interest of record in or is in
possession of the real property and:
(1) the security interest is a purchase-money security interest;
(2) the interest of the encumbrancer or owner arises before the
goods become fixtures; and
(3) the security interest is perfected by a fixture filing before the
goods become fixtures or within 20 days thereafter.
(e) A perfected security interest in fixtures has priority over
a conflicting interest of an encumbrancer or owner of the real
property if:
(1) the debtor has an interest of record in the real property or is
in possession of the real property and the security interest:
(A) is perfected by a fixture filing before the interest of the
encumbrancer or owner is of record; and
(B) has priority over any conflicting interest of a predecessor in
title of the encumbrancer or owner;
(2) before the goods become fixtures, the security interest is
perfected by any method permitted by this article and the
fixtures are readily removable:
(A) factory or office machines;
(B) equipment that is not primarily used or leased for use in
the operation of the real property; or
(C) replacements of domestic appliances that are consumer
goods;
(3) the conflicting interest is a lien on the real property obtained
by legal or equitable proceedings after the security interest was
perfected by any method permitted by this article; or
(4) the security interest is:
(A) created in a manufactured home in a manufactured-home
transaction; and
(B) perfected pursuant to a statute described in
Section 9–311(a)(2).
(f) A security interest in fixtures, whether or not perfected,
has priority over a conflicting interest of an encumbrancer or
owner of the real property if:
(1) the encumbrancer or owner has, in an authenticated record,
consented to the security interest or disclaimed an interest in the
goods as fixtures; or
(2) the debtor has a right to remove the goods as against the
encumbrancer or owner.
(g) The priority of the security interest under paragraph (f)
(2) continues for a reasonable time if the debtor’s right to
remove the goods as against the encumbrancer or owner
terminates.
(h) A mortgage is a construction mortgage to the extent
that it secures an obligation incurred for the construction of
an improvement on land, including the acquisition cost of the
land, if a recorded record of the mortgage so indicates.
Except as otherwise provided in subsections (e) and (f),
a security interest in fixtures is subordinate to a construction
mortgage if a record of the mortgage is recorded before the
goods become fixtures and the goods become fixtures
before the completion of the construction. A mortgage has
this priority to the same extent as a construction mortgage
to the extent that it is given to refinance a construction
mortgage.
(i) A perfected security interest in crops growing on real
property has priority over a conflicting interest of an
encumbrancer or owner of the real property if the debtor has an
interest of record in or is in possession of the real property.
(j) Subsection (i) prevails over any inconsistent provisions of
the following statutes:
[List here any statutes containing provisions inconsistent with
subsection (i).]
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B49
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Legislative Note: States that amend statutes to remove provisions incon-
sistent with subsection (i) need not enact subsection (j).
§ 9–335. Accessions.
(a) A security interest may be created in an accession and
continues in collateral that becomes an accession.
(b) If a security interest is perfected when the collateral
becomes an accession, the security interest remains perfected in
the collateral.
(c) Except as otherwise provided in subsection (d), the
other provisions of this part determine the priority of a security
interest in an accession.
(d) A security interest in an accession is subordinate to a
security interest in the whole which is perfected by compliance
with the requirements of a certificate-of-title statute under
Section 9–311(b).
(e) After default, subject to Part 6, a secured party may
remove an accession from other goods if the security interest in
the accession has priority over the claims of every person having
an interest in the whole.
(f) A secured party that removes an accession from other
goods under subsection (e) shall promptly reimburse any
holder of a security interest or other lien on, or owner of, the
whole or of the other goods, other than the debtor, for the
cost of repair of any physical injury to the whole or the other
goods. The secured party need not reimburse the holder or
owner for any diminution in value of the whole or the other
goods caused by the absence of the accession removed
or by any necessity for replacing it. A person entitled to
reimbursement may refuse permission to remove until the
secured party gives adequate assurance for the performance of
the obligation to reimburse.
§ 9–336. Commingled Goods.
(a) In this section, “commingled goods” means goods that
are physically united with other goods in such a manner that
their identity is lost in a product or mass.
(b) A security interest does not exist in commingled goods
as such. However, a security interest may attach to a product or
mass that results when goods become commingled goods.
(c) If collateral becomes commingled goods, a security
interest attaches to the product or mass.
(d) If a security interest in collateral is perfected before
the collateral becomes commingled goods, the security
interest that attaches to the product or mass under subsection
(c) is perfected.
(e) Except as otherwise provided in subsection (f), the
other provisions of this part determine the priority of a
security interest that attaches to the product or mass under
subsection (c).
(f) If more than one security interest attaches to the product or
mass under subsection (c), the following rules determine priority:
(1) A security interest that is perfected under subsection (d)
has priority over a security interest that is unperfected at the
time the collateral becomes commingled goods.
(2) If more than one security interest is perfected under subsection
(d), the security interests rank equally in proportion to the value of
the collateral at the time it became commingled goods.
§ 9–337. Priority of Security Interests in
Goods Covered by Certificate of Title.
If, while a security interest in goods is perfected by any method
under the law of another jurisdiction, this State issues a certifi-
cate of title that does not show that the goods are subject to the
security interest or contain a statement that they may be subject
to security interests not shown on the certificate:
(1) a buyer of the goods, other than a person in the business of
selling goods of that kind, takes free of the security interest if
the buyer gives value and receives delivery of the goods after
issuance of the certificate and without knowledge of the security
interest; and
(2) the security interest is subordinate to a conflicting security
interest in the goods that attaches, and is perfected under
Section 9–311(b), after issuance of the certificate and without
the conflicting secured party’s knowledge of the security
interest.
§ 9–338. Priority of Security Interest or
Agricultural Lien Perfected by Filed
Financing Statement Providing
Certain Incorrect Information.
If a security interest or agricultural lien is perfected by a filed
financing statement providing information described in Section
9–516(b)(5) which is incorrect at the time the financing state-
ment is filed:
(1) the security interest or agricultural lien is subordinate to a
conflicting perfected security interest in the collateral to the
extent that the holder of the conflicting security interest gives
value in reasonable reliance upon the incorrect information; and
(2) a purchaser, other than a secured party, of the collateral
takes free of the security interest or agricultural lien to the
extent that, in reasonable reliance upon the incorrect
information, the purchaser gives value and, in the case of
chattel paper, documents, goods, instruments, or a security
certificate, receives delivery of the collateral.
§ 9–339. Priority Subject to Subordination.
This article does not preclude subordination by agreement by a
person entitled to priority.
B50 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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[Subpart 4. Rights of Bank]
§ 9–340. Effectiveness of Right of
Recoupment or Set-Off against
Deposit Account.
(a) Except as otherwise provided in subsection (c), a
bank with which a deposit account is maintained may
exercise any right of recoupment or set-off against a secured
party that holds a security interest in the deposit account.
(b) Except as otherwise provided in subsection (c), the
application of this article to a security interest in a deposit
account does not affect a right of recoupment or set-off of
the secured party as to a deposit account maintained with the
secured party.
(c) The exercise by a bank of a set-off against a deposit
account is ineffective against a secured party that holds a
security interest in the deposit account which is perfected by
control under Section 9–104(a)(3), if the set-off is based on a
claim against the debtor.
§ 9–341. Bank’s Rights and Duties with
Respect to Deposit Account.
Except as otherwise provided in Section 9–340(c), and unless
the bank otherwise agrees in an authenticated record, a bank’s
rights and duties with respect to a deposit account maintained
with the bank are not terminated, suspended, or modified by:
(1) the creation, attachment, or perfection of a security interest
in the deposit account;
(2) the bank’s knowledge of the security interest; or
(3) the bank’s receipt of instructions from the secured party.
§ 9–342. Bank’s Right to Refuse to Enter into
or Disclose Existence of Control
Agreement.
This article does not require a bank to enter into an agree-
ment of the kind described in Section 9–104(a)(2), even if its
customer so requests or directs. A bank that has entered into
such an agreement is not required to confirm the existence of
the agreement to another person unless requested to do so by
its customer.
PART 4 Rights of Third Parties
§ 9–401. Alienability of Debtor’s Rights.
(a) Except as otherwise provided in subsection (b) and
Sections 9–406, 9–407, 9–408, and 9–409, whether a debtor’s
rights in collateral may be voluntarily or involuntarily
transferred is governed by law other than this article.
(b) An agreement between the debtor and secured party
which prohibits a transfer of the debtor’s rights in collateral or
makes the transfer a default does not prevent the transfer from
taking effect.
§ 9–402. Secured Party Not Obligated on
Contract of Debtor or in Tort.
The existence of a security interest, agricultural lien, or authority
given to a debtor to dispose of or use collateral, without more,
does not subject a secured party to liability in contract or tort for
the debtor’s acts or omissions.
§ 9–403. Agreement Not to Assert Defenses
against Assignee.
(a) In this section, “value” has the meaning provided in
Section 3–303(a).
(b) Except as otherwise provided in this section, an
agreement between an account debtor and an assignor not to
assert against an assignee any claim or defense that the account
debtor may have against the assignor is enforceable by an
assignee that takes an assignment:
(1) for value;
(2) in good faith;
(3) without notice of a claim of a property or possessory right to
the property assigned; and
(4) without notice of a defense or claim in recoupment of the
type that may be asserted against a person entitled to enforce a
negotiable instrument under Section 3–305(a).
(c) Subsection (b) does not apply to defenses of a type that
may be asserted against a holder in due course of a negotiable
instrument under Section 3–305(b).
(d) In a consumer transaction, if a record evidences the
account debtor’s obligation, law other than this article requires
that the record include a statement to the effect that the rights of
an assignee are subject to claims or defenses that the account
debtor could assert against the original obligee, and the record
does not include such a statement:
(1) the record has the same effect as if the record included such a
statement; and
(2) the account debtor may assert against an assignee those
claims and defenses that would have been available if the record
included such a statement.
(e) This section is subject to law other than this article
which establishes a different rule for an account debtor who is an
individual and who incurred the obligation primarily for
personal, family, or household purposes.
(f) Except as otherwise provided in subsection (d), this
section does not displace law other than this article which gives
effect to an agreement by an account debtor not to assert a claim
or defense against an assignee.
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§ 9–404. Rights Acquired by Assignee;
Claims and Defenses against
Assignee.
(a) Unless an account debtor has made an enforceable
agreement not to assert defenses or claims, and subject to
subsections (b) through (e), the rights of an assignee are
subject to:
(1) all terms of the agreement between the account debtor and
assignor and any defense or claim in recoupment arising from
the transaction that gave rise to the contract; and
(2) any other defense or claim of the account debtor against the
assignor which accrues before the account debtor receives a
notification of the assignment authenticated by the assignor or
the assignee.
(b) Subject to subsection (c) and except as otherwise
provided in subsection (d), the claim of an account debtor
against an assignor may be asserted against an assignee under
subsection (a) only to reduce the amount the account debtor
owes.
(c) This section is subject to law other than this article
which establishes a different rule for an account debtor who is an
individual and who incurred the obligation primarily for
personal, family, or household purposes.
(d) In a consumer transaction, if a record evidences the
account debtor’s obligation, law other than this article requires
that the record include a statement to the effect that the account
debtor’s recovery against an assignee with respect to claims and
defenses against the assignor may not exceed amounts paid by
the account debtor under the record, and the record does not
include such a statement, the extent to which a claim of an
account debtor against the assignor may be asserted against an
assignee is determined as if the record included such a
statement.
(e) This section does not apply to an assignment of a
health-care-insurance receivable.
§ 9–405. Modification of Assigned Contract.
(a) A modification of or substitution for an assigned
contract is effective against an assignee if made in good faith.
The assignee acquires corresponding rights under the
modified or substituted contract. The assignment may
provide that the modification or substitution is a breach of
contract by the assignor. This subsection is subject to
subsections (b) through (d).
(b) Subsection (a) applies to the extent that:
(1) the right to payment or a part thereof under an assigned
contract has not been fully earned by performance; or
(2) the right to payment or a part thereof has been fully earned
by performance and the account debtor has not received
notification of the assignment under Section 9–406(a).
(c) This section is subject to law other than this article
which establishes a different rule for an account debtor who is
an individual and who incurred the obligation primarily for
personal, family, or household purposes.
(d) This section does not apply to an assignment of a
health-care-insurance receivable.
§ 9–406. Discharge of Account Debtor;
Notification of Assignment;
Identification and Proof of
Assignment; Restrictions on
Assignment of Accounts,
Chattel Paper, Payment
Intangibles, and Promissory
Notes Ineffective.
(a) Subject to subsections (b) through (i), an account
debtor on an account, chattel paper, or a payment intangible
may discharge its obligation by paying the assignor until,
but not after, the account debtor receives a notification,
authenticated by the assignor or the assignee, that the
amount due or to become due has been assigned and that
payment is to be made to the assignee. After receipt of
the notification, the account debtor may discharge its
obligation by paying the assignee and may not discharge
the obligation by paying the assignor.
(b) Subject to subsection (h), notification is ineffective
under subsection (a):
(1) if it does not reasonably identify the rights assigned;
(2) to the extent that an agreement between an account debtor
and a seller of a payment intangible limits the account debtor’s
duty to pay a person other than the seller and the limitation is
effective under law other than this article; or
(3) at the option of an account debtor, if the notification
notifies the account debtor to make less than the full amount
of any installment or other periodic payment to the assignee,
even if:
(A) only a portion of the account, chattel paper, or payment
intangible has been assigned to that assignee;
(B) a portion has been assigned to another assignee; or
(C) the account debtor knows that the assignment to that
assignee is limited.
(c) Subject to subsection (h), if requested by the account
debtor, an assignee shall seasonably furnish reasonable proof
that the assignment has been made. Unless the assignee
complies, the account debtor may discharge its obligation by
paying the assignor, even if the account debtor has received a
notification under subsection (a).
(d) Except as otherwise provided in subsection (e) and
Sections 2A–303 and 9–407, and subject to subsection (h), a term
in an agreement between an account debtor and an assignor or in
a promissory note is ineffective to the extent that it:
(1) prohibits, restricts, or requires the consent of the account
debtor or person obligated on the promissory note to the
assignment or transfer of, or the creation, attachment, perfection,
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or enforcement of a security interest in, the account, chattel
paper, payment intangible, or promissory note; or
(2) provides that the assignment or transfer or the creation,
attachment, perfection, or enforcement of the security interest
may give rise to a default, breach, right of recoupment, claim,
defense, termination, right of termination, or remedy under the
account, chattel paper, payment intangible, or promissory note.
(e) Subsection (d) does not apply to the sale of a payment
intangible or promissory note.
(f) Except as otherwise provided in Sections 2A–303 and 9–
407 and subject to subsections (h) and (i), a rule of law, statute,
or regulation that prohibits, restricts, or requires the consent of a
government, governmental body or official, or account debtor to
the assignment or transfer of, or creation of a security interest in,
an account or chattel paper is ineffective to the extent that the
rule of law, statute, or regulation:
(1) prohibits, restricts, or requires the consent of the government,
governmental body or official, or account debtor to the assignment
or transfer of, or the creation, attachment, perfection, or
enforcement of a security interest in the account or chattel paper; or
(2) provides that the assignment or transfer or the creation,
attachment, perfection, or enforcement of the security interest
may give rise to a default, breach, right of recoupment, claim,
defense, termination, right of termination, or remedy under the
account or chattel paper.
(g) Subject to subsection (h), an account debtor may not
waive or vary its option under subsection (b)(3).
(h) This section is subject to law other than this article
which establishes a different rule for an account debtor who is an
individual and who incurred the obligation primarily for
personal, family, or household purposes.
(i) This section does not apply to an assignment of a health-
care-insurance receivable.
(j) This section prevails over any inconsistent provisions of
the following statutes, rules, and regulations:
[List here any statutes, rules, and regulations containing provi-
sions inconsistent with this section.]
Legislative Note: States that amend statutes, rules, and regulations
to remove provisions inconsistent with this section need not enact sub-
section (j).
As amended in 1999 and 2000.
§ 9–407. Restrictions on Creation or
Enforcement of Security Interest in
Leasehold Interest or in Lessor’s
Residual Interest.
(a) Except as otherwise provided in subsection (b), a term
in a lease agreement is ineffective to the extent that it:
(1) prohibits, restricts, or requires the consent of a party to
the lease to the assignment or transfer of, or the creation,
attachment, perfection, or enforcement of a security interest
in an interest of a party under the lease contract or in the lessor’s
residual interest in the goods; or
(2) provides that the assignment or transfer or the creation,
attachment, perfection, or enforcement of the security interest
may give rise to a default, breach, right of recoupment, claim,
defense, termination, right of termination, or remedy under
the lease.
(b) Except as otherwise provided in Section 2A–303(7), a
term described in subsection (a)(2) is effective to the extent that
there is:
(1) a transfer by the lessee of the lessee’s right of possession or
use of the goods in violation of the term; or
(2) a delegation of a material performance of either party to the
lease contract in violation of the term.
(c) The creation, attachment, perfection, or enforcement
of a security interest in the lessor’s interest under the lease
contract or the lessor’s residual interest in the goods is not a
transfer that materially impairs the lessee’s prospect of obtaining
return performance or materially changes the duty of or
materially increases the burden or risk imposed on the lessee
within the purview of Section 2A–303(4) unless, and then only
to the extent that, enforcement actually results in a delegation of
material performance of the lessor.
As amended in 1999.
§ 9–408. Restrictions on Assignment of
Promissory Notes, Health-Care-
Insurance Receivables, and Certain
General Intangibles Ineffective.
(a) Except as otherwise provided in subsection (b), a
term in a promissory note or in an agreement between an
account debtor and a debtor which relates to a health-care-
insurance receivable or a general intangible, including
a contract, permit, license, or franchise, and which term
prohibits, restricts, or requires the consent of the person
obligated on the promissory note or the account debtor to,
the assignment or transfer of, or creation, attachment,
or perfection of a security interest in, the promissory note,
health-care-insurance receivable, or general intangible,
is ineffective to the extent that the term:
(1) would impair the creation, attachment, or perfection of a
security interest; or
(2) provides that the assignment or transfer or the creation,
attachment, or perfection of the security interest may give
rise to a default, breach, right of recoupment, claim, defense,
termination, right of termination, or remedy under the
promissory note, health-care-insurance receivable, or general
intangible.
(b) Subsection (a) applies to a security interest in a
payment intangible or promissory note only if the security
interest arises out of a sale of the payment intangible or
promissory note.
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(c) A rule of law, statute, or regulation that prohibits, restricts,
or requires the consent of a government, governmental body or
official, person obligated on a promissory note, or account debtor to
the assignment or transfer of, or creation of a security interest in, a
promissory note, health-care-insurance receivable, or general
intangible, including a contract, permit, license, or franchise
between an account debtor and a debtor, is ineffective to the
extent that the rule of law, statute, or regulation:
(1) would impair the creation, attachment, or perfection of a
security interest; or
(2) provides that the assignment or transfer or the creation,
attachment, or perfection of the security interest may give rise to a
default, breach, right of recoupment, claim, defense, termination,
right of termination, or remedy under the promissory note, health-
care-insurance receivable, or general intangible.
(d) To the extent that a term in a promissory note or in an
agreement between an account debtor and a debtor which
relates to a health-care-insurance receivable or general
intangible or a rule of law, statute, or regulation described in
subsection (c) would be effective under law other than this
article but is ineffective under subsection (a) or (c),
the creation, attachment, or perfection of a security interest
in the promissory note, health-care-insurance receivable,
or general intangible:
(1) is not enforceable against the person obligated on the
promissory note or the account debtor;
(2) does not impose a duty or obligation on the person obligated
on the promissory note or the account debtor;
(3) does not require the person obligated on the promissory note
or the account debtor to recognize the security interest, pay or
render performance to the secured party, or accept payment or
performance from the secured party;
(4) does not entitle the secured party to use or assign the
debtor’s rights under the promissory note, health-care-insurance
receivable, or general intangible, including any related
information or materials furnished to the debtor in the
transaction giving rise to the promissory note, health-care-
insurance receivable, or general intangible;
(5) does not entitle the secured party to use, assign, possess, or
have access to any trade secrets or confidential information of
the person obligated on the promissory note or the account
debtor; and
(6) does not entitle the secured party to enforce the security
interest in the promissory note, health-care-insurance receivable,
or general intangible.
(e) This section prevails over any inconsistent provisions of
the following statutes, rules, and regulations:
[List here any statutes, rules, and regulations containing provi-
sions inconsistent with this section.]
Legislative Note: States that amend statutes, rules, and regulations
to remove provisions inconsistent with this section need not enact sub-
section (e).
As amended in 1999.
§ 9–409. Restrictions on Assignment of
Letter-of-Credit Rights Ineffective.
(a) A term in a letter of credit or a rule of law, statute,
regulation, custom, or practice applicable to the letter of
credit which prohibits, restricts, or requires the consent
of an applicant, issuer, or nominated person to a beneficiary’s
assignment of or creation of a security interest in a letter-of-
credit right is ineffective to the extent that the term or rule
of law, statute, regulation, custom, or practice:
(1) would impair the creation, attachment, or perfection of a
security interest in the letter-of-credit right; or
(2) provides that the assignment or the creation, attachment,
or perfection of the security interest may give rise to a
default, breach, right of recoupment, claim, defense,
termination, right of termination, or remedy under the letter-
of-credit right.
(b) To the extent that a term in a letter of credit is
ineffective under subsection (a) but would be effective under
law other than this article or a custom or practice applicable
to the letter of credit, to the transfer of a right to draw or
otherwise demand performance under the letter of credit, or to
the assignment of a right to proceeds of the letter of credit, the
creation, attachment, or perfection of a security interest in
the letter-of-credit right:
(1) is not enforceable against the applicant, issuer, nominated
person, or transferee beneficiary;
(2) imposes no duties or obligations on the applicant, issuer,
nominated person, or transferee beneficiary; and
(3) does not require the applicant, issuer, nominated person, or
transferee beneficiary to recognize the security interest, pay or
render performance to the secured party, or accept payment
or other performance from the secured party.
As amended in 1999.
PART 5 Filing
[Subpart 1. Filing Office; Contents and
Effectiveness of Financing
Statement]
§ 9–501. Filing Office.
(a) Except as otherwise provided in subsection (b), if the
local law of this State governs perfection of a security interest
or agricultural lien, the office in which to file a financing
statement to perfect the security interest or agricultural
lien is:
(1) the office designated for the filing or recording of a record of
a mortgage on the related real property, if:
(A) the collateral is as-extracted collateral or timber to be
cut; or
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(B) the financing statement is filed as a fixture filing and the
collateral is goods that are or are to become fixtures; or
(2) the office of [ ] [or any office duly authorized by [ ]], in all
other cases, including a case in which the collateral is goods that
are or are to become fixtures and the financing statement is not
filed as a fixture filing.
(b) The office in which to file a financing statement to perfect
a security interest in collateral, including fixtures, of a transmitting
utility is the office of [ ]. The financing statement also constitutes a
fixture filing as to the collateral indicated in the financing
statement which is or is to become fixtures.
Legislative Note: The State should designate the filing office where the
brackets appear. The filing office may be that of a governmental official
(e.g., the Secretary of State) or a private party that maintains the State’s
filing system.
§ 9–502. Contents of Financing Statement;
Record of Mortgage as Financing
Statement; Time of Filing Financing
Statement.
(a) Subject to subsection (b), a financing statement is
sufficient only if it:
(1) provides the name of the debtor;
(2) provides the name of the secured party or a representative of
the secured party; and
(3) indicates the collateral covered by the financing statement.
(b) Except as otherwise provided in Section 9–501(b), to be
sufficient, a financing statement that covers as-extracted
collateral or timber to be cut, or which is filed as a fixture filing
and covers goods that are or are to become fixtures, must satisfy
subsection (a) and also:
(1) indicate that it covers this type of collateral;
(2) indicate that it is to be filed [for record] in the real property
records;
(3) provide a description of the real property to which the
collateral is related [sufficient to give constructive notice
of a mortgage under the law of this State if the description
were contained in a record of the mortgage of the real
property]; and
(4) if the debtor does not have an interest of record in the real
property, provide the name of a record owner.
(c) A record of a mortgage is effective, from the date of
recording, as a financing statement filed as a fixture filing or as a
financing statement covering as-extracted collateral or timber to
be cut only if:
(1) the record indicates the goods or accounts that it covers;
(2) the goods are or are to become fixtures related to the real
property described in the record or the collateral is related to the
real property described in the record and is as-extracted
collateral or timber to be cut;
(3) the record satisfies the requirements for a financing
statement in this section other than an indication that it is to be
filed in the real property records; and
(4) the record is [duly] recorded.
(d) A financing statement may be filed before a security
agreement is made or a security interest otherwise attaches.
Legislative Note: Language in brackets is optional. Where the State has
any special recording system for real property other than the usual
grantor-grantee index (as, for instance, a tract system or a title registra-
tion or Torrens system) local adaptations of subsection (b) and Section
9–519(d) and (e) may be necessary. See, e.g., Mass. Gen. Laws Chapter
106, Section 9–410.
§ 9–503. Name of Debtor and Secured Party.
(a) A financing statement sufficiently provides the name of
the debtor:
(1) if the debtor is a registered organization, only if the financing
statement provides the name of the debtor indicated on the
public record of the debtor’s jurisdiction of organization which
shows the debtor to have been organized;
(2) if the debtor is a decedent’s estate, only if the financing
statement provides the name of the decedent and indicates that
the debtor is an estate;
(3) if the debtor is a trust or a trustee acting with respect to
property held in trust, only if the financing statement:
(A) provides the name specified for the trust in its organic
documents or, if no name is specified, provides the name of the
settlor and additional information sufficient to distinguish
the debtor from other trusts having one or more of the same
settlors; and
(B) indicates, in the debtor’s name or otherwise, that the
debtor is a trust or is a trustee acting with respect to property held
in trust; and
(4) in other cases:
(A) if the debtor has a name, only if it provides the individual
or organizational name of the debtor; and
(B) if the debtor does not have a name, only if it provides the
names of the partners, members, associates, or other persons
comprising the debtor.
(b) A financing statement that provides the name of the
debtor in accordance with subsection (a) is not rendered
ineffective by the absence of:
(1) a trade name or other name of the debtor; or
(2) unless required under subsection (a)(4)(B), names of partners,
members, associates, or other persons comprising the debtor.
(c) A financing statement that provides only the debtor’s
trade name does not sufficiently provide the name of the debtor.
(d) Failure to indicate the representative capacity of a
secured party or representative of a secured party does not
affect the sufficiency of a financing statement.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B55
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(e) A financing statement may provide the name of
more than one debtor and the name of more than one
secured party.
§ 9–504. Indication of Collateral.
A financing statement sufficiently indicates the collateral that it
covers if the financing statement provides:
(1) a description of the collateral pursuant to Section 9–108; or
(2) an indication that the financing statement covers all assets or
all personal property.
As amended in 1999.
§ 9–505. Filing and Compliance with Other
Statutes and Treaties for
Consignments, Leases, Other
Bailments, and Other Transactions.
(a) A consignor, lessor, or other bailor of goods, a licensor, or
a buyer of a payment intangible or promissory note may file a
financing statement, or may comply with a statute or treaty
described in Section 9–311(a), using the terms “consignor”,
“consignee”, “lessor”, “lessee”, “bailor”, “bailee”, “licensor”,
“licensee”, “owner”, “registered owner”, “buyer”, “seller”, or
words of similar import, instead of the terms “secured party” and
“debtor”.
(b) This part applies to the filing of a financing statement
under subsection (a) and, as appropriate, to compliance that is
equivalent to filing a financing statement under Section 9–311
(b), but the filing or compliance is not of itself a factor in
determining whether the collateral secures an obligation.
If it is determined for another reason that the collateral secures
an obligation, a security interest held by the consignor,
lessor, bailor, licensor, owner, or buyer which attaches to the
collateral is perfected by the filing or compliance.
§ 9–506. Effect of Errors or Omissions.
(a) A financing statement substantially satisfying the
requirements of this part is effective, even if it has minor errors
or omissions, unless the errors or omissions make the financing
statement seriously misleading.
(b) Except as otherwise provided in subsection (c), a
financing statement that fails sufficiently to provide the name of
the debtor in accordance with Section 9–503(a) is seriously
misleading.
(c) If a search of the records of the filing office under the
debtor’s correct name, using the filing office’s standard search
logic, if any, would disclose a financing statement that fails
sufficiently to provide the name of the debtor in accordance with
Section 9–503(a), the name provided does not make the
financing statement seriously misleading.
(d) For purposes of Section 9–508(b), the “debtor’s correct
name” in subsection (c) means the correct name of the new debtor.
§ 9–507. Effect of Certain Events on
Effectiveness of Financing
Statement.
(a) A filed financing statement remains effective with
respect to collateral that is sold, exchanged, leased, licensed, or
otherwise disposed of and in which a security interest or
agricultural lien continues, even if the secured party knows of or
consents to the disposition.
(b) Except as otherwise provided in subsection (c) and
Section 9–508, a financing statement is not rendered ineffective
if, after the financing statement is filed, the information
provided in the financing statement becomes seriously
misleading under Section 9–506.
(c) If a debtor so changes its name that a filed
financing statement becomes seriously misleading under
Section 9–506:
(1) the financing statement is effective to perfect a security
interest in collateral acquired by the debtor before, or within
four months after, the change; and
(2) the financing statement is not effective to perfect a
security interest in collateral acquired by the debtor more
than four months after the change, unless an amendment to
the financing statement which renders the financing
statement not seriously misleading is filed within four months
after the change.
§ 9–508. Effectiveness of Financing
Statement If New Debtor Becomes
Bound by Security Agreement.
(a) Except as otherwise provided in this section, a filed
financing statement naming an original debtor is effective to
perfect a security interest in collateral in which a new debtor has
or acquires rights to the extent that the financing statement
would have been effective had the original debtor acquired
rights in the collateral.
(b) If the difference between the name of the original
debtor and that of the new debtor causes a filed financing
statement that is effective under subsection (a) to be seriously
misleading under Section 9–506:
(1) the financing statement is effective to perfect a security
interest in collateral acquired by the new debtor before, and
within four months after, the new debtor becomes bound under
Section 9B–203(d); and
(2) the financing statement is not effective to perfect a security
interest in collateral acquired by the new debtor more than
four months after the new debtor becomes bound under
Section 9–203(d) unless an initial financing statement providing
the name of the new debtor is filed before the expiration of
that time.
(c) This section does not apply to collateral as to which a
filed financing statement remains effective against the new
debtor under Section 9–507(a).
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§ 9–509. Persons Entitled to File a Record.
(a) A person may file an initial financing statement,
amendment that adds collateral covered by a financing
statement, or amendment that adds a debtor to a financing
statement only if:
(1) the debtor authorizes the filing in an authenticated record or
pursuant to subsection (b) or (c); or
(2) the person holds an agricultural lien that has become
effective at the time of filing and the financing statement
covers only collateral in which the person holds an
agricultural lien.
(b) By authenticating or becoming bound as debtor by
a security agreement, a debtor or new debtor authorizes the
filing of an initial financing statement, and an amendment,
covering:
(1) the collateral described in the security agreement; and
(2) property that becomes collateral under Section 9–315(a)(2),
whether or not the security agreement expressly covers
proceeds.
(c) By acquiring collateral in which a security interest
or agricultural lien continues under Section 9–315(a)(1),
a debtor authorizes the filing of an initial financing
statement, and an amendment, covering the collateral
and property that becomes collateral under
Section 9–315(a)(2).
(d) A person may file an amendment other than an
amendment that adds collateral covered by a financing
statement or an amendment that adds a debtor to a financing
statement only if:
(1) the secured party of record authorizes the filing; or
(2) the amendment is a termination statement for a financing
statement as to which the secured party of record has failed
to file or send a termination statement as required by
Section 9–513(a) or (c), the debtor authorizes the filing,
and the termination statement indicates that the debtor
authorized it to be filed.
(e) If there is more than one secured party of record for a
financing statement, each secured party of record may authorize
the filing of an amendment under subsection (d).
As amended in 2000.
§ 9–510. Effectiveness of Filed Record.
(a) A filed record is effective only to the extent that it was
filed by a person that may file it under Section 9–509.
(b) A record authorized by one secured party of record does
not affect the financing statement with respect to another
secured party of record.
(c) A continuation statement that is not filed within
the six-month period prescribed by Section 9–515(d) is
ineffective.
§ 9–511. Secured Party of Record.
(a) A secured party of record with respect to a financing
statement is a person whose name is provided as the name
of the secured party or a representative of the secured party
in an initial financing statement that has been filed. If an
initial financing statement is filed under Section 9–514(a),
the assignee named in the initial financing statement is the
secured party of record with respect to the financing
statement.
(b) If an amendment of a financing statement which
provides the name of a person as a secured party or a
representative of a secured party is filed, the person named in
the amendment is a secured party of record. If an amendment is
filed under Section 9–514(b), the assignee named in the
amendment is a secured party of record.
(c) A person remains a secured party of record until the
filing of an amendment of the financing statement which deletes
the person.
§ 9–512. Amendment of Financing Statement.
[Alternative A]
(a) Subject to Section 9–509, a person may add or delete
collateral covered by, continue or terminate the effectiveness of,
or, subject to subsection (e), otherwise amend the information
provided in, a financing statement by filing an amendment that:
(1) identifies, by its file number, the initial financing statement
to which the amendment relates; and
(2) if the amendment relates to an initial financing statement
filed [or recorded] in a filing office described in Section 9–501(a)
(1), provides the information specified in Section 9–502(b).
[Alternative B]
(a) Subject to Section 9–509, a person may add or delete
collateral covered by, continue or terminate the effectiveness
of, or, subject to subsection (e), otherwise amend the
information provided in, a financing statement by filing an
amendment that:
(1) identifies, by its file number, the initial financing statement
to which the amendment relates; and
(2) if the amendment relates to an initial financing statement
filed [or recorded] in a filing office described in Section 9–501(a)
(1), provides the date [and time] that the initial financing
statement was filed [or recorded] and the information specified
in Section 9–502(b).
[End of Alternatives]
(b) Except as otherwise provided in Section 9–515, the
filing of an amendment does not extend the period of
effectiveness of the financing statement.
(c) A financing statement that is amended by an
amendment that adds collateral is effective as to the added
collateral only from the date of the filing of the amendment.
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(d) A financing statement that is amended by an
amendment that adds a debtor is effective as to the added
debtor only from the date of the filing of the amendment.
(e) An amendment is ineffective to the extent it:
(1) purports to delete all debtors and fails to provide the name of
a debtor to be covered by the financing statement; or
(2) purports to delete all secured parties of record and fails to
provide the name of a new secured party of record.
Legislative Note: States whose real-estate filing offices require additional
information in amendments and cannot search their records by both the
name of the debtor and the file number should enact Alternative B to
Sections 9–512(a), 9–518(b), 9–519(f), and 9–522(a).
§ 9–513. Termination Statement.
(a) A secured party shall cause the secured party of record
for a financing statement to file a termination statement for the
financing statement if the financing statement covers consumer
goods and:
(1) there is no obligation secured by the collateral covered by the
financing statement and no commitment to make an advance,
incur an obligation, or otherwise give value; or
(2) the debtor did not authorize the filing of the initial financing
statement.
(b) To comply with subsection (a), a secured party shall cause
the secured party of record to file the termination statement:
(1) within one month after there is no obligation secured by the
collateral covered by the financing statement and no
commitment to make an advance, incur an obligation, or
otherwise give value; or
(2) if earlier, within 20 days after the secured party receives an
authenticated demand from a debtor.
(c) In cases not governed by subsection (a), within 20 days
after a secured party receives an authenticated demand from a
debtor, the secured party shall cause the secured party of record
for a financing statement to send to the debtor a termination
statement for the financing statement or file the termination
statement in the filing office if:
(1) except in the case of a financing statement covering
accounts or chattel paper that has been sold or goods that are
the subject of a consignment, there is no obligation secured
by the collateral covered by the financing statement and no
commitment to make an advance, incur an obligation, or
otherwise give value;
(2) the financing statement covers accounts or chattel paper that
has been sold but as to which the account debtor or other person
obligated has discharged its obligation;
(3) the financing statement covers goods that were the subject of
a consignment to the debtor but are not in the debtor’s
possession; or
(4) the debtor did not authorize the filing of the initial financing
statement.
(d) Except as otherwise provided in Section 9–510, upon
the filing of a termination statement with the filing office, the
financing statement to which the termination statement relates
ceases to be effective. Except as otherwise provided in Section
9–510, for purposes of Sections 9–519(g), 9–522(a), and 9–523
(c), the filing with the filing office of a termination statement
relating to a financing statement that indicates that the debtor
is a transmitting utility also causes the effectiveness of the
financing statement to lapse.
As amended in 2000.
§ 9–514. Assignment of Powers of Secured
Party of Record.
(a) Except as otherwise provided in subsection (c), an initial
financing statement may reflect an assignment of all of the
secured party’s power to authorize an amendment to the
financing statement by providing the name and mailing
address of the assignee as the name and address of the
secured party.
(b) Except as otherwise provided in subsection (c), a
secured party of record may assign of record all or part of its
power to authorize an amendment to a financing statement
by filing in the filing office an amendment of the financing
statement which:
(1) identifies, by its file number, the initial financing statement
to which it relates;
(2) provides the name of the assignor; and
(3) provides the name and mailing address of the assignee.
(c) An assignment of record of a security interest in a fixture
covered by a record of a mortgage which is effective as a
financing statement filed as a fixture filing under Section 9–502(c)
may be made only by an assignment of record of the mortgage in
the manner provided by law of this State other than [the Uniform
Commercial Code].
§ 9–515. Duration and Effectiveness of
Financing Statement; Effect of
Lapsed Financing Statement.
(a) Except as otherwise provided in subsections (b), (e), (f),
and (g), a filed financing statement is effective for a period of
five years after the date of filing.
(b) Except as otherwise provided in subsections (e), (f),
and (g), an initial financing statement filed in connection
with a public-finance transaction or manufactured-home
transaction is effective for a period of 30 years after the
date of filing if it indicates that it is filed in connection with
a public-finance transaction or manufactured-home
transaction.
(c) The effectiveness of a filed financing statement lapses
on the expiration of the period of its effectiveness unless before
the lapse a continuation statement is filed pursuant to subsection
(d). Upon lapse, a financing statement ceases to be effective and
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any security interest or agricultural lien that was perfected by the
financing statement becomes unperfected, unless the security
interest is perfected otherwise. If the security interest or
agricultural lien becomes unperfected upon lapse, it is deemed
never to have been perfected as against a purchaser of the
collateral for value.
(d) A continuation statement may be filed only within six
months before the expiration of the five-year period specified in
subsection (a) or the 30-year period specified in subsection (b),
whichever is applicable.
(e) Except as otherwise provided in Section 9–510, upon
timely filing of a continuation statement, the effectiveness of the
initial financing statement continues for a period of five years
commencing on the day on which the financing statement would
have become ineffective in the absence of the filing. Upon the
expiration of the five-year period, the financing statement lapses
in the same manner as provided in subsection (c), unless, before
the lapse, another continuation statement is filed pursuant to
subsection (d). Succeeding continuation statements may be filed
in the same manner to continue the effectiveness of the initial
financing statement.
(f) If a debtor is a transmitting utility and a filed financing
statement so indicates, the financing statement is effective until
a termination statement is filed.
(g) A record of a mortgage that is effective as a financing
statement filed as a fixture filing under Section 9–502(c) remains
effective as a financing statement filed as a fixture filing until
the mortgage is released or satisfied of record or its effectiveness
otherwise terminates as to the real property.
§ 9–516. What Constitutes Filing;
Effectiveness of Filing.
(a) Except as otherwise provided in subsection (b),
communication of a record to a filing office and tender of the
filing fee or acceptance of the record by the filing office
constitutes filing.
(b) Filing does not occur with respect to a record that a
filing office refuses to accept because:
(1) the record is not communicated by a method or medium of
communication authorized by the filing office;
(2) an amount equal to or greater than the applicable filing fee is
not tendered;
(3) the filing office is unable to index the record because:
(A) in the case of an initial financing statement, the record
does not provide a name for the debtor;
(B) in the case of an amendment or correction statement, the
record:
(i) does not identify the initial financing statement as
required by Section 9–512 or 9–518, as applicable; or
(ii) identifies an initial financing statement whose
effectiveness has lapsed under Section 9–515;
(C) in the case of an initial financing statement that provides
the name of a debtor identified as an individual or an amendment
that provides a name of a debtor identified as an individual which
was not previously provided in the financing statement to which
the record relates, the record does not identify the debtor’s last
name; or
(D) in the case of a record filed [or recorded] in the filing
office described in Section 9–501(a)(1), the record does not
provide a sufficient description of the real property to which it
relates;
(4) in the case of an initial financing statement or an
amendment that adds a secured party of record, the record
does not provide a name and mailing address for the secured
party of record;
(5) in the case of an initial financing statement or an amendment
that provides a name of a debtor which was not previously
provided in the financing statement to which the amendment
relates, the record does not:
(A) provide a mailing address for the debtor;
(B) indicate whether the debtor is an individual or an
organization; or
(C) if the financing statement indicates that the debtor is an
organization, provide:
(i) a type of organization for the debtor;
(ii) a jurisdiction of organization for the debtor; or
(iii) an organizational identification number for the debtor
or indicate that the debtor has none;
(6) in the case of an assignment reflected in an initial financing
statement under Section 9–514(a) or an amendment filed under
Section 9–514(b), the record does not provide a name and
mailing address for the assignee; or
(7) in the case of a continuation statement, the record is
not filed within the six-month period prescribed by
Section 9–515(d).
(c) For purposes of subsection (b):
(1) a record does not provide information if the filing office is
unable to read or decipher the information; and
(2) a record that does not indicate that it is an amendment or
identify an initial financing statement to which it relates, as
required by Section 9–512, 9–514, or 9–518, is an initial
financing statement.
(d) A record that is communicated to the filing office with
tender of the filing fee, but which the filing office refuses to
accept for a reason other than one set forth in subsection (b), is
effective as a filed record except as against a purchaser of the
collateral which gives value in reasonable reliance upon the
absence of the record from the files.
§ 9–517. Effect of Indexing Errors.
The failure of the filing office to index a record correctly does
not affect the effectiveness of the filed record.
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§ 9–518. Claim Concerning Inaccurate or
Wrongfully Filed Record.
(a) A person may file in the filing office a correction
statement with respect to a record indexed there under the
person’s name if the person believes that the record is inaccurate
or was wrongfully filed.
[Alternative A]
(b) A correction statement must:
(1) identify the record to which it relates by the file number
assigned to the initial financing statement to which the record
relates;
(2) indicate that it is a correction statement; and
(3) provide the basis for the person’s belief that the record is
inaccurate and indicate the manner in which the person believes
the record should be amended to cure any inaccuracy or provide the
basis for the person’s belief that the record was wrongfully filed.
[Alternative B]
(b) A correction statement must:
(1) identify the record to which it relates by:
(A) the file number assigned to the initial financing statement
to which the record relates; and
(B) if the correction statement relates to a record filed [or
recorded] in a filing office described in Section 9–501(a)(1), the date
[and time] that the initial financing statement was filed [or
recorded] and the information specified in Section 9–502(b);
(2) indicate that it is a correction statement; and
(3) provide the basis for the person’s belief that the record is
inaccurate and indicate the manner in which the person
believes the record should be amended to cure any inaccuracy
or provide the basis for the person’s belief that the record was
wrongfully filed.
[End of Alternatives]
(c) The filing of a correction statement does not affect the
effectiveness of an initial financing statement or other filed record.
Legislative Note: States whose real-estate filing offices require additional
information in amendments and cannot search their records by both the
name of the debtor and the file number should enact Alternative B to
Sections 9–512(a), 9–518(b), 9–519(f), and 9–522(a).
[Subpart 2. Duties and Operation of Filing Office]
§ 9–519. Numbering, Maintaining, and
Indexing Records; Communicating
Information Provided in Records.
(a) For each record filed in a filing office, the filing office shall:
(1) assign a unique number to the filed record;
(2) create a record that bears the number assigned to the filed
record and the date and time of filing;
(3) maintain the filed record for public inspection; and
(4) index the filed record in accordance with subsections (c), (d),
and (e).
(b) A file number [assigned after January 1, 2002,] must
include a digit that:
(1) is mathematically derived from or related to the other digits
of the file number; and
(2) aids the filing office in determining whether a number
communicated as the file number includes a single-digit or
transpositional error.
(c) Except as otherwise provided in subsections (d) and (e),
the filing office shall:
(1) index an initial financing statement according to the
name of the debtor and index all filed records relating
to the initial financing statement in a manner that
associates with one another an initial financing statement
and all filed records relating to the initial financing
statement; and
(2) index a record that provides a name of a debtor which was
not previously provided in the financing statement to which the
record relates also according to the name that was not previously
provided.
(d) If a financing statement is filed as a fixture filing or
covers as-extracted collateral or timber to be cut, [it must be
filed for record and] the filing office shall index it:
(1) under the names of the debtor and of each owner of record
shown on the financing statement as if they were the mortgagors
under a mortgage of the real property described; and
(2) to the extent that the law of this State provides for indexing
of records of mortgages under the name of the mortgagee, under
the name of the secured party as if the secured party were the
mortgagee thereunder, or, if indexing is by description, as if the
financing statement were a record of a mortgage of the real
property described.
(e) If a financing statement is filed as a fixture filing or
covers as-extracted collateral or timber to be cut, the filing office
shall index an assignment filed under Section 9–514(a) or an
amendment filed under Section 9–514(b):
(1) under the name of the assignor as grantor; and
(2) to the extent that the law of this State provides for indexing a
record of the assignment of a mortgage under the name of the
assignee, under the name of the assignee.
[Alternative A]
(f) The filing office shall maintain a capability:
(1) to retrieve a record by the name of the debtor and by the file
number assigned to the initial financing statement to which the
record relates; and
(2) to associate and retrieve with one another an initial financing
statement and each filed record relating to the initial financing
statement.
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[Alternative B]
(f) The filing office shall maintain a capability:
(1) to retrieve a record by the name of the debtor and:
(A) if the filing office is described in Section 9–501(a)(1), by
the file number assigned to the initial financing statement to which
the record relates and the date [and time] that the record was filed
[or recorded]; or
(B) if the filing office is described in Section 9–501(a)(2), by
the file number assigned to the initial financing statement to which
the record relates; and
(2) to associate and retrieve with one another an initial financing
statement and each filed record relating to the initial financing
statement.
[End of Alternatives]
(g) The filing office may not remove a debtor’s name from the
index until one year after the effectiveness of a financing statement
naming the debtor lapses under Section 9–515 with respect to all
secured parties of record.
(h) The filing office shall perform the acts required by subsec-
tions (a) through (e) at the time and in the manner prescribed by
filing-office rule, but not later than two business days after the filing
office receives the record in question.
[(i) Subsection[s] [(b)] [and] [(h)] do[es] not apply to a filing
office described in Section 9–501(a)(1).]
Legislative Notes:
1. States whose filing offices currently assign file numbers that include a
verification number, commonly known as a “check digit,” or can
implement this requirement before the effective date of this Article should
omit the bracketed language in subsection (b).
2. In States in which writings will not appear in the real property
records and indices unless actually recorded the bracketed language in
subsection (d) should be used.
3. States whose real-estate filing offices require additional information
in amendments and cannot search their records by both the name of the
debtor and the file number should enact Alternative B to Sections 9–512
(a), 9–518(b), 9–519(f), and 9–522(a).
4. A State that elects not to require real-estate filing offices to comply
with either or both of subsections (b) and (h) may adopt an applicable
variation of subsection (i) and add “Except as otherwise provided in
subsection (i),” to the appropriate subsection or subsections.
§ 9–520. Acceptance and Refusal to Accept
Record.
(a) A filing office shall refuse to accept a record for filing for
a reason set forth in Section 9–516(b) and may refuse to accept a
record for filing only for a reason set forth in Section 9–516(b).
(b) If a filing office refuses to accept a record for filing, it
shall communicate to the person that presented the record the
fact of and reason for the refusal and the date and time the
record would have been filed had the filing office accepted it.
The communication must be made at the time and in the
manner prescribed by filing-office rule but [, in the case of a
filing office described in Section 9–501(a)(2),] in no event more
than two business days after the filing office receives the record.
(c) A filed financing statement satisfying Section 9–502(a)
and (b) is effective, even if the filing office is required to refuse
to accept it for filing under subsection (a). However, Section 9–
338 applies to a filed financing statement providing information
described in Section 9–516(b)(5) which is incorrect at the time
the financing statement is filed.
(d) If a record communicated to a filing office provides
information that relates to more than one debtor, this part
applies as to each debtor separately.
Legislative Note: A State that elects not to require real-property filing offices
to comply with subsection (b) should include the bracketed language.
§ 9–521. Uniform Form of Written Financing
Statement and Amendment.
(a) A filing office that accepts written records may not
refuse to accept a written initial financing statement in the
following form and format except for a reason set forth in Section
9–516(b):
[NATIONAL UCC FINANCING STATEMENT (FORM
UCC1)(REV. 7/29/98)]
[NATIONAL UCC FINANCING STATEMENT ADDEN-
DUM (FORM UCC1Ad)(REV. 07/29/98)]
(b) A filing office that accepts written records may not
refuse to accept a written record in the following form and
format except for a reason set forth in Section 9–516(b):
[NATIONAL UCC FINANCING STATEMENT AMEND-
MENT (FORM UCC3)(REV. 07/29/98)]
[NATIONAL UCC FINANCING STATEMENT AMEND-
MENT ADDENDUM (FORM UCC3Ad)(REV. 07/29/98)]
§ 9–522. Maintenance and Destruction of
Records.
[Alternative A]
(a) The filing office shall maintain a record of the
information provided in a filed financing statement for at least
one year after the effectiveness of the financing statement has
lapsed under Section 9–515 with respect to all secured parties of
record. The record must be retrievable by using the name of the
debtor and by using the file number assigned to the initial
financing statement to which the record relates.
[Alternative B]
(a) The filing office shall maintain a record of the
information provided in a filed financing statement for at least
one year after the effectiveness of the financing statement has
lapsed under Section 9–515 with respect to all secured parties of
record. The record must be retrievable by using the name of the
debtor and:
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(1) if the record was filed [or recorded] in the filing office
described in Section 9–501(a)(1), by using the file number
assigned to the initial financing statement to which the record
relates and the date [and time] that the record was filed [or
recorded]; or
(2) if the record was filed in the filing office described in Section
9–501(a)(2), by using the file number assigned to the initial
financing statement to which the record relates.
[End of Alternatives]
(b) Except to the extent that a statute governing disposition
of public records provides otherwise, the filing office
immediately may destroy any written record evidencing a
financing statement. However, if the filing office destroys a
written record, it shall maintain another record of the financing
statement which complies with subsection (a).
Legislative Note: States whose real-estate filing offices require additional
information in amendments and cannot search their records by both the
name of the debtor and the file number should enact Alternative B to
Sections 9–512(a), 9–518(b), 9–519(f), and 9–522(a).
§ 9–523. Information from Filing Office; Sale
or License of Records.
(a) If a person that files a written record requests an
acknowledgment of the filing, the filing office shall send to the
person an image of the record showing the number assigned to
the record pursuant to Section 9–519(a)(1) and the date and time
of the filing of the record. However, if the person furnishes a
copy of the record to the filing office, the filing office may
instead:
(1) note upon the copy the number assigned to the record
pursuant to Section 9–519(a)(1) and the date and time of the
filing of the record; and
(2) send the copy to the person.
(b) If a person files a record other than a written record,
the filing office shall communicate to the person an
acknowledgment that provides:
(1) the information in the record;
(2) the number assigned to the record pursuant to
Section 9–519(a)(1); and
(3) the date and time of the filing of the record.
(c) The filing office shall communicate or otherwise make
available in a record the following information to any person that
requests it:
(1) whether there is on file on a date and time specified by the
filing office, but not a date earlier than three business days
before the filing office receives the request, any financing
statement that:
(A) designates a particular debtor [or, if the request so states,
designates a particular debtor at the address specified in the
request];
(B) has not lapsed under Section 9–515 with respect to all
secured parties of record; and
(C) if the request so states, has lapsed under Section 9–515
and a record of which is maintained by the filing office under
Section 9–522(a);
(2) the date and time of filing of each financing statement; and
(3) the information provided in each financing statement.
(d) In complying with its duty under subsection (c), the
filing office may communicate information in any medium.
However, if requested, the filing office shall communicate
information by issuing [its written certificate] [a record that can
be admitted into evidence in the courts of this State without
extrinsic evidence of its authenticity].
(e) The filing office shall perform the acts required by
subsections (a) through (d) at the time and in the manner
prescribed by filing-office rule, but not later than two business
days after the filing office receives the request.
(f) At least weekly, the [insert appropriate official or
governmental agency] [filing office] shall offer to sell or license
to the public on a nonexclusive basis, in bulk, copies of all
records filed in it under this part, in every medium from time to
time available to the filing office.
Legislative Notes:
1. States whose filing office does not offer the additional service of
responding to search requests limited to a particular address should
omit the bracketed language in subsection (c)(1)(A).
2. A State that elects not to require real-estate filing offices to comply with
either or both of subsections (e) and (f) should specify in the appropriate
subsection(s) only the filing office described in Section 9–501(a)(2).
§ 9–524. Delay by Filing Office.
Delay by the filing office beyond a time limit prescribed by this
part is excused if:
(1) the delay is caused by interruption of communication or
computer facilities, war, emergency conditions, failure of
equipment, or other circumstances beyond control of the filing
office; and
(2) the filing office exercises reasonable diligence under the
circumstances.
§ 9–525. Fees.
(a) Except as otherwise provided in subsection (e), the fee
for filing and indexing a record under this part, other than an
initial financing statement of the kind described in subsection
(b), is [the amount specified in subsection (c), if applicable,
plus]:
(1) $[X] if the record is communicated in writing and consists of
one or two pages;
(2) $[2X] if the record is communicated in writing and consists of
more than two pages; and
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(3) $[1/2X] if the record is communicated by another medium
authorized by filing-office rule.
(b) Except as otherwise provided in subsection (e), the fee
for filing and indexing an initial financing statement of the
following kind is [the amount specified in subsection (c), if
applicable, plus]:
(1) $––––––– if the financing statement indicates that it is filed
in connection with a public-finance transaction;
(2) $––––––– if the financing statement indicates that it is filed
in connection with a manufactured-home transaction.
[Alternative A]
(c) The number of names required to be indexed does not
affect the amount of the fee in subsections (a) and (b).
[Alternative B]
(c) Except as otherwise provided in subsection (e), if a record is
communicated in writing, the fee for each name more than two
required to be indexed is $–––––––.
[End of Alternatives]
(a) The fee for responding to a request for information from
the filing office, including for [issuing a certificate showing]
[communicating] whether there is on file any financing
statement naming a particular debtor, is:
(1) $––––––– if the request is communicated in writing; and
(2) $––––––– if the request is communicated by another medium
authorized by filing-office rule.
(e) This section does not require a fee with respect to a record
of a mortgage which is effective as a financing statement filed as
a fixture filing or as a financing statement covering as-extracted
collateral or timber to be cut under Section 9–502(c). However,
the recording and satisfaction fees that otherwise would be
applicable to the record of the mortgage apply.
Legislative Notes:
1. To preserve uniformity, a State that places the provisions of this
section together with statutes setting fees for other services should do so
without modification.
2. A State should enact subsection (c), Alternative A, and omit the
bracketed language in subsections (a) and (b) unless its indexing system
entails a substantial additional cost when indexing additional names.
As amended in 2000.
§ 9–526. Filing-Office Rules.
(a) The [insert appropriate governmental official or agency]
shall adopt and publish rules to implement this article. The
filing-office rules must be[:
(1) consistent with this article[; and
(2) adopted and published in accordance with the [insert any
applicable state administrative procedure act]].
(b) To keep the filing-office rules and practices of the filing
office in harmony with the rules and practices of filing offices in
other jurisdictions that enact substantially this part, and to keep
the technology used by the filing office compatible with the
technology used by filing offices in other jurisdictions that enact
substantially this part, the [insert appropriate governmental
official or agency], so far as is consistent with the purposes,
policies, and provisions of this article, in adopting, amending,
and repealing filing-office rules, shall:
(1) consult with filing offices in other jurisdictions that enact
substantially this part; and
(2) consult the most recent version of the Model Rules
promulgated by the International Association of Corporate
Administrators or any successor organization; and
(3) take into consideration the rules and practices of, and the
technology used by, filing offices in other jurisdictions that enact
substantially this part.
§ 9–527. Duty to Report.
The [insert appropriate governmental official or agency] shall
report [annually on or before –––––––] to the [Governor and
Legislature] on the operation of the filing office. The report
must contain a statement of the extent to which:
(1) the filing-office rules are not in harmony with the rules of
filing offices in other jurisdictions that enact substantially this
part and the reasons for these variations; and
(2) the filing-office rules are not in harmony with the most recent
version of the Model Rules promulgated by the International
Association of Corporate Administrators, or any successor
organization, and the reasons for these variations.
PART 6 Default
[Subpart 1. Default and Enforcement of Security
Interest]
§ 9–601. Rights after Default; Judicial
Enforcement; Consignor or Buyer
of Accounts, Chattel Paper,
Payment Intangibles, or Promissory
Notes.
(a) After default, a secured party has the rights provided
in this part and, except as otherwise provided in Section
9–602, those provided by agreement of the parties.
A secured party:
(1) may reduce a claim to judgment, foreclose, or otherwise
enforce the claim, security interest, or agricultural lien by any
available judicial procedure; and
(2) if the collateral is documents, may proceed either as to the
documents or as to the goods they cover.
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(b) A secured party in possession of collateral or control of
collateral under Section 9–104, 9–105, 9–106, or 9–107 has the
rights and duties provided in Section 9–207.
(c) The rights under subsections (a) and (b) are cumulative
and may be exercised simultaneously.
(d) Except as otherwise provided in subsection (g)
and Section 9–605, after default, a debtor and an obligor
have the rights provided in this part and by agreement of
the parties.
(e) If a secured party has reduced its claim to judgment, the
lien of any levy that may be made upon the collateral by virtue
of an execution based upon the judgment relates back to the
earliest of:
(1) the date of perfection of the security interest or agricultural
lien in the collateral;
(2) the date of filing a financing statement covering the
collateral; or
(3) any date specified in a statute under which the agricultural
lien was created.
(f) A sale pursuant to an execution is a foreclosure of the
security interest or agricultural lien by judicial procedure within
the meaning of this section. A secured party may purchase at the
sale and thereafter hold the collateral free of any other
requirements of this article.
(g) Except as otherwise provided in Section 9–607(c), this
part imposes no duties upon a secured party that is a consignor
or is a buyer of accounts, chattel paper, payment intangibles, or
promissory notes.
§ 9–602. Waiver and Variance of Rights and
Duties.
Except as otherwise provided in Section 9–624, to the extent
that they give rights to a debtor or obligor and impose duties on
a secured party, the debtor or obligor may not waive or vary the
rules stated in the following listed sections:
(1) Section 9–207(b)(4)(C), which deals with use and operation
of the collateral by the secured party;
(2) Section 9–210, which deals with requests for an accounting
and requests concerning a list of collateral and statement of
account;
(3) Section 9–607(c), which deals with collection and
enforcement of collateral;
(4) Sections 9–608(a) and 9–615(c) to the extent that they deal
with application or payment of noncash proceeds of collection,
enforcement, or disposition;
(5) Sections 9–608(a) and 9–615(d) to the extent that they require
accounting for or payment of surplus proceeds of collateral;
(6) Section 9–609 to the extent that it imposes upon a secured
party that takes possession of collateral without judicial process
the duty to do so without breach of the peace;
(7) Sections 9–610(b), 9–611, 9–613, and 9–614, which deal with
disposition of collateral;
(8) Section 9–615(f), which deals with calculation of a
deficiency or surplus when a disposition is made to the secured
party, a person related to the secured party, or a secondary
obligor;
(9) Section 9–616, which deals with explanation of the
calculation of a surplus or deficiency;
(10) Sections 9–620, 9–621, and 9–622, which deal with
acceptance of collateral in satisfaction of obligation;
(11) Section 9–623, which deals with redemption of collateral;
(12) Section 9–624, which deals with permissible waivers; and
(13) Sections 9–625 and 9–626, which deal with the secured
party’s liability for failure to comply with this article.
§ 9–603. Agreement on Standards
Concerning Rights and Duties.
(a) The parties may determine by agreement the standards
measuring the fulfillment of the rights of a debtor or obligor and
the duties of a secured party under a rule stated in Section 9–602
if the standards are not manifestly unreasonable.
(b) Subsection (a) does not apply to the duty under Section
9–609 to refrain from breaching the peace.
§ 9–604. Procedure If Security Agreement
Covers Real Property or Fixtures.
(a) If a security agreement covers both personal and real
property, a secured party may proceed:
(1) under this part as to the personal property without
prejudicing any rights with respect to the real property; or
(2) as to both the personal property and the real property in
accordance with the rights with respect to the real property,
in which case the other provisions of this part do not apply.
(b) Subject to subsection (c), if a security agreement covers
goods that are or become fixtures, a secured party may proceed:
(1) under this part; or
(2) in accordance with the rights with respect to real property, in
which case the other provisions of this part do not apply.
(c) Subject to the other provisions of this part, if a secured
party holding a security interest in fixtures has priority over all
owners and encumbrancers of the real property, the secured party,
after default, may remove the collateral from the real property.
(d) A secured party that removes collateral shall promptly
reimburse any encumbrancer or owner of the real property, other
than the debtor, for the cost of repair of any physical injury
caused by the removal. The secured party need not reimburse
the encumbrancer or owner for any diminution in value of the
real property caused by the absence of the goods removed or by
any necessity of replacing them. A person entitled to
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reimbursement may refuse permission to remove until the
secured party gives adequate assurance for the performance of
the obligation to reimburse.
§ 9–605. Unknown Debtor or Secondary
Obligor.
A secured party does not owe a duty based on its status as
secured party:
(1) to a person that is a debtor or obligor, unless the secured
party knows:
(A) that the person is a debtor or obligor;
(B) the identity of the person; and
(C) how to communicate with the person; or
(2) to a secured party or lienholder that has filed a financing
statement against a person, unless the secured party knows:
(A) that the person is a debtor; and
(B) the identity of the person.
§ 9–606. Time of Default for Agricultural Lien.
For purposes of this part, a default occurs in connection with an
agricultural lien at the time the secured party becomes entitled
to enforce the lien in accordance with the statute under which it
was created.
§ 9–607. Collection and Enforcement by
Secured Party.
(a) If so agreed, and in any event after default, a secured
party:
(1) may notify an account debtor or other person obligated on
collateral to make payment or otherwise render performance to
or for the benefit of the secured party;
(2) may take any proceeds to which the secured party is entitled
under Section 9–315;
(3) may enforce the obligations of an account debtor or other
person obligated on collateral and exercise the rights of the
debtor with respect to the obligation of the account debtor or
other person obligated on collateral to make payment or
otherwise render performance to the debtor, and with
respect to any property that secures the obligations of the
account debtor or other person obligated on the collateral;
(4) if it holds a security interest in a deposit account perfected
by control under Section 9–104(a)(1), may apply the balance of
the deposit account to the obligation secured by the deposit
account; and
(5) if it holds a security interest in a deposit account perfected by
control under Section 9–104(a)(2) or (3), may instruct the bank to
pay the balance of the deposit account to or for the benefit of the
secured party.
(b) If necessary to enable a secured party to exercise under
subsection (a)(3) the right of a debtor to enforce a mortgage
nonjudicially, the secured party may record in the office in
which a record of the mortgage is recorded:
(1) a copy of the security agreement that creates or provides for a
security interest in the obligation secured by the mortgage; and
(2) the secured party’s sworn affidavit in recordable form stating
that:
(A) a default has occurred; and
(B) the secured party is entitled to enforce the mortgage
nonjudicially.
(c) A secured party shall proceed in a commercially
reasonable manner if the secured party:
(1) undertakes to collect from or enforce an obligation of an
account debtor or other person obligated on collateral; and
(2) is entitled to charge back uncollected collateral or otherwise
to full or limited recourse against the debtor or a secondary
obligor.
(d) A secured party may deduct from the collections made
pursuant to subsection (c) reasonable expenses of collection and
enforcement, including reasonable attorney’s fees and legal
expenses incurred by the secured party.
(e) This section does not determine whether an account
debtor, bank, or other person obligated on collateral owes a duty
to a secured party.
As amended in 2000.
§ 9–608. Application of Proceeds of Collection
or Enforcement; Liability for
Deficiency and Right to Surplus.
(a) If a security interest or agricultural lien secures payment
or performance of an obligation, the following rules apply:
(1) A secured party shall apply or pay over for application the
cash proceeds of collection or enforcement under Section 9–607
in the following order to:
(A) the reasonable expenses of collection and enforcement and,
to the extent provided for by agreement and not prohibited by law,
reasonable attorney’s fees and legal expenses incurred by the secured
party;
(B) the satisfaction of obligations secured by the security
interest or agricultural lien under which the collection or
enforcement is made; and
(C) the satisfaction of obligations secured by any subordinate
security interest in or other lien on the collateral subject to the security
interest or agricultural lien under which the collection or enforcement
is made if the secured party receives an authenticated demand for
proceeds before distribution of the proceeds is completed.
(2) If requested by a secured party, a holder of a subordinate
security interest or other lien shall furnish reasonable proof of
the interest or lien within a reasonable time. Unless the holder
complies, the secured party need not comply with the holder’s
demand under paragraph (1)(C).
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(3) A secured party need not apply or pay over for application
noncash proceeds of collection and enforcement under Section
9–607 unless the failure to do so would be commercially
unreasonable. A secured party that applies or pays over for
application noncash proceeds shall do so in a commercially
reasonable manner.
(4) A secured party shall account to and pay a debtor for any
surplus, and the obligor is liable for any deficiency.
(b) If the underlying transaction is a sale of accounts, chattel
paper, payment intangibles, or promissory notes, the debtor is
not entitled to any surplus, and the obligor is not liable for any
deficiency.
As amended in 2000.
§ 9–609. Secured Party’s Right to Take
Possession after Default.
(a) After default, a secured party:
(1) may take possession of the collateral; and
(2) without removal, may render equipment unusable and
dispose of collateral on a debtor’s premises under Section
9–610.
(b) A secured party may proceed under subsection (a):
(1) pursuant to judicial process; or
(2) without judicial process, if it proceeds without breach of the
peace.
(c) If so agreed, and in any event after default, a secured
party may require the debtor to assemble the collateral and
make it available to the secured party at a place to be designated
by the secured party which is reasonably convenient to both
parties.
§ 9–610. Disposition of Collateral after
Default.
(a) After default, a secured party may sell, lease, license, or
otherwise dispose of any or all of the collateral in its present
condition or following any commercially reasonable preparation
or processing.
(b) Every aspect of a disposition of collateral, including the
method, manner, time, place, and other terms, must be
commercially reasonable. If commercially reasonable, a secured
party may dispose of collateral by public or private proceedings,
by one or more contracts, as a unit or in parcels, and at any time
and place and on any terms.
(c) A secured party may purchase collateral:
(1) at a public disposition; or
(2) at a private disposition only if the collateral is of a kind that is
customarily sold on a recognized market or the subject of widely
distributed standard price quotations.
(d) A contract for sale, lease, license, or other disposition
includes the warranties relating to title, possession, quiet
enjoyment, and the like which by operation of law accompany a
voluntary disposition of property of the kind subject to the
contract.
(e) A secured party may disclaim or modify warranties under
subsection (d):
(1) in a manner that would be effective to disclaim or modify the
warranties in a voluntary disposition of property of the kind
subject to the contract of disposition; or
(2) by communicating to the purchaser a record evidencing the
contract for disposition and including an express disclaimer or
modification of the warranties.
(f) A record is sufficient to disclaim warranties under
subsection (e) if it indicates “There is no warranty relating to
title, possession, quiet enjoyment, or the like in this disposition”
or uses words of similar import.
§ 9–611. Notification before Disposition of
Collateral.
(a) In this section, “notification date” means the earlier of
the date on which:
(1) a secured party sends to the debtor and any secondary obligor
an authenticated notification of disposition; or
(2) the debtor and any secondary obligor waive the right to
notification.
(b) Except as otherwise provided in subsection (d), a
secured party that disposes of collateral under Section 9–610
shall send to the persons specified in subsection (c) a reasonable
authenticated notification of disposition.
(c) To comply with subsection (b), the secured party shall
send an authenticated notification of disposition to:
(1) the debtor;
(2) any secondary obligor; and
(3) if the collateral is other than consumer goods:
(A) any other person from which the secured party has
received, before the notification date, an authenticated notification
of a claim of an interest in the collateral;
(B) any other secured party or lienholder that, 10 days before
the notification date, held a security interest in or other lien on the
collateral perfected by the filing of a financing statement that:
(i) identified the collateral;
(ii) was indexed under the debtor’s name as of that date;
and
(iii) was filed in the office in which to file a financing
statement against the debtor covering the collateral as of that date;
and
(C) any other secured party that, 10 days before the
notification date, held a security interest in the collateral perfected
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by compliance with a statute, regulation, or treaty described in
Section 9–311(a).
(d) Subsection (b) does not apply if the collateral is
perishable or threatens to decline speedily in value or is of a type
customarily sold on a recognized market.
(e) A secured party complies with the requirement for
notification prescribed by subsection (c)(3)(B) if:
(1) not later than 20 days or earlier than 30 days before the
notification date, the secured party requests, in a commercially
reasonable manner, information concerning financing statements
indexed under the debtor’s name in the office indicated in
subsection (c)(3)(B); and
(2) before the notification date, the secured party:
(A) did not receive a response to the request for information; or
(B) received a response to the request for information and sent
an authenticated notification of disposition to each secured party or
other lienholder named in that response whose financing statement
covered the collateral.
§ 9–612. Timeliness of Notification before
Disposition of Collateral.
(a) Except as otherwise provided in subsection (b), whether
a notification is sent within a reasonable time is a question
of fact.
(b) In a transaction other than a consumer transaction, a
notification of disposition sent after default and 10 days or more
before the earliest time of disposition set forth in the notification
is sent within a reasonable time before the disposition.
§ 9–613. Contents and Form of Notification
before Disposition of Collateral:
General.
Except in a consumer-goods transaction, the following rules apply:
(1) The contents of a notification of disposition are sufficient if
the notification:
(A) describes the debtor and the secured party;
(B) describes the collateral that is the subject of the intended
disposition;
(C) states the method of intended disposition;
(D) states that the debtor is entitled to an accounting of the
unpaid indebtedness and states the charge, if any, for an accounting;
and
(E) states the time and place of a public disposition or the time
after which any other disposition is to be made.
(2) Whether the contents of a notification that lacks any of the
information specified in paragraph (1) are nevertheless sufficient
is a question of fact.
(3) The contents of a notification providing substantially the
information specified in paragraph (1) are sufficient, even if the
notification includes:
(A) information not specified by that paragraph; or
(b) minor errors that are not seriously misleading.
(4) A particular phrasing of the notification is not required.
(5) The following form of notification and the form appearing in
Section 9–614(3), when completed, each provides sufficient
information:
NOTIFICATION OF DISPOSITION
OF COLLATERAL
To: [Name of debtor, obligor, or other person to which the notification
is sent]
From: [Name, address, and telephone number of secured party]
Name of Debtor(s): [Include only if debtor(s) are not an
addressee]
[For a public disposition:]
We will sell [or lease or license, as applicable] the [describe colla-
teral] [to the highest qualified bidder] in public as follows:
Day and Date: _______
Time: _______
Place: _______
[For a private disposition:]
We will sell [or lease or license, as applicable] the [describe
collateral] privately sometime after [day and date].
You are entitled to an accounting of the unpaid indebted ness
secured by the property that we intend to sell [or lease or
license as applicable] [for a charge of $_______]. You may
request an accounting by calling us at [telephone number].
[End of Form]
As amended in 2000.
§ 9–614. Contents and Form of Notification
before Disposition of Collateral:
Consumer-Goods Transaction.
In a consumer-goods transaction, the following rules apply:
(1) A notification of disposition must provide the following
information:
(A) the information specified in Section 9–613(1);
(B) a description of any liability for a deficiency of the person to
which the notification is sent;
(C) a telephone number from which the amount that must
be paid to the secured party to redeem the collateral under Section
9–623 is available; and
(D) a telephone number or mailing address from which
additional information concerning the disposition and the obligation
secured is available.
(2) A particular phrasing of the notification is not required.
(3) The following form of notification, when completed,
provides sufficient information:
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[Name and address of secured party]
[Date]
NOTICE OF OUR PLAN TO SELL PROPERTY
[Name and address of any obligor who is also a debtor]
Subject: [Identification of Transaction]
We have your [describe collateral], because you broke promises
in our agreement.
[For a public disposition:]
We will sell [describe collateral] at public sale. A sale
could include a lease or license. The sale will be held
as follows:
Date: _______
Time: _______
Place: _______
You may attend the sale and bring bidders if you want.
[For a private disposition:]
We will sell [describe collateral] at private sale sometime after
[date]. A sale could include a lease or license.
The money that we get from the sale (after paying our
costs) will reduce the amount you owe. If we get less money
than you owe, you [will or will not, as applicable] still owe us
the difference. If we get more money than you owe, you
will get the extra money, unless we must pay it to someone
else.
You can get the property back at any time before we sell it by
paying us the full amount you owe (not just the past due
payments), including our expenses. To learn the exact
amount you must pay, call us at [telephone number].
If you want us to explain to you in writing how we have
figured the amount that you owe us, you may call us at
[telephone number] [or write us at [secured party’s address]] and
request a written explanation. [We will charge you
$_______ for the explanation if we sent you another writ-
ten explanation of the amount you owe us within the last
six months.]
If you need more information about the sale call us at [tele-
phone number] [or write us at [secured party’s address]].
We are sending this notice to the following other people who
have an interest in [describe collateral] or who owe money
under your agreement:
[Names of all other debtors and obligors, if any]
[End of Form]
(4) A notification in the form of paragraph (3) is sufficient, even
if additional information appears at the end of the form.
(5) A notification in the form of paragraph (3) is sufficient, even
if it includes errors in information not required by paragraph (1),
unless the error is misleading with respect to rights arising under
this article.
(6) If a notification under this section is not in the form
of paragraph (3), law other than this article determines the
effect of including information not required by paragraph (1).
§ 9–615. Application of Proceeds of
Disposition; Liability for Deficiency
and Right to Surplus.
(a) A secured party shall apply or pay over for application
the cash proceeds of disposition under Section 9–610 in the
following order to:
(1) the reasonable expenses of retaking, holding, preparing for
disposition, processing, and disposing, and, to the extent
provided for by agreement and not prohibited by law,
reasonable attorney’s fees and legal expenses incurred by the
secured party;
(2) the satisfaction of obligations secured by the security interest
or agricultural lien under which the disposition is made;
(3) the satisfaction of obligations secured by any subordinate
security interest in or other subordinate lien on the collateral if:
(A) the secured party receives from the holder of the
subordinate security interest or other lien an authenticated demand
for proceeds before distribution of the proceeds is completed; and
(B) in a case in which a consignor has an interest in the
collateral, the subordinate security interest or other lien is senior to
the interest of the consignor; and
(4) a secured party that is a consignor of the collateral if the
secured party receives from the consignor an authenticated
demand for proceeds before distribution of the proceeds is
completed.
(b) If requested by a secured party, a holder of a
subordinate security interest or other lien shall furnish
reasonable proof of the interest or lien within a reasonable time.
Unless the holder does so, the secured party need not comply
with the holder’s demand under subsection (a)(3).
(c) A secured party need not apply or pay over for
application noncash proceeds of disposition under Section
9–610 unless the failure to do so would be commercially
unreasonable. A secured party that applies or pays over for
application noncash proceeds shall do so in a commercially
reasonable manner.
(d) If the security interest under which a disposition is
made secures payment or performance of an obligation, after
making the payments and applications required by subsection
(a) and permitted by subsection (c):
(1) unless subsection (a)(4) requires the secured party to apply or
pay over cash proceeds to a consignor, the secured party shall
account to and pay a debtor for any surplus; and
(2) the obligor is liable for any deficiency.
(e) If the underlying transaction is a sale of accounts, chattel
paper, payment intangibles, or promissory notes:
(1) the debtor is not entitled to any surplus; and
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(2) the obligor is not liable for any deficiency.
(f) The surplus or deficiency following a disposition is
calculated based on the amount of proceeds that would have
been realized in a disposition complying with this part to a
transferee other than the secured party, a person related to the
secured party, or a secondary obligor if:
(1) the transferee in the disposition is the secured party, a person
related to the secured party, or a secondary obligor; and
(2) the amount of proceeds of the disposition is significantly
below the range of proceeds that a complying disposition to a
person other than the secured party, a person related to the
secured party, or a secondary obligor would have brought.
(g) A secured party that receives cash proceeds of a
disposition in good faith and without knowledge that the receipt
violates the rights of the holder of a security interest or other lien
that is not subordinate to the security interest or agricultural lien
under which the disposition is made:
(1) takes the cash proceeds free of the security interest or other
lien;
(2) is not obligated to apply the proceeds of the disposition to
the satisfaction of obligations secured by the security interest or
other lien; and
(3) is not obligated to account to or pay the holder of the security
interest or other lien for any surplus.
As amended in 2000.
§ 9–616. Explanation of Calculation
of Surplus or Deficiency.
(a) In this section:
(1) “Explanation” means a writing that:
(A) states the amount of the surplus or deficiency;
(B) provides an explanation in accordance with subsection (c)
of how the secured party calculated the surplus or deficiency;
(C) states, if applicable, that future debits, credits, charges,
including additional credit service charges or interest, rebates, and
expenses may affect the amount of the surplus or deficiency; and
(D) provides a telephone number or mailing address from
which additional information concerning the transaction is
available.
(2) “Request” means a record:
(A) authenticated by a debtor or consumer obligor;
(B) requesting that the recipient provide an explanation; and
(C) sent after disposition of the collateral under Section 9–610.
(b) In a consumer-goods transaction in which the debtor is
entitled to a surplus or a consumer obligor is liable for a
deficiency under Section 9–615, the secured party shall:
(1) send an explanation to the debtor or consumer obligor, as
applicable, after the disposition and:
(A) before or when the secured party accounts to the debtor
and pays any surplus or first makes written demand on the consumer
obligor after the disposition for payment of the deficiency; and
(B) within 14 days after receipt of a request; or
(2) in the case of a consumer obligor who is liable for a
deficiency, within 14 days after receipt of a request, send to the
consumer obligor a record waiving the secured party’s right to a
deficiency.
(c) To comply with subsection (a)(1)(B), a writing must
provide the following information in the following order:
(1) the aggregate amount of obligations secured by the security
interest under which the disposition was made, and, if the
amount reflects a rebate of unearned interest or credit service
charge, an indication of that fact, calculated as of a specified
date:
(A) if the secured party takes or receives possession of the
collateral after default, not more than 35 days before the secured
party takes or receives possession; or
(B) if the secured party takes or receives possession of the
collateral before default or does not take possession of the collateral,
not more than 35 days before the disposition;
(2) the amount of proceeds of the disposition;
(3) the aggregate amount of the obligations after deducting the
amount of proceeds;
(4) the amount, in the aggregate or by type, and types of
expenses, including expenses of retaking, holding, preparing for
disposition, processing, and disposing of the collateral, and
attorney’s fees secured by the collateral which are known to the
secured party and relate to the current disposition;
(5) the amount, in the aggregate or by type, and types of credits,
including rebates of interest or credit service charges, to which
the obligor is known to be entitled and which are not reflected
in the amount in paragraph (1); and
(6) the amount of the surplus or deficiency.
(d) A particular phrasing of the explanation is not required.
An explanation complying substantially with the requirements
of subsection (a) is sufficient, even if it includes minor errors that
are not seriously misleading.
(e) A debtor or consumer obligor is entitled without charge
to one response to a request under this section during any six-
month period in which the secured party did not send to the
debtor or consumer obligor an explanation pursuant to
subsection (b)(1). The secured party may require payment of a
charge not exceeding $25 for each additional response.
§ 9–617. Rights of Transferee of Collateral.
(a) A secured party’s disposition of collateral after default:
(1) transfers to a transferee for value all of the debtor’s rights in
the collateral;
(2) discharges the security interest under which the disposition is
made; and
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(3) discharges any subordinate security interest or other
subordinate lien [other than liens created under [cite acts or
statutes providing for liens, if any, that are not to be
discharged]].
(b) A transferee that acts in good faith takes free of the
rights and interests described in subsection (a), even if
the secured party fails to comply with this article or the
requirements of any judicial proceeding.
(c) If a transferee does not take free of the rights and
interests described in subsection (a), the transferee takes the
collateral subject to:
(1) the debtor’s rights in the collateral;
(2) the security interest or agricultural lien under which the
disposition is made; and
(3) any other security interest or other lien.
§ 9–618. Rights and Duties of Certain
Secondary Obligors.
(a) A secondary obligor acquires the rights and becomes
obligated to perform the duties of the secured party after the
secondary obligor:
(1) receives an assignment of a secured obligation from the
secured party;
(2) receives a transfer of collateral from the secured party and
agrees to accept the rights and assume the duties of the secured
party; or
(3) is subrogated to the rights of a secured party with respect to
collateral.
(b) An assignment, transfer, or subrogation described in
subsection (a):
(1) is not a disposition of collateral under Section 9–610; and
(2) relieves the secured party of further duties under this article.
§ 9–619. Transfer of Record or Legal Title.
(a) In this section, “transfer statement” means a record
authenticated by a secured party stating:
(1) that the debtor has defaulted in connection with an
obligation secured by specified collateral;
(2) that the secured party has exercised its post-default remedies
with respect to the collateral;
(3) that, by reason of the exercise, a transferee has acquired the
rights of the debtor in the collateral; and
(4) the name and mailing address of the secured party, debtor,
and transferee.
(b) A transfer statement entitles the transferee to the
transfer of record of all rights of the debtor in the collateral
specified in the statement in any official filing, recording,
registration, or certificate-of-title system covering the collateral.
If a transfer statement is presented with the applicable fee and
request form to the official or office responsible for maintaining
the system, the official or office shall:
(1) accept the transfer statement;
(2) promptly amend its records to reflect the transfer; and
(3) if applicable, issue a new appropriate certificate of title in the
name of the transferee.
(c) A transfer of the record or legal title to collateral to
a secured party under subsection (b) or otherwise is not of itself
a disposition of collateral under this article and does not of
itself relieve the secured party of its duties under this article.
§ 9–620. Acceptance of Collateral in Full or
Partial Satisfaction of Obligation;
Compulsory Disposition of
Collateral.
(a) Except as otherwise provided in subsection (g), a
secured party may accept collateral in full or partial satisfaction
of the obligation it secures only if:
(1) the debtor consents to the acceptance under subsection (c);
(2) the secured party does not receive, within the time set forth
in subsection (d), a notification of objection to the proposal
authenticated by:
(A) a person to which the secured party was required to send a
proposal under Section 9–621; or
(B) any other person, other than the debtor, holding an
interest in the collateral subordinate to the security interest that is
the subject of the proposal;
(3) if the collateral is consumer goods, the collateral is not in the
possession of the debtor when the debtor consents to the
acceptance; and
(4) subsection (e) does not require the secured party to dispose
of the collateral or the debtor waives the requirement pursuant
to Section 9–624.
(b) A purported or apparent acceptance of collateral under
this section is ineffective unless:
(1) the secured party consents to the acceptance in an
authenticated record or sends a proposal to the debtor; and
(2) the conditions of subsection (a) are met.
(c) For purposes of this section:
(1) a debtor consents to an acceptance of collateral in partial
satisfaction of the obligation it secures only if the debtor agrees
to the terms of the acceptance in a record authenticated after
default; and
(2) a debtor consents to an acceptance of collateral in full
satisfaction of the obligation it secures only if the debtor agrees
to the terms of the acceptance in a record authenticated after
default or the secured party:
(A) sends to the debtor after default a proposal that
is unconditional or subject only to a condition that collateral
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not in the possession of the secured party be preserved or
maintained;
(B) in the proposal, proposes to accept collateral in full
satisfaction of the obligation it secures; and
(C) does not receive a notification of objection authenticated
by the debtor within 20 days after the proposal is sent.
(d) To be effective under subsection (a)(2), a notification of
objection must be received by the secured party:
(1) in the case of a person to which the proposal was sent
pursuant to Section 9–621, within 20 days after notification was
sent to that person; and
(2) in other cases:
(A) within 20 days after the last notification was sent pursuant
to Section 9–621; or
(B) if a notification was not sent, before the debtor consents to
the acceptance under subsection (c).
(e) A secured party that has taken possession of collateral
shall dispose of the collateral pursuant to Section 9–610 within
the time specified in subsection (f) if:
(1) 60 percent of the cash price has been paid in the case of a
purchase-money security interest in consumer goods; or
(2) 60 percent of the principal amount of the obligation secured
has been paid in the case of a non-purchase-money security
interest in consumer goods.
(f) To comply with subsection (e), the secured party shall
dispose of the collateral:
(1) within 90 days after taking possession; or
(2) within any longer period to which the debtor and all
secondary obligors have agreed in an agreement to that effect
entered into and authenticated after default.
(g) In a consumer transaction, a secured party may not
accept collateral in partial satisfaction of the obligation it secures.
§ 9–621. Notification of Proposal to Accept
Collateral.
(a) A secured party that desires to accept collateral in full or
partial satisfaction of the obligation it secures shall send its
proposal to:
(1) any person from which the secured party has received, before
the debtor consented to the acceptance, an authenticated
notification of a claim of an interest in the collateral;
(2) any other secured party or lienholder that, 10 days before the
debtor consented to the acceptance, held a security interest in or
other lien on the collateral perfected by the filing of a financing
statement that:
(A) identified the collateral;
(B) was indexed under the debtor’s name as of that date; and
(C) was filed in the office or offices in which to file a
financing statement against the debtor covering the collateral as of
that date; and
(3) any other secured party that, 10 days before the debtor
consented to the acceptance, held a security interest in the
collateral perfected by compliance with a statute, regulation, or
treaty described in Section 9–311(a).
(b) A secured party that desires to accept collateral in partial
satisfaction of the obligation it secures shall send its proposal to
any secondary obligor in addition to the persons described in
subsection (a).
§ 9–622. Effect of Acceptance of Collateral.
(a) A secured party’s acceptance of collateral in full or partial
satisfaction of the obligation it secures:
(1) discharges the obligation to the extent consented to by the
debtor;
(2) transfers to the secured party all of a debtor’s rights in the
collateral;
(3) discharges the security interest or agricultural lien that is the
subject of the debtor’s consent and any subordinate security
interest or other subordinate lien; and
(4) terminates any other subordinate interest.
(b) A subordinate interest is discharged or terminated under
subsection (a), even if the secured party fails to comply with this
article.
§ 9–623. Right to Redeem Collateral.
(a) A debtor, any secondary obligor, or any other secured
party or lienholder may redeem collateral.
(b) To redeem collateral, a person shall tender:
(1) fulfillment of all obligations secured by the collateral; and
(2) the reasonable expenses and attorney’s fees described in
Section 9–615(a)(1).
(c) A redemption may occur at any time before a secured
party:
(1) has collected collateral under Section 9–607;
(2) has disposed of collateral or entered into a contract for its
disposition under Section 9–610; or
(3) has accepted collateral in full or partial satisfaction of the
obligation it secures under Section 9–622.
§ 9–624. Waiver.
(a) A debtor or secondary obligor may waive the right to
notification of disposition of collateral under Section 9–611 only
by an agreement to that effect entered into and authenticated
after default.
(b) A debtor may waive the right to require disposition of
collateral under Section 9–620(e) only by an agreement to that
effect entered into and authenticated after default.
(c) Except in a consumer-goods transaction, a debtor or
secondary obligor may waive the right to redeem collateral under
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Section 9–623 only by an agreement to that effect entered into
and authenticated after default.
[Subpart 2. Noncompliance with Article]
§ 9–625. Remedies for Secured Party’s
Failure to Comply with Article.
(a) If it is established that a secured party is not proceeding
in accordance with this article, a court may order or restrain
collection, enforcement, or disposition of collateral on
appropriate terms and conditions.
(b) Subject to subsections (c), (d), and (f), a person is liable
for damages in the amount of any loss caused by a failure to
comply with this article. Loss caused by a failure to comply may
include loss resulting from the debtor’s inability to obtain, or
increased costs of, alternative financing.
(c) Except as otherwise provided in Section 9–628:
(1) a person that, at the time of the failure, was a debtor, was an
obligor, or held a security interest in or other lien on the
collateral may recover damages under subsection (b) for its loss;
and
(2) if the collateral is consumer goods, a person that was a
debtor or a secondary obligor at the time a secured party failed
to comply with this part may recover for that failure in any
event an amount not less than the credit service charge plus
10 percent of the principal amount of the obligation or the
time-price differential plus 10 percent of the cash price.
(d) A debtor whose deficiency is eliminated under
Section 9–626 may recover damages for the loss of any surplus.
However, a debtor or secondary obligor whose deficiency is
eliminated or reduced under Section 9–626 may not otherwise
recover under subsection (b) for noncompliance with the
provisions of this part relating to collection, enforcement,
disposition, or acceptance.
(e) In addition to any damages recoverable under
subsection (b), the debtor, consumer obligor, or person named as
a debtor in a filed record, as applicable, may recover $500 in each
case from a person that:
(1) fails to comply with Section 9–208;
(2) fails to comply with Section 9–209;
(3) files a record that the person is not entitled to file under
Section 9–509(a);
(4) fails to cause the secured party of record to file or send a
termination statement as required by Section 9–513(a) or (c);
(5) fails to comply with Section 9–616(b)(1) and whose failure
is part of a pattern, or consistent with a practice, of
noncompliance; or
(6) fails to comply with Section 9–616(b)(2).
(f) A debtor or consumer obligor may recover damages
under subsection (b) and, in addition, $500 in each case from a
person that, without reasonable cause, fails to comply with a
request under Section 9–210. A recipient of a request under
Section 9–210 which never claimed an interest in the collateral
or obligations that are the subject of a request under that section
has a reasonable excuse for failure to comply with the request
within the meaning of this subsection.
(g) If a secured party fails to comply with a request
regarding a list of collateral or a statement of account under
Section 9–210, the secured party may claim a security interest
only as shown in the list or statement included in the request as
against a person that is reasonably misled by the failure.
As amended in 2000.
§ 9–626. Action in Which Deficiency or
Surplus Is in Issue.
(a) In an action arising from a transaction, other than a
consumer transaction, in which the amount of a deficiency or
surplus is in issue, the following rules apply:
(1) A secured party need not prove compliance with the
provisions of this part relating to collection, enforcement,
disposition, or acceptance unless the debtor or a secondary
obligor places the secured party’s compliance in issue.
(2) If the secured party’s compliance is placed in issue, the
secured party has the burden of establishing that the collection,
enforcement, disposition, or acceptance was conducted in
accordance with this part.
(3) Except as otherwise provided in Section 9–628, if a secured
party fails to prove that the collection, enforcement, disposition,
or acceptance was conducted in accordance with the provisions
of this part relating to collection, enforcement, disposition, or
acceptance, the liability of a debtor or a secondary obligor for a
deficiency is limited to an amount by which the sum of the
secured obligation, expenses, and attorney’s fees exceeds the
greater of:
(A) the proceeds of the collection, enforcement, disposition, or
acceptance; or
(B) the amount of proceeds that would have been realized had
the noncomplying secured party proceeded in accordance with the
provisions of this part relating to collection, enforcement,
disposition, or acceptance.
(4) For purposes of paragraph (3)(B), the amount of proceeds
that would have been realized is equal to the sum of the secured
obligation, expenses, and attorney’s fees unless the secured
party proves that the amount is less than that sum.
(5) If a deficiency or surplus is calculated under Section 9–615
(f), the debtor or obligor has the burden of establishing that
the amount of proceeds of the disposition is significantly
below the range of prices that a complying disposition to
a person other than the secured party, a person related to
the secured party, or a secondary obligor would have
brought.
(b) The limitation of the rules in subsection (a) to
transactions other than consumer transactions is intended to
leave to the court the determination of the proper rules in
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consumer transactions. The court may not infer from that
limitation the nature of the proper rule in consumer transactions
and may continue to apply established approaches.
§ 9–627. Determination of Whether Conduct
Was Commercially Reasonable.
(a) The fact that a greater amount could have been obtained
by a collection, enforcement, disposition, or acceptance at a
different time or in a different method from that selected by the
secured party is not of itself sufficient to preclude the secured party
from establishing that the collection, enforcement, disposition, or
acceptance was made in a commercially reasonable manner.
(b) A disposition of collateral is made in a commercially
reasonable manner if the disposition is made:
(1) in the usual manner on any recognized market;
(2) at the price current in any recognized market at the time of
the disposition; or
(3) otherwise in conformity with reasonable commercial practices
among dealers in the type of property that was the subject of the
disposition.
(c) A collection, enforcement, disposition, or acceptance is
commercially reasonable if it has been approved:
(1) in a judicial proceeding;
(2) by a bona fide creditors’ committee;
(3) by a representative of creditors; or
(4) by an assignee for the benefit of creditors.
(d) Approval under subsection (c) need not be obtained, and
lack of approval does not mean that the collection, enforcement,
disposition, or acceptance is not commercially reasonable.
§ 9–628. Nonliability and Limitation on
Liability of Secured Party; Liability of
Secondary Obligor.
(a) Unless a secured party knows that a person is a debtor or
obligor, knows the identity of the person, and knows how to
communicate with the person:
(1) the secured party is not liable to the person, or to a secured
party or lienholder that has filed a financing statement against
the person, for failure to comply with this article; and
(2) the secured party’s failure to comply with this article does not
affect the liability of the person for a deficiency.
(b) A secured party is not liable because of its status as
secured party:
(1) to a person that is a debtor or obligor, unless the secured
party knows:
(A) that the person is a debtor or obligor;
(B) the identity of the person; and
(C) how to communicate with the person; or
(2) to a secured party or lienholder that has filed a financing
statement against a person, unless the secured party knows:
(A) that the person is a debtor; and
(B) the identity of the person.
(c) A secured party is not liable to any person, and a
person’s liability for a deficiency is not affected, because of any
act or omission arising out of the secured party’s reasonable
belief that a transaction is not a consumer-goods transaction or a
consumer transaction or that goods are not consumer goods, if
the secured party’s belief is based on its reasonable reliance on:
(1) a debtor’s representation concerning the purpose for which
collateral was to be used, acquired, or held; or
(2) an obligor’s representation concerning the purpose for which
a secured obligation was incurred.
(d) A secured party is not liable to any person under Section
9–625(c)(2) for its failure to comply with Section 9–616.
(e) A secured party is not liable under Section 9–625(c)(2)
more than once with respect to any one secured obligation.
PART 7 Transition
§ 9–701. Effective Date.
This [Act] takes effect on July 1, 2001.
§ 9–702. Savings Clause.
(a) Except as otherwise provided in this part, this [Act]
applies to a transaction or lien within its scope, even if the
transaction or lien was entered into or created before this [Act]
takes effect.
(b) Except as otherwise provided in subsection (c) and
Sections 9–703 through 9–709:
(1) transactions and liens that were not governed by [former
Article 9], were validly entered into or created before this [Act]
takes effect, and would be subject to this [Act] if they had been
entered into or created after this [Act] takes effect, and the
rights, duties, and interests flowing from those transactions and
liens remain valid after this [Act] takes effect; and
(2) the transactions and liens may be terminated, completed,
consummated, and enforced as required or permitted by this
[Act] or by the law that otherwise would apply if this [Act] had
not taken effect.
(c) This [Act] does not affect an action, case, or proceeding
commenced before this [Act] takes effect.
As amended in 2000.
§ 9–703. Security Interest Perfected before
Effective Date.
(a) A security interest that is enforceable immediately
before this [Act] takes effect and would have priority over the
rights of a person that becomes a lien creditor at that time is a
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perfected security interest under this [Act] if, when this [Act]
takes effect, the applicable requirements for enforceability and
perfection under this [Act] are satisfied without further action.
(b) Except as otherwise provided in Section 9–705, if,
immediately before this [Act] takes effect, a security interest is
enforceable and would have priority over the rights of a person
that becomes a lien creditor at that time, but the applicable
requirements for enforceability or perfection under this [Act]
are not satisfied when this [Act] takes effect, the security
interest:
(1) is a perfected security interest for one year after this [Act]
takes effect;
(2) remains enforceable thereafter only if the security interest
becomes enforceable under Section 9–203 before the year
expires; and
(3) remains perfected thereafter only if the applicable
requirements for perfection under this [Act] are satisfied before
the year expires.
§ 9–704. Security Interest Unperfected
before Effective Date.
A security interest that is enforceable immediately before this
[Act] takes effect but which would be subordinate to the rights
of a person that becomes a lien creditor at that time:
(1) remains an enforceable security interest for one year after this
[Act] takes effect;
(2) remains enforceable thereafter if the security interest
becomes enforceable under Section 9–203 when this [Act] takes
effect or within one year thereafter; and
(3) becomes perfected:
(A) without further action, when this [Act] takes effect if the
applicable requirements for perfection under this [Act] are satisfied
before or at that time; or
(B) when the applicable requirements for perfection are satisfied
if the requirements are satisfied after that time.
§ 9–705. Effectiveness of Action Taken before
Effective Date.
(a) If action, other than the filing of a financing statement, is
taken before this [Act] takes effect and the action would have
resulted in priority of a security interest over the rights of a
person that becomes a lien creditor had the security interest
become enforceable before this [Act] takes effect, the action is
effective to perfect a security interest that attaches under this
[Act] within one year after this [Act] takes effect. An attached
security interest becomes unperfected one year after this [Act]
takes effect unless the security interest becomes a perfected
security interest under this [Act] before the expiration of that
period.
(b) The filing of a financing statement before this [Act]
takes effect is effective to perfect a security interest to the
extent the filing would satisfy the applicable requirements for
perfection under this [Act].
(c) This [Act] does not render ineffective an effective
financing statement that, before this [Act] takes effect, is filed
and satisfies the applicable requirements for perfection
under the law of the jurisdiction governing perfection as
provided in [former Section 9–103]. However, except as
otherwise provided in subsections (d) and (e) and Section
9–706, the financing statement ceases to be effective at the
earlier of:
(1) the time the financing statement would have ceased to
be effective under the law of the jurisdiction in which it is
filed; or
(2) June 30, 2006.
(d) The filing of a continuation statement after this [Act]
takes effect does not continue the effectiveness of the financing
statement filed before this [Act] takes effect. However, upon the
timely filing of a continuation statement after this [Act] takes
effect and in accordance with the law of the jurisdiction
governing perfection as provided in Part 3, the effectiveness of a
financing statement filed in the same office in that jurisdiction
before this [Act] takes effect continues for the period provided
by the law of that jurisdiction.
(e) Subsection (c)(2) applies to a financing statement
that, before this [Act] takes effect, is filed against a
transmitting utility and satisfies the applicable requirements
for perfection under the law of the jurisdiction governing
perfection as provided in [former Section 9–103] only to the
extent that Part 3 provides that the law of a jurisdiction other
than the jurisdiction in which the financing statement is filed
governs perfection of a security interest in collateral covered
by the financing statement.
(f) A financing statement that includes a financing
statement filed before this [Act] takes effect and a continuation
statement filed after this [Act] takes effect is effective only to
the extent that it satisfies the requirements of Part 5 for an initial
financing statement.
§ 9–706. When Initial Financing Statement
Suffices to Continue Effectiveness of
Financing Statement.
(a) The filing of an initial financing statement in the office
specified in Section 9–501 continues the effectiveness of a
financing statement filed before this [Act] takes effect if:
(1) the filing of an initial financing statement in that office would
be effective to perfect a security interest under this [Act];
(2) the pre-effective-date financing statement was filed in an
office in another State or another office in this State; and
(3) the initial financing statement satisfies subsection (c).
(b) The filing of an initial financing statement under
subsection (a) continues the effectiveness of the pre-effective-
date financing statement:
B74 A P P E N D I X B Uniform Commercial Code (Selected Provisions)
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(1) if the initial financing statement is filed before this [Act]
takes effect, for the period provided in [former Section 9–403]
with respect to a financing statement; and
(2) if the initial financing statement is filed after this [Act] takes
effect, for the period provided in Section 9–515 with respect to
an initial financing statement.
(c) To be effective for purposes of subsection (a), an initial
financing statement must:
(1) satisfy the requirements of Part 5 for an initial financing
statement;
(2) identify the pre-effective-date financing statement by
indicating the office in which the financing statement was filed
and providing the dates of filing and file numbers, if any, of the
financing statement and of the most recent continuation
statement filed with respect to the financing statement; and
(3) indicate that the pre-effective-date financing statement
remains effective.
§ 9–707. Amendment of Pre-Effective-Date
Financing Statement.
(a) In this section, “Pre-effective-date financing
statement” means a financing statement filed before this
[Act] takes effect.
(b) After this [Act] takes effect, a person may add or delete
collateral covered by, continue or terminate the effectiveness of,
or otherwise amend the information provided in, a pre-effective-
date financing statement only in accordance with the law of the
jurisdiction governing perfection as provided in Part 3. However,
the effectiveness of a pre-effective-date financing statement also
may be terminated in accordance with the law of the jurisdiction
in which the financing statement is filed.
(c) Except as otherwise provided in subsection (d), if the
law of this State governs perfection of a security interest, the
information in a pre-effective-date financing statement may be
amended after this [Act] takes effect only if:
(1) the pre-effective-date financing statement and an
amendment are filed in the office specified in Section 9–501;
(2) an amendment is filed in the office specified in Section 9–501
concurrently with, or after the filing in that office of, an initial
financing statement that satisfies Section 9–706(c); or
(3) an initial financing statement that provides the information as
amended and satisfies Section 9–706(c) is filed in the office
specified in Section 9–501.
(d) If the law of this State governs perfection of a security
interest, the effectiveness of a pre-effective-date financing
statement may be continued only under Section 9–705(d) and
(f) or 9–706.
(e) Whether or not the law of this State governs perfection
of a security interest, the effectiveness of a pre-effective-date
financing statement filed in this State may be terminated after
this [Act] takes effect by filing a termination statement in the
office in which the pre-effective-date financing statement is
filed, unless an initial financing statement that satisfies Section
9–706(c) has been filed in the office specified by the law of the
jurisdiction governing perfection as provided in Part 3 as the
office in which to file a financing statement.
As amended in 2000.
§ 9–708. Persons Entitled to File Initial
Financing Statement or Continuation
Statement.
A person may file an initial financing statement or a continuation
statement under this part if:
(1) the secured party of record authorizes the filing; and
(2) the filing is necessary under this part:
(A) to continue the effectiveness of a financing statement filed
before this [Act] takes effect; or
(B) to perfect or continue the perfection of a security interest.
As amended in 2000.
§ 9–709. Priority.
(a) This [Act] determines the priority of conflicting claims
to collateral. However, if the relative priorities of the claims were
established before this [Act] takes effect, [former Article 9]
determines priority.
(b) For purposes of Section 9–322(a), the priority of a
security interest that becomes enforceable under Section 9–203
of this [Act] dates from the time this [Act] takes effect if the
security interest is perfected under this [Act] by the filing of a
financing statement before this [Act] takes effect which would
not have been effective to perfect the security interest under
[former Article 9]. This subsection does not apply to conflicting
security interests each of which is perfected by the filing of such
a financing statement.
A P P E N D I X B Uniform Commercial Code (Selected Provisions) B75
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GLOSSARY
A
Abatement An order to the owner of a property to eliminate a
nuisance.
Absolute privilege Exists in courtrooms and legislative hearings.
Anyone speaking there, such as a witness in a court, can say anything
and never be sued for defamation.
Accept To sign a check.
Acceptance Retention of the collateral by a secured party as full or
partial satisfaction of a debt.
Accepted check A check that the drawee bank has signed. This
signature is a promise that the bank will pay the check out of its own
funds.
Accession The use of labor and/or materials to add value to the
personal property of another.
Accommodation party Someone who does not benefit from an
instrument but agrees to guarantee its payment.
Accord and satisfaction An agreement to settle a debt for less
than the sum claimed.
Accounts Any right to receive payment for goods sold or leased,
other than rights covered by chattel paper or instruments.
Account party Party that applies for the letter of credit from its
bank.
Accredited investor Under the Securities Act of 1933, an
accredited investor is an institution (such as a bank or insurance
company) or any individual with a net worth of more than $1 million
or an annual income of more than $200,000.
Acquit To find the defendant not guilty of the crime for which he
was tried.
Act of State doctrine A rule requiring American courts to
abstain from cases if a court order would interfere with the ability of
the President or Congress to conduct foreign policy.
Actual authority An agent is authorized to act for a principal.
Actus reus The guilty act. The prosecution must show that a
criminal defendant committed some proscribed act. In a murder
prosecution, taking another person’s life is the actus reus.
Ad valorem According to the value of the goods.
Additional terms Those terms that raise issues not covered in
an offer.
Adhesion contract A standard form contract prepared by one
party and presented to the other on a “take it or leave it” basis.
Adjudicate To hold a formal hearing in a disputed matter and
issue an official decision.
Administrative law Concerns all agencies, boards, commissions,
and other entities created by a federal or state legislature and charged
with investigating, regulating, and adjudicating a particular industry
or issue.
Administrative law judge An agency employee who acts as an
impartial decision-maker.
Administrator A person appointed by the court to oversee the
probate process for someone who has died intestate (that is, without
a will).
Administratrix A female administrator.
Adverse possession A means of gaining ownership of land
belonging to another by entering upon the property, openly and
notoriously, and claiming exclusive use of it for a period of
years.
Affidavit A written statement signed under oath.
Affirm An appellate court issues a decision upholding the
judgment of a lower court.
Affirmative action A plan introduced in a workplace for the
purpose of either remedying the effects of past discrimination or
achieving equitable representation of minorities and women.
After-acquired property Items that a debtor obtains after
making a security agreement with the secured party.
Agent A person who acts for a principal.
Alternative dispute resolution Any method of resolving a legal
conflict other than litigation, such as negotiation, arbitration,
mediation, mini-trials, and summary jury trials.
Amendment Any addition to a legal document. The constitu-
tional amendments, the first ten of which are known collectively as
the Bill of Rights, secure numerous liberties and protections directly
for the people.
Annual report Each year, public companies must send their
shareholders a document that contains detailed financial data.
Annuity Payment to a beneficiary during his lifetime.
Answer The pleading, filed by the defendant in court and served
on the plaintiff, which responds to each allegation in the plaintiff’s
complaint.
G1
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Antitrust laws Make it illegal to destroy competition and capture
an entire market.
Apparent authority A situation in which conduct of a principal
causes a third party to believe that the principal consents to have an
act done on his behalf by a person purporting to act for him when, in
fact, that person is not acting for the principal.
Appeals court Any court in a state or federal system that reviews
cases that have already been tried.
Appellant The party who appeals a lower court decision to a
higher court.
Appellee The party opposing an appeal from a lower court to a
higher court.
Arbitration A form of alternative dispute resolution in which the
parties hire a neutral third party to hear their respective arguments,
receive evidence, and then make a binding decision.
Arson Malicious use of fire or explosives to damage or destroy real
estate or personal property.
Artisan’s lien A security interest in personal property.
Assault An intentional act that causes the plaintiff to fear an
imminent battery.
Assignee The party who receives an assignment of contract rights
from a party to the contract.
Assignment The act by which a party transfers contract rights to a
third person.
Assignor The party who assigns contract rights to a third person.
Assisted suicide The process of hastening death for a terminally
ill patient at the request of this patient.
Attachment A court order seizing property of a party to a civil
action, so that there will be sufficient assets available to pay the
judgment.
Authorized and unissued stock Stock that has been approved
by the corporation’s charter but has not yet been sold.
Authorized and issued stock Stock that has been approved by
the corporation’s charter and subsequently sold.
Automatic stay Prohibits creditors from collecting debts that the
bankrupt incurred before the bankruptcy petition was filed.
B
Bailee A person who rightfully possesses goods belonging to
another.
Bailment Giving possession and control of personal property to
another person.
Bailor One who creates a bailment by delivering goods to another.
Bait and switch A practice where sellers advertise products that
are not generally available but are being used to draw interested
parties in so that they will buy other products.
Bankrupt Another term for debtor.
Bankruptcy estate The new legal entity created when a debtor
files a bankruptcy petition. All of the debtor’s existing assets pass
into the estate.
Battery The intentional touching of another person in a way that
is unwanted or offensive.
Bearer paper An instrument payable “to bearer.” Any holder in
due course can demand payment.
Beneficiary Party that will be paid by the issuing bank pursuant to
a letter of credit.
Best efforts underwriting When the underwriter does not buy
the stock but instead acts as the company’s agent in selling it.
Beyond a reasonable doubt The government’s burden in a
criminal prosecution.
Bilateral contract A binding agreement in which each party has
made a promise to the other.
Bilateral mistake Occurs when both parties negotiate based on
the same factual error.
Bill A proposed statute that has been submitted for consideration to
Congress or a state legislature.
Bill of lading A receipt for goods, given by a carrier such as a ship,
that minutely describes the merchandise being shipped. A negotiable
bill of lading may be transferred to other parties, and entitles any
holder to collect the goods.
Bill of Rights The first ten amendments to the Constitution.
Blue sky laws State securities laws.
Bona fide occupational qualification (BFOQ) A job require-
ment that would otherwise be discriminatory is permitted in
situations in which it is essential to the position in question.
Bona fide purchaser Someone who buys goods in good faith, for
value, typically from a seller who has merely voidable title.
Bonds Long-term debt secured by some of the issuing company’s
assets.
Brief The written legal argument that an attorney files with an
appeal court.
Bulk sale A transfer of most or all of a merchant’s assets.
Burden of proof The allocation of which party must prove its
case. In a civil case, the plaintiff has the burden of proof to persuade
the fact finder of every element of her case. In a criminal case, the
government has the burden of proof.
G2 Glossary
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Business judgment rule A common law rule that protects
managers from liability if they are acting without a conflict of
interest and make informed decisions that have a rational business
purpose.
Business trust An unincorporated association run by trustees for
the benefit of investors.
Buyer in ordinary course of business (BIOC) Someone who
buys goods in good faith from a seller who routinely deals in such
goods.
Bylaws A document that specifies the organizational rules of a
corporation or other organization, such as the date of the annual
meeting and the required number of directors.
C
Cap and trade A market-based system for reducing emissions.
Capacity The legal ability to enter into a contract.
Cashier’s check A check that is drawn by a bank on itself.
Certificate of deposit An instrument issued by a bank which
promises to repay a deposit, with interest, on a specified date.
Certified check A check that the drawee bank has signed. This
signature is a promise that the bank will pay the check out of its own
funds.
Certiorari, writ of Formal notice from the United States
Supreme Court that it will accept a case for review.
Challenge for cause An attorney’s request, during voir dire, to
excuse a prospective juror because of apparent bias.
Chancery, court of In medieval England, the court originally
operated by the Chancellor.
Charging order A court order granting the creditor of a partner
the right to receive that partner’s share of partnership profits.
Chattel paper Any writing that indicates two things: (1) a debtor
owes money and (2) a secured party has a security interest in specific
goods. The most common chattel paper is a document indicating a
consumer sale on credit.
Check An instrument in which the drawer orders the drawee bank
to pay money to the payee.
Chicago School A theory of antitrust law first developed at the
University of Chicago. Adherents to this theory believe that antitrust
enforcement should focus on promoting efficiency and should not
generally be concerned about the size or number of competitors in any
market.
CISG See Convention on Contracts for the International Sale of
Goods (CISG).
Civil law The large body of law concerning the rights and duties
between parties. It is distinguished from criminal law, which
concerns behavior outlawed by a government.
Claim in recoupment An issuer subtracts (i.e., “sets off”) any
other claims that he has against the initial payee from the amount
that he owes on an instrument.
Class action A method of litigating a civil lawsuit in which one or
more plaintiffs (or occasionally defendants) seek to represent an entire
group of people with similar claims against a common opponent.
Classification The process by which the Customs Service decides
what label to attach to imported merchandise, and therefore what level
of tariff to impose.
Classes of stock Categories of stock with different rights.
Close corporation A corporation with a small number of
shareholders. Its stock is not publicly traded. Also known as a
closely held corporation.
Codicil An amendment to a will.
Collateral The property subject to a security interest.
Collateral promise A promise to pay the debt of another person,
as a favor to the debtor.
Collective bargaining Contract negotiations between an
employer and a union.
Collective bargaining agreement (CBA) A contract between a
union and management.
Collective bargaining unit The precisely defined group of
employees who are represented by a particular union.
Comity A doctrine that requires a court to abstain from hearing a
case out of respect for another court that also has jurisdiction.
International comity demands that a U.S. court refuse to hear a case
in which a foreign court shares jurisdiction if there is a conflict
between the laws and if it is more logical for the foreign court to take
the case.
Comment letter A document from the SEC listing required
changes in the registration statement.
Commerce clause One of the powers granted by Article I,
Section 8 of the Constitution, it gives Congress exclusive power to
regulate international commerce and concurrent power with the
states to regulate domestic commerce.
Commercial impracticability After the creation of a contract,
an entirely unforeseen event occurs which makes enforcement of the
contract extraordinarily unfair.
Commercial paper Instruments such as checks and promissory
notes that contain a promise to pay money. Commercial paper
includes both negotiable and non-negotiable instruments.
Glossary G3
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Commercial speech Communication, such as television advertise-
ments, that has the dominant theme of proposing a commercial
transaction.
Common carrier A transportation company that makes its
services available on a regular basis to the general public.
Common law Judge-made law, that is, the body of all decisions
made by appellate courts over the years.
Common stock Certificates that reflect ownership in a corpora-
tion. Owners of this equity security are last in line for corporate pay-
outs such as dividends and liquidation proceeds.
Comparative negligence A rule of tort law that permits a
plaintiff to recover even when the defendant can show that the
plaintiff’s own conduct contributed in some way to her harm.
Compensatory damages The amount of money that the court
thinks will restore the plaintiff to the position he was in before the
defendant’s conduct caused an injury.
Complaint A pleading, filed by the plaintiff, providing a short
statement of the claim.
Concerted action Tactics, such as a strike, used by a union to
gain a bargaining advantage.
Concurrent estate Two or more people owning property at the
same time.
Condition A condition is an event that must occur in order for a
party to be obligated under a contract.
Condition precedent A condition that must occur before a
particular contract duty arises.
Condition subsequent A condition that must occur after a
particular contract duty arises, or the duty will be discharged.
Confiscation Expropriation without adequate compensation of
property owned by foreigners.
Conforming goods Items that satisfy the contract terms. If a
contract calls for blue sailboats, then green sailboats are non-
conforming.
Consent order An agreement entered into by a wrongdoer and an
administrative agency (such as the Securities and Exchange
Commission or the Federal Trade Commission) in which the
wrongdoer agrees not to violate the law in the future.
Consequential damages Those resulting from the unique
circumstances of this injured party.
Consideration In contract law, something of legal value that has
been bargained for and given in exchange by the parties.
Constitution The supreme law of a political entity. The United
States Constitution is the highest law in the country.
Consumer Any natural person, that is, not a corporation or
business.
Consumer credit contract A contract in which a consumer
borrows money from a lender to purchase goods and services from a
seller who is affiliated with the lender.
Consumer reporting agency A business that supplies consumer
reports to third parties.
Contract A legally enforceable promise or set of promises.
Contract carrier A transportation company that does not make
its services available to the general public but engages in continuing
agreements with particular customers.
Contributory negligence A rule of tort law that permits a
negligent defendant to escape liability if she can demonstrate that
the plaintiff’s own conduct contributed in any way to the plaintiff’s
harm.
Control security Stock owned by any officer or director of the
issuer, or by any shareholder who holds more than 10 percent of a
class of stock of the issuer.
Convention on Contracts for the International Sale of
Goods (CISG) A United Nations–sponsored agreement that
creates a neutral body of law for sale of goods contracts between
companies from different countries.
Conversion (1) A tort committed by taking or using someone
else’s personal property without his permission. (2) A bank has paid
a check that has a forged indorsement.
Cookie A small computer file that identifies the user of a computer.
Internet sites typically place cookies on a computer’s hard drive to
track visitors to their site.
Cooperative A group of individuals or businesses that join
together to gain the advantages of volume purchases or sales.
Copyright Under federal law, the holder of a copyright owns a
particular expression of an idea, but not the idea itself. This ownership
right applies to creative activities such as literature, music, drama, and
software.
Corporate social responsibility An organization’s obligation to
contribute positively to the world around it.
Corporation by estoppel Even if a corporation has not actually
been formed, courts will sometimes enforce contracts entered into in
the belief that the corporation did indeed exist.
Compliance program A plan to prevent and detect criminal
conduct at all levels of the company.
Constructive insider Anyone who has an indirect employment
relationship with a company, such as employees of the company’s
auditors or law firm.
Counter-claim A claim made by the defendant against the
plaintiff.
Counteroffer A return offer and a rejection of the original offer.
G4 Glossary
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Cover The buyer’s right to obtain substitute goods when a seller
has breached a contract.
Cramdown The bankruptcy court confirms a plan of reorganiza-
tion despite a negative vote from one or more classes of creditors
and/or shareholders.
Creditor beneficiary When one party to a contract intends to
benefit a third party to whom he owes a debt, that third party is
referred to as a creditor beneficiary.
Criminal law Rules that permit a government to punish certain
behavior by fine or imprisonment.
Criminal procedure The process of investigating, interrogating,
and trying a criminal defendant.
Cross-examine During a hearing, when a lawyer questions an
opposing witness.
Cure The seller’s right to respond to a buyer’s rejection of
nonconforming goods; the seller accomplishes this by delivering
conforming goods before the contract deadline.
D
Damages (1) The harm that a plaintiff complains of at trial, such
as an injury to her person, or money lost because of a contract
breach. (2) Money awarded by a trial court for injury suffered.
De facto corporation Occurs when a promoter makes a good
faith effort to incorporate (although fails to complete the process
entirely) and uses the corporation to conduct business. The state
can challenge the validity of the corporation, but a third party
cannot.
De jure corporation The promoter of the corporation has
substantially complied with the requirements for incorporation,
but has made some minor error. No one has the right to challenge
the validity of the corporation.
De novo decision The power of an appellate court or appellate
agency to make a new decision in a matter under appeal, entirely
ignoring the findings and conclusions of the lower court or agency
official.
Debentures Long-term, unsecured debt, typically issued by a
corporation.
Debtor A person who owes money or some other obligation to
another party.
Decedent A person who has died.
Deed A document that proves ownership of property.
Defamation The act of injuring someone’s reputation by stating
something false abouther to a third person.Libel is defamationdone either
in writing or by broadcast. Slander is defamation done orally.
Default The failure to perform an obligation, such as the failure to
pay money when due.
Default judgment A court order awarding one party everything it
requested because the opposing party failed to respond in time.
Default rules Under the Uniform Partnership Act, these rules
govern the relationship among the partners unless the partners
explicitly make a different agreement.
Defendant The person being sued.
Deficiency Having insufficient funds to pay off a debt.
Definiteness A doctrine holding that a contract will only be
enforced if its terms are sufficiently precise that a court can
determine what the parties meant.
Delegation The act by which a party to a contract transfers duties
to a third person who is not a party to the contract.
Deontological From the Greek word for obligation. The duty to
do the right thing, regardless of the result.
Deponent The person being questioned in a deposition.
Deposition A form of discovery in which a party’s attorney has the
right to ask oral questions of the other party or of a witness. Answers
are given under oath.
Derivative action A lawsuit brought by shareholders in the name
of the corporation to enforce a right of the corporation.
Deterrence Using punishment, such as imprisonment, to dis-
courage criminal behavior.
Devisee Someone who inherits under a will.
Different terms Terms that contradict those in an offer.
Difference principle Rawls’ suggestion that society should reward
behavior that provides the most benefit to the community as a
whole.
Direct examination During a hearing, when a lawyer asks
questions of his own witness.
Directed verdict The decision by a court to instruct a jury that it
must find in favor of a particular party because, in the judge’s
opinion, no reasonable person could disagree on the outcome.
Disabled person Someone with a physical or mental impairment
that substantially limits a major life activity, or someone who is
regarded as having such an impairment.
Disability insurance Replaces the insured’s income if he becomes
unable to work because of illness or injury.
Disaffirm To give notice to the other party to a contract that the
party giving the notice refuses to be bound by the agreement.
Discharge (1) A party to a contract has no more duties. (2) A
party to an instrument is released from liability.
Glossary G5
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Disclaimer A statement that a particular warranty does not apply.
Discovery A stage in litigation, after all pleadings have been
served, in which each party seeks as much relevant information as
possible about the opposing party’s case.
Dishonor An obligor refuses to pay an instrument that is due.
Dismiss To terminate a lawsuit, often on procedural grounds,
without reaching the merits of the case.
Dissenters’ rights A privately held company must buy back the
stock of any shareholder who objects to a fundamental change.
Dissociation A dissociation occurs when a partner leaves a
partnership.
Diversity jurisdiction One of the two main types of civil cases
that a U.S. district court has the power to hear. It involves a lawsuit
between citizens of different states, in which at least one party makes
a claim for more than $75,000.
Domestic corporation A corporation is a domestic corporation
in the state in which it was formed.
Donee A person who receives a gift.
Donee beneficiary When one party to a contract intends to make
a gift to a third party, that third party is referred to as a donee
beneficiary.
Donor A person who makes a gift to another.
Double jeopardy A criminal defendant may be prosecuted only
once for a particular criminal offense.
Draft The drawer of this instrument orders someone else to pay
money. Checks are the most common form of draft. The drawer of a
check orders a bank to pay money.
Dram acts Make businesses liable for serving drinks to intoxicated
customers who later cause harm.
Drawee The person who pays a draft. In the case of a check, the
bank is the drawee.
Drawer The person who issues a draft.
Due diligence An investigation of the registration statement by
someone who signs it.
Due Process Clause Part of the Fifth Amendment. Procedural
due process ensures that before depriving anyone of liberty or
property, the government must go through procedures which ensure
that the deprivation is fair. Substantive due process holds that certain
rights, such as privacy, are so fundamental that the government may
not eliminate them.
Dumping Selling merchandise at one price in the domestic market
and at a cheaper, unfair price in an international market.
Durable power of attorney An instrument that permits an
attorney-in-fact to act for a principal. A durable power is effective
until the principal revokes it or dies. It continues in effect even if the
principal becomes incapacitated.
Duress (1) A criminal defense in which the defendant shows that
she committed the wrongful act because a third person threatened
her with imminent physical harm. (2) An improper threat made to
force another party to enter into a contract.
Duty A tax imposed on imported items.
Duty of care The requirement that a manager act with care and in
the best interests of the corporation.
Duty of loyalty The obligation of a manager to act without a
conflict of interest.
E
Easement The right to enter land belonging to another and make
a limited use of it, without taking anything away.
Economic loss doctrine A common-law rule holding that when
an injury is purely economic, and it arises from a contract made
between two businesses, the injured party may sue only under the
Universal Commercial Code (UCC).
Electronic funds Moneys that are moved between accounts by
means of a computer, an ATM, or a wire transfer.
Element A fact that a party to a lawsuit must prove in order to
prevail.
Embezzlement Fraudulent conversion of property already in the
defendant’s possession.
Eminent domain The power of the government to take private
property for public use.
Employee at will A worker whose job does not have a specified
duration.
Enabling legislation A statute authorizing the creation of a new
administrative agency and specifying its powers and duties.
Engagement letter A written contract by which a client hires an
accountant.
Entrapment A criminal defense in which the defendant demon-
strates that the government induced him to break the law.
Equal dignities rule If an agent is empowered to enter into a
contract that must be in writing, then the appointment of the agent
must also be written.
Equal Protection Clause Part of the Fourteenth Amendment, it
generally requires the government to treat equally situated people the
same.
Equity The broad powers of a court to fashion a remedy where
justice demands it and no common law remedy exists. An injunction
is an example of an equitable remedy.
G6 Glossary
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Error of law A mistake made by a trial judge that concerns a legal
issue as opposed to a factual matter. Permitting too many leading
questions is a legal error; choosing to believe one witness rather than
another is a factual matter.
Escalator clause A lease clause allowing the landlord to raise the
rent for specified reasons.
Estate The legal entity that holds title to assets after the owner
dies and before the property is distributed.
Estoppel Out of fairness, a person is denied the right to assert a
claim.
Ethics The study of how people ought to act.
Ethics decision Any choice that affects people or animals.
Euro The common currency of most EU countries.
Eviction An act that forces a tenant to abandon the property.
Evidence, rules of Law governing the proof offered during a trial
or formal hearing. These rules limit the questions that may be asked
of witnesses and the introduction of physical objects.
Exclusionary rule In a criminal trial, a ban on the use of evidence
obtained in violation of the Constitution.
Exclusive dealing contract A contract in which a distributor or
retailer agrees with a supplier not to carry the products of any other
supplier.
Exculpatory clause A contract provision that attempts to release
one party from liability in the event the other party is injured.
Executed contract A binding agreement in which all parties
have fulfilled all obligations.
Executive agency An administrative agency within the executive
branch of government.
Executive order An order by a president or governor, having the
full force of law.
Executor A person chosen by the decedent to oversee the probate
process.
Executory contract A binding agreement in which one or more
of the parties has not fulfilled its obligations.
Executrix A female executor.
Exhaustion of remedies A principle of administrative law that
no party may appeal an agency action to a court until she has utilized
all available appeals within the agency itself.
Expectation interest A remedy in a contract case that puts the
injured party in the position he would have been in had both sides
fully performed.
Expert witness A witness in a court case who has special training
or qualifications to discuss a specific issue, and who is generally
permitted to state an opinion.
Export To transport goods or services out of a country.
Express authority Conduct of a principal that, reasonably
interpreted, causes the agent to believe that the principal desires
him to do a specific act.
Express contract A binding agreement in which the parties
explicitly state all important terms.
Express warranty A guarantee, created by the words or actions
of the seller, that goods will meet certain standards.
Expropriation A government’s seizure of property or companies
owned by foreigners.
Extraterritoriality The power of one nation to impose its laws in
other countries.
F
Factfinder The one responsible, during a trial, for deciding what
occurred, that is, who did what to whom, when, how, and why. It is
either the jury or, in a jury-waived case, the judge.
Fair representation, duty of The union’s obligation to act on
behalf of all members impartially and in good faith.
Fair use doctrine Permits limited use of copyrighted material
without permission of the author.
False imprisonment The intentional restraint of another person
without reasonable cause and without her consent.
Federal question One of the two main types of civil cases that a
U.S. district court has the power to hear. It involves a federal statute
or a constitutional provision.
Federal Sentencing Guidelines Detailed rules that judges must
followwhen sentencing defendants convicted of crimes in federal court.
Federalism A form of national government in which power is
shared between one central authority and numerous local authorities.
Fee simple absolute The greatest possible ownership right in
real property, including the right to possess, use, and dispose of the
property in any lawful manner.
Fee simple defeasible Ownership interest in real property that
may terminate upon the occurrence of some limiting event.
Felony The most serious crimes, typically those for which the
defendant could be imprisoned for more than a year.
Fiduciary duty An obligation to behave in a trustworthy and
confidential fashion toward the object of that duty.
Fiduciary relationship A trustee acts for the benefit of the
beneficiary, always putting the interests of the beneficiary before his
own.
Glossary G7
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Financing statement A document that a secured party files to
give the general public notice that the secured party has a secured
interest in the collateral.
Finding statutes Laws that govern found property. Also known
as estray statutes.
Firm commitment underwriting The underwriter buys stock
from the issuer and sells it to the public.
Firm offer A contract offer that cannot be withdrawn during a
stated period.
Fixtures Goods that are attached to real estate.
Forced share The percentage of a decendent’s estate that a spouse
is entitled to claim under state law. Also known as statutory share.
Foreign corporation A corporation formed in another state.
Foreign Corrupt Practices Act A statute that illegalizes bribes
to foreign officials by U.S. individuals or businesses.
Foreign Sovereign Immunity Act (FSIA) A federal statute that
protects other nations from suit in courts of the United States,
except under specified circumstances.
Formal rulemaking The process whereby an administrative
agency notifies the public of a proposed new rule and then permits
a formal hearing, with opportunity for evidence and cross-
examination, before promulgating the final rule.
Founding Fathers The authors of the U.S. Constitution, who
participated in the Constitutional Convention in Philadelphia in 1787.
Framers See Founding Fathers.
Franchise An arrangement in which the franchisee buys from a
franchiser the right to establish a business using the franchiser’s
trade name and selling the franchiser’s products. Typically the
franchiser also trains the franchisee in the proper operation of the
business.
Fraud Deception of another person to obtain money or property.
Freedom of Information Act (FOIA) A federal statute giving
private citizens and corporations access to many of the documents
possessed by an administrative agency.
Freehold estate The present right to possess property and to use
it in any lawful manner.
Fresh start After the termination of a bankruptcy case, creditors
cannot make a claim against the debtor for money owed before the
initial bankruptcy petition was filed.
Frustration of purpose After the creation of a contract, an
entirely unforeseen event occurs that eliminates the value of the
contract for one of the parties.
Fully disclosed principal If the third party in an agency
relationship knows the identity of the principal, that principal is
fully disclosed.
Fundamental rights In constitutional law, those rights that are
so basic that any governmental interference with them is suspect and
likely to be unconstitutional.
G
GAAP Generally accepted accounting principles. Rules set by the
Financial Accounting Standards Board to be used in preparing
financial statements.
GAAS Generally accepted auditing standards. Rules set by the
American Institute of Certified Public Accountants (AICPA) to be
used in conducting audits.
Gap-filler provisions Uniform Commercial Code (UCC) rules
for supplying missing terms.
Gap period The period between the time that creditors file an
involuntary petition and the court issues the order for relief.
GATT See General Agreement on Tariffs and Trade.
General Agreement on Tariffs and Trade (GATT) A massive
international treaty, negotiated in stages between the 1940s and
1994 and signed by over 130 nations.
General deterrence See Deterrence.
General intangibles Potential sources of income such as copy-
rights, patents, trademarks, goodwill and certain other rights to
payment.
General intent The defendant intended to do the prohibited
physical action (the actus reus).
Gift A voluntary transfer of property from one person to another
without consideration.
Gift causa mortis A gift made in contemplation of approaching
death.
Go effective The securities registration is complete and the
company may begin the sale of its stock.
Goods Anything movable, except for money, securities, and certain
legal rights.
Grand jury A group of ordinary citizens that decides whether there is
probable cause the defendant committed the crime and should be tried.
Grantee The person who receives property, or some interest in it,
from the owner.
Grantor (1) An owner who conveys property, or some interest in
it. (2) Someone who creates a trust.
Gratuitous agent An agent who is not paid by the principal.
Gratuitous assignment An assignment made as a gift, for no
consideration.
G8 Glossary
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Greenmail If a company is threatened with a hostile takeover, its
board of directors may offer to buy the stock of the attacker at an
above-market price with the hope that the attacker will take her
profits and leave the company alone.
Grievance A formal complaint alleging a contract violation.
Guilty A court’s finding that a defendant has committed a crime.
H
Hacking Gaining unauthorized access to a computer system.
Harmless error A ruling made by a trial court which an appeals
court determines was legally wrong but not fatal to the decision.
Heir Someone who inherits from a decedent who died intestate
(that is, without a will).
Holder For order paper, anyone in possession of the instrument if
it is payable to or indorsed to her. For bearer paper, anyone in
possession.
Holder in due course Someone who has given value for an
instrument, in good faith, without notice of outstanding claims or
other defenses.
Holographic will A handwritten will that has not been witnessed.
Horizontal agreement or merger An agreement or merger
between two potential competitors.
Hostile takeover An outsider buys a company in the face of
opposition from the target company’s board of directors.
Hybrid rulemaking A method of administrative agency procedure
incorporating some elements of formal and some elements of
informal rulemaking, typically involving a limited public hearing
with restricted rights of testimony and cross-examination.
I
Identify In sales law, to designate the specific goods that are the
subject of a contract.
IFRS “International Financial Reporting Standards” is a new set of
international standard accounting rules, used by over 100 countries,
currently being proposed for U.S. companies to follow.
Illegal contract An agreement that is void because it violates a
statute or public policy.
Illusory promise An apparent promise that is unenforceable
because the promisor makes no firm commitment.
Implied authority When a principal directs an agent to
undertake a transaction, the agent has the right to do acts that
are incidental to it, usually accompany it, or are reasonably
necessary to accomplish it.
Implied contract A binding agreement created not by explicit
language but by the informal words and conduct of the parties.
Implied warranty Guarantees created by the Uniform Commer-
cial Code and imposed on the seller of goods.
Implied warranty of fitness for a particular purpose If the
seller knows that the buyer plans to use the goods for a particular
purpose, the seller generally is held to warrant that the goods are in
fact fit for that purpose.
Implied warranty of habitability A landlord must meet all
standards set by the local building code, or otherwise ensure that the
premises are fit for human habitation.
Implied warranty of merchantability Requires that goods
must be of at least average, passable quality in the trade.
Import To transport goods or services into a country.
Import ban A prohibition of certain goods.
In camera “In the judge’s chambers,” meaning that the judge does
something out of view of the jury and the public.
In camera inspection A judge’s private review of evidence to
determine whether it should be provided to the opposing party.
Incidental beneficiary Someone who might have benefited from
a contract between two others but has no right to enforce that
agreement.
Incidental damages The relatively minor costs, such as storage
and advertising, that the injured party suffered when responding to a
contract breach.
Incorporator The person who signs a corporate charter.
Indemnification A promise to pay someone else’s obligations.
Independent agency An administrative agency outside the
executive branch of government, such as the Interstate Commerce
Commission.
Independent contractor Someone who undertakes tasks for
others and whose work is not closely controlled.
Indictment The government’s formal charge that a defendant has
committed a crime.
Indorser Anyone, other than the issuer or acceptor, who signs an
instrument.
Indorsement The signature of a payee.
Infliction of emotional distress A tort. It can be the intentional
infliction of emotional distress, meaning that the defendant behaved
outrageously and deliberately caused the plaintiff severe psycholo-
gical injury, or it can be the negligent infliction of emotional distress,
meaning that the defendant’s conduct violated the rules of
negligence.
Glossary G9
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Informal rulemaking The process whereby an administrative
agency notifies the public of a proposed new rule and permits
comment but is then free to promulgate the final rule without a
public hearing.
Initial public offering (IPO) A company’s first public sale of
securities.
Injunction A court order that a person either do or stop doing
something.
Inside directors Members of the board of directors who are also
officers of the corporation.
Insider Family members of an individual debtor, officers and
directors of a corporation, or partners of a partnership.
Instructions or charge The explanation given by a judge to a
jury, outlining the jury’s task in deciding a lawsuit and the
underlying rules of law the jury should use in reaching its decision.
Instruments Drafts, checks, certificates of deposit and notes.
Insurable interest A person has an insurable interest if she
would be harmed by the danger that she has insured against.
Insured A person whose loss is the subject of an insurance policy.
Insurer The person who issues an insurance policy.
Integrated contract A writing that the parties intend as the
complete and final expression of their agreement.
Intended beneficiary Someone who may enforce a contract made
between two other parties.
Intentional infliction of emotional distress Results from
extreme and outrageous conduct that causes serious emotional
harm.
Intentional tort An act deliberately performed that violates a
legally imposed duty and injures someone.
Inter vivos gift A gift made “during life,” that is, when the donor
is not under any fear of impending death.
Inter vivos trust A trust established while the grantor is still
living.
Interest A legal right in something, such as ownership or a
mortgage or a tenancy.
Interference with a contract See Tortious interference with a
contract.
Interference with a prospective advantage See Tortious
interference with a prospective advantage.
International comity Requires one court to reject a lawsuit that
would more logically be resolved in another nation.
Internet An international computer network that connects smaller
groups of linked computer networks.
Interpretive rules A formal statement by an administrative
agency expressing its view of what existing statutes or regulations
mean.
Interrogatory A form of discovery in which one party sends to an
opposing party written questions that must be answered under oath.
Intestate Without a will.
Intrusion A tort if a reasonable person would find the invasion of
her private life offensive.
Inventory Goods that the seller is holding for sale or lease in the
ordinary course of its business.
Involuntary bailment A bailment that occurs without an
agreement between the bailor and bailee.
Invitee Someone who has the right to be on property, such as a
customer in a shop.
Issue All direct descendants such as children, grandchildren, and so
on.
Issuer The maker of a promissory note or the drawer of a draft.
J
Joint and several liability All members of a group are liable.
They can be sued as a group, or any one of them can be sued
individually for the full amount owing.
Joint liability All members of a group are liable and must be sued
together.
Joint tenancy Two or more people holding equal interest in a
property, with the right of survivorship.
Joint venture A partnership for a limited purpose.
Judgment non obstante veredicto (JNOV) “Judgment not-
withstanding the verdict.” A trial judge overturns the verdict of the
jury and enters a judgment in favor of the opposing party.
Judgment rate The interest rate that courts use on court-ordered
judgments.
Judicial activism The willingness shown by certain courts (and
not by others) to decide issues of public policy, such as constitutional
questions (free speech, equal protection, etc.) and matters of contract
fairness (promissory estoppel, unconscionability, etc.).
Judicial restraint A court’s preference to abstain from adjudicating
major social issues and to leave such matters to legislatures.
Judicial review The power of the judicial system to examine,
interpret, and even nullify actions taken by another branch of
government.
Jurisdiction The power of a court to hear a particular dispute, civil
or criminal, and to make a binding decision.
G10 Glossary
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Jurisprudence The study of the purposes and philosophies of the
law, as opposed to particular provisions of the law.
Justification A criminal defense in which the defendant estab-
lishes that he broke the law to avoid a greater harm.
K
Kantian evasion or palter A truthful statement that is none-
theless misleading.
Kant’s categorical imperative An act is only ethical if it would
be acceptable for everyone to do the same thing.
L
Labor-Management Relations Act Designed to curb union
abuses.
Landlord The owner of a freehold estate who allows another
person to live on his property temporarily.
Larceny Taking personal property with the intention of preventing
the owner from ever using it.
Law merchant The body of rules and customs developed by
traders and businesspersons throughout Europe from roughly the
fifteenth to the eighteenth century.
Lease A contract creating a landlord-tenant relationship.
Legal positivism The legal philosophy holding that law is what
the sovereign says it is, regardless of its moral content.
Legal realism The legal philosophy holding that what really
influences law is who makes and enforces it, not what is put in
writing.
Legal remedy Generally, money damages. It is distinguished from
equitable remedy, which includes injunctions and other nonmone-
tary relief.
Legislative history Used by courts to interpret the meaning of a
statute, this is the record of hearings, speeches, and explanations that
accompanied a statute as it made its way from newly proposed bill to
final law.
Legislative rules Regulations issued by an administrative agency.
Letter of credit A commercial device used to guarantee payment
in international trade, usually between parties that have not
previously worked together.
Letter of intent A letter that summarizes negotiating progress.
Liability insurance Reimburses the insured for any liability she
incurs by accidentally harming someone else.
Libel The act of injuring someone’s reputation by stating (in
writing or by broadcast) something false about her to a third
person.
License To grant permission to another person (1) to make or sell
something or (2) to enter on property.
Licensee A person who is on the property of another for her own
purposes, but with the owner’s permission. A social guest is a typical
licensee.
Lien A security interest created by rule of law, often based on labor
that the secured party has expended on the collateral.
Life estate An ownership interest in real property entitling the
holder to use the property during his lifetime, but which terminates
upon his death.
Life insurance Provides for payments to a beneficiary upon the
death of the insured.
Life-prospects The opportunities one has at birth, based on one’s
natural attributes and initial place in society.
Life tenant A person who has the use of a property during his
lifetime only.
Limited liability company An organization that has the limited
liability of a corporation but is not a taxable entity.
Limited liability limited partnership In a limited liability
limited partnership, the general partner is not personally liable for
the debts of the partnership.
Limited partnership A partnership with two types of partners:
(1) limited partners who have no personal liability for the debts of
the enterprise nor any right to manage the business, and (2) general
partners who are responsible for management and personally liable
for all debts.
Liquidated damages clause A contract clause specifying how
much a party must pay upon breach.
Liquidated debt The amount of the indebtedness is not in
dispute.
Litigation The process of resolving disputes through formal court
proceedings.
Litigator A lawyer who handles court cases.
Living trust A trust established while the grantor is alive. See inter
vivos trust.
Living will An instrument that permits adults to refuse medical
treatment. It can also appoint a health care proxy to make medical
decisions for a person who has become incompetent.
Local A regional union that represents workers at a particular
company.
Glossary G11
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Lockout A management tactic, designed to gain a bargaining
advantage, in which the company refuses to allow union members to
work (and hence deprives them of their pay).
M
Mailbox rule A contract doctrine holding that acceptance is
effective upon dispatch, that is, when it is mailed or otherwise taken
out of the control of the offeree.
Maker The issuer of a promissory note.
Marital trust A legal entity created for the purpose of reducing a
married couple’s estate taxes.
Material Important or significant. Information that would affect a
person’s decision if he knew it.
Mechanic’s lien A security created when a worker improves real
property.
Mediation The process of using a neutral person to aid in the
settlement of a legal dispute. A mediator’s decision is non-
binding.
Meeting of the minds The parties understood each other and
intended to reach an agreement.
Memorandum A document detailing the arguments in support of
a motion.
Mens rea Guilty state of mind.
Merchant Someone who routinely deals in the particular goods
involved, or who appears to have special knowledge or skill in those
goods, or who uses agents with special knowledge or skill in those
goods.
Merchantable The goods are fit for the ordinary purposes for
which they are used.
Merger An acquisition of one company by another.
Midnight deadline A rule that each bank in the collection process
must pass a check along before midnight of the next banking day
after it receives the check.
Minor A person under the age of 18.
Minority shareholders Shareholders who do not own enough
stock to control their corporation.
Minute book Records of shareholder meetings and directors’
meetings are kept in the corporation’s minute book.
Mirror image rule A contract doctrine that requires acceptance to
be on exactly the same terms as the offer.
Misdemeanor A less serious crime, typically one for which the
maximum penalty is incarceration for less than a year, often in a jail,
as opposed to a prison.
Misrepresentation A factually incorrect statement made during
contract negotiations.
Mitigation One party acts to minimize its losses when the other
party breaches a contract.
Modify An appellate court issues an order changing a lower court
ruling.
Money laundering Taking the profits of criminal acts and either
(1) using the money to promote more crime or (2) attempting to
conceal the money’s source.
Monopolization A company acquires or maintains a monopoly
through the commission of unacceptably aggressive acts. A violation
of Section 2 of the Sherman Act.
Mortgage A security interest in real property.
Mortgagee A creditor who obtains a security interest in real
property, typically in exchange for money given to the mortgagor to
buy the property.
Mortgagor A debtor who gives a mortgage (security interest) in
real property to a creditor, typically in exchange for money used to
buy the property.
Motion A formal request that a court take some specified step during
litigation.Amotion to compel discovery is a request that a trial judge order
the other party to respond to discovery.
Motion for a protective order A request that the court limit
discovery.
Motion to suppress A request that the court exclude evidence
because it was obtained in violation of the Constitution.
Multinational enterprise A corporation that is doing business
in more than one country simultaneously.
N
NAFTA See North American Free Trade Agreement (NAFTA).
National Labor Relations Act (NLRA) Ensures the right of
workers to form unions and encourages management and unions to
bargain collectively.
National Labor Relations Board (NLRB) The administrative
agency charged with overseeing labor law.
Nationalization A government’s seizure of property or companies.
Natural law The theory that an unjust law is no law at all, and
that a rule is only legitimate if based on an immutable morality.
Negative or dormant aspect of the Commerce Clause The
doctrine that prohibits a state from any action that interferes with or
discriminates against interstate commerce.
Negligence and strict liability Injuries caused by neglect and
oversight rather than by deliberate conduct.
G12 Glossary
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Negligence per se Violation of a standard of care set by statute.
Driving while intoxicated is illegal; thus, if a drunk driver injures a
pedestrian, he has committed negligence per se.
Negotiable bill of lading A document of title that describes the
goods received by the common carrier.
Negotiable instrument A type of commercial paper that is freely
transferable.
Negotiation The transfer of an instrument. To be negotiated,
order paper must be indorsed and then delivered to the transferee.
For bearer paper, no indorsement is required—it must simply be
delivered to the transferee.
No-strike clause A clause in a CBA that prohibits the union
from striking while the CBA is in force.
Nominal damages A token sum, such as one dollar, given to a
plaintiff who demonstrates that the defendant breached the contract
but cannot prove serious injury.
Noncompetition agreement A contract in which one party
agrees not to compete with another in a stated type of business.
Nonconforming goods Merchandise that differs from that
specified in the contract.
Non-point source When pollutants are released simultaneously
from more than one source.
Norris-LaGuardia Act Prohibits federal court injunctions in
peaceful labor disputes.
North American Free Trade Agreement A commercial
association among Canada, the United States, and Mexico designed
to eliminate almost all trade barriers.
Note An unconditional, written promise that the maker of the
instrument will pay a specific amount of money on demand or at a
definite time. When issued by a corporation, a note refers to short-
term debt, typically payable within five years.
Notice to quit A landlord’s notice terminating a tenancy.
Novation A three-way agreement in which the obligor transfers all
rights and duties to a third party.
Nuisance An unprivileged interference with a person’s use and
enjoyment of property.
Nuncupative will An oral will.
O
Obligee The party to a contract who is entitled to receive
performance from the other party.
Obligor The party to a contract who is required to do something
for the benefit of the other party.
Obscenity Constitutional law doctrine holding that some works
will receive no First Amendment protection because a court
determines they depict sexual matters in an offensive way.
Offer In contract law, an act or statement that proposes definite terms
and permits the other party to create a contract by accepting those
terms.
Offeree The party in contract negotiations who receives the first
offer.
Offeror The party in contract negotiations who makes the first
offer.
Open-end credit A lender makes a series of loans that the
consumer can repay at once or in installments.
Opinion Because it cannot be proven right or wrong, an opinion is
generally a valid defense in defamation cases.
Oppression One party uses its superior power to force a contract
on the weaker party.
Order for relief An official acknowledgment that a debtor is
under the jurisdiction of the bankruptcy court.
Order paper An instrument that includes the words “pay to the
order of ” or their equivalent.
Output contract An agreement that obligates the seller of goods
to sell everything he produces during a stated period to a particular
buyer.
Outside directors Members of the board of directors who are not
employees of the corporation. Also known as independent directors.
Override The power of Congress or a state legislature to pass
legislation despite a veto by a president or governor. A congressional
override requires a two-thirds vote in each house.
P
Parol evidence Written or oral evidence, outside the language of a
contract, offered by one party to clarify interpretation of the
agreement.
Parol evidence rule In the case of an integrated contract, neither
party may use evidence outside the writing to contradict, vary, or add
to its terms.
Part performance An exception to the statute of frauds
permitting a buyer of real estate to enforce an oral contract if she
paid part of the price, entered the property, and made improve-
ments, with the owner’s knowledge.
Partially disclosed principal If the third party in an agency
relationship knows that the agent is acting for a principal, but does
not know the identity of the principal, that principal is partially
disclosed.
Glossary G13
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Partnership An association of two or more persons to carry on as
co-owners of a business for profit.
Partnership at will A partnership that has no fixed duration. A
partner has the right to resign from the partnership at any time.
Partnership by estoppel If a person who is not a partner implies
that he is a partner or does not object when other people imply it, he
is liable as if he really were a partner.
Patent The right to the exclusive use of an invention for 20 years.
Payable on demand The holder of an instrument is entitled to be
paid whenever she asks.
Payee Someone who is owed money under the terms of an
instrument.
Payment order A transfer money from the issuer’s account into
the payee’s.
Per se An automatic breach of antitrust laws.
Per se violation of an antitrust law An automatic breach.
Courts will generally not consider mitigating factors.
Peremptory challenge During voir dire, a request by one
attorney that a prospective juror be excused for an unstated reason.
Perfect tender rule A rule permitting the buyer to reject goods if
they fail in any respect to conform to the contract.
Perfection A series of steps a secured party must take to protect its
rights in collateral against people other than the debtor.
Periodic tenancy A lease for a fixed period, automatically
renewable unless terminated.
Period for years A lease for a fixed period, automatically
renewable unless terminated.
Perpetual trust A trust that lasts forever. Also known as a
dynasty trust.
Personal property All property other than real property.
Personally identifiable information (PII) Data that identifies a
user of a Web site, such as name and address.
Personal satisfaction contracts Permits the promisee to
make a subjective evaluation of the promisor’s performance.
Pierce the corporate veil When the court holds shareholders
personally liable for the debts of the corporation.
Plain meaning rule In statutory interpretation, the premise that
words with an ordinary, everyday significance will be so interpreted,
unless there is some apparent reason not to.
Plaintiff The person who is suing.
Plea bargain An agreement in which the defendant pleads guilty
to a reduced charge and the prosecution recommends to the judge a
relatively lenient sentence.
Pleadings The documents that begin a lawsuit: the complaint, the
answer, the counter-claim, and the reply.
Pledge A secured transaction in which a debtor gives collateral to
the secured party.
Point source A single producer of pollution.
Political speech Protected unless it is intended and likely to
create imminent lawless action.
Positive aspect of the Commerce Clause The power granted
to Congress to regulate commerce between the states.
Precedent An earlier case that decided the same legal issue as that
presently in dispute, and which therefore will control the outcome of
the current case.
Predatory pricing A violation of Section 2 of the Sherman Act in
which a company lowers its prices below cost to drive competitors
out of business.
Preemption The doctrine, based on the Supremacy Clause, by
which any federal statute takes priority whenever (1) a state statute
conflicts or (2) there is no conflict but Congress indicated an
intention to control the issue involved.
Preference When a debtor unfairly pays creditors immediately
before filing a bankruptcy petition.
Preferred stock Owners of preferred stock have a right to receive
dividends and liquidation proceeds of the company before common
shareholders.
Preponderance of the evidence The level of proof that a
plaintiff must meet to prevail in a civil lawsuit. It means that the
plaintiff must offer evidence that, in sum, is slightly more persuasive
than the defendant’s evidence.
Presentment A holder of an instrument makes a demand for
payment.
Pretermitted child A child omitted from a parent’s will.
Prima facie “At first sight.” A fact or conclusion that is presumed
to be true unless someone presents evidence to disprove it.
Principal In an agency relationship, the principal is the person for
whom the agent is acting.
Privacy Act A federal statute prohibiting federal agencies from
divulging to other agencies or organizations information about private
citizens.
Private offering A sale of securities that, under the 1933 Act, is
not considered a public offering because of the limited number of
investors or the small amount of money raised.
Privity The relationship that exists between two parties who make
a contract, as opposed to a third party who, though affected by the
contract, is not a party to it.
G14 Glossary
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Probable cause In a search and seizure case, it means that the
information available indicates that it is more likely than not that a
search will uncover particular criminal evidence.
Probate The process of carrying out the terms of a will.
Procedural due process See Due Process Clause.
Procedural law The rules establishing how the legal system itself
is to operate in a particular kind of case.
Proceeds Anything that a debtor obtains from the sale or
disposition of collateral. Normally, the term proceeds refers to cash
obtained from the sale of the secured property.
Production of documents and things A form of discovery in
which one party demands that the other furnish original
documents or physical things, relating to the suit, for inspection
and copying.
Product liability The potential responsibility that a manufacturer
or seller has for injuries caused by defective goods.
Professional corporation A form of organization that permits
professionals (such as doctors, lawyers, and accountants) to
incorporate. Shareholders are not personally liable for the torts of
other shareholders, or for the contract debts of the organization.
Profit The right to enter land belonging to another and take
something away, such as minerals or timber.
Promisee The person to whom a promise is made.
Promisor A person who makes a promise.
Promissory estoppel A doctrine in which a court may enforce a
promise made by the defendant even when there is no contract, if
the defendant knew that the plaintiff was likely to rely on the
promise, the plaintiff did in fact rely, and enforcement of it is the
only way to avoid injustice.
Promissory note The maker of the instrument promises to pay a
specific amount of money.
Promoter The person who creates a corporation by raising capital
and undertaking the legal steps necessary for formation.
Promulgate To issue a new rule.
Proof of claim A form stating the name of an unsecured creditor
and the amount of the claim against the debtor.
Property insurance Covers physical damage to real estate,
personal property, or inventory from causes such as fire, smoke,
lightning, wind, riot, vandalism, or theft.
Prosecution The government’s attempt to convict a defendant of
a crime by charging him, trying the case, and forcing him to defend
himself.
Prospectus Under the Securities Act of 1933, an issuer must
provide this document to anyone who purchases a security in a
public transaction. The prospectus contains detailed information
about the issuer and its business, a description of the stock, and
audited financial statements.
Protective order A court order limiting one party’s discovery.
Provisional patent application A simpler, shorter filing that
provides protection for an invention for one year.
Proxy (1) A person whom the shareholder designates to vote in his
place. (2) The written form (typically a card) that the shareholder
uses to appoint a designated voter.
Proxy statement When a public company seeks proxy votes
from its shareholders, it must include a proxy statement. This
statement contains information about the company, such as a
detailed description of management compensation.
Publicly traded corporation A company that (1) has completed
a public offering under the Securities Act of 1933, or (2) has
securities traded on a national exchange, or (3) has 500 shareholders
and $10 million in assets.
Punitive damages Money awarded at trial not to compensate the
plaintiff for harm but to punish the defendant for conduct that the
factfinder considers extreme and outrageous.
Purchase money security interest (PMSI) A security interest
taken by the person who sells the collateral to the debtor, or by a person
who advances money so that the debtor may buy the collateral.
Purchaser representative Someone who has enough knowl-
edge and experience in financial matters to evaluate the merits and
risks of an investment.
Q
Qualified privilege When providing a reference about a former
employee, an employer is liable for false statements only if he knows them
to be false or if he is primarily motivated by ill will between two people
who have a legitimate need to exchange information.
Qualifying to do business Registering a corporation in a state in
which it is not organized but in which it has an ongoing presence.
Quantum meruit “As much as she deserves.” The damages
awarded in a quasi-contract case.
Quasi-contract A legal fiction in which, to avoid injustice, the
court awards damages as if a contract had existed, although one
did not.
Quid pro quo A Latin phrase meaning “this for that.” It refers to a
form of sexual harassment in which some aspect of a job is made
contingent upon sexual activity.
Quiet enjoyment A tenant’s right to use property without the
interference of the landlord.
Quota A limit on the quantity of a particular good that may enter a
nation.
Glossary G15
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Quorum The number of voters that must be present for a meeting
to count.
R
Racketeer Influenced and Corrupt Organizations Act
(RICO) A powerful federal statute, originally aimed at organized
crime, now used in many criminal prosecutions and civil lawsuits.
Racketeering acts Any of a long list of specified crimes, such as
embezzlement, arson, mail fraud, wire fraud, and so forth.
Ratification When someone accepts the benefit of an unauthor-
ized transaction or fails to repudiate it once he has learned of it, he is
then bound by it.
Reaffirm To promise to pay a debt even after it is discharged.
Real property Land, together with certain things associated
with it, such as buildings, subsurface rights, air rights, plant life
and fixtures.
Reasonable doubt The level of proof that the government must
meet to convict the defendant in a criminal case. The factfinder must
be persuaded to a very high degree of certainty that the defendant
did what the government alleges.
Reciprocal dealing agreement An agreement under which
Company A will purchase from Company B only if Company B also
buys from Company A. These agreements are rule of reason
violations of the Sherman Act.
Record Information written on paper or stored in an electronic or
other medium.
Record date To vote at a shareholders meeting, a shareholder
must own stock on the record date.
Red herring A preliminary prospectus.
Redeem To pay the full value of a debt to get the collateral back.
Reformation The process by which a court rewrites a contract to
ensure its accuracy or viability.
Refusal to deal An agreement among competitors that they will
not trade with a particular supplier or buyer. Such an agreement is a
rule of reason violation of the Sherman Act.
Registration statement A document filed with the Securities
and Exchange Commission under the Securities Act of 1933 by an
issuer seeking to sell securities in a public transaction.
Regulation D The most common and important type of private
offering.
Reliance interest A remedy in a contract case that puts the
injured party in the position he would have been in had the parties
never entered into a contract.
Remand The power of an appellate court to return a case to a lower
court for additional action.
Rent Compensation paid by a tenant to a landlord.
Repatriation of profits The act of bringing profits earned in a
foreign country back to a company’s home country.
Reply A pleading, filed by the plaintiff in response to a defendant’s
counter-claim.
Repossession A secured party takes collateral because the debtor
has defaulted on payments.
Repudiation An indication made by one contracting party to the
other that it will not perform.
Request for admission A form of discovery in which one party
demands that the opposing party either admit or deny particular
factual or legal allegations.
Requirements contract An agreement that obligates a buyer of
specified goods to purchase all of the goods she needs during a stated
period from a particular seller.
Res ipsa loquitur A doctrine of tort law holding that the facts
may imply negligence when the defendant had exclusive control of
the thing that caused the harm, the accident would not normally
have occurred without negligence, and the plaintiff played no role in
causing the injury.
Resale price maintenance A per se violation of the Sherman
Act in which a manufacturer enters into an agreement with retailers
about the prices they will charge.
Rescind To cancel a contract.
Rescission To “undo” a contract and put the parties where they
were before they made their agreement.
Respondeat superior A rule of agency law holding that a
principal is liable when a servant acting within the scope of
employment commits a tort that causes physical harm to a person or
property.
Restitution Restoring an injured party to its original position.
Restitution interest A remedy in a contract case that returns to
the injured party a benefit that he has conferred on the other party,
which would be unjust to leave with that person.
Restricted security Any stock purchased in a private offering
(such as one under Regulation D).
Restricted stock Securities purchased strictly for investment
purposes.
Retribution Giving a criminal defendant the punishment he
deserves.
Reverse An appellate court issues an order overruling a lower court and
granting judgment for the party that had lost in the lower court.
G16 Glossary
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Reverse and remand To nullify the lower decision and return
the case for reconsideration or retrial.
Reversion The right of an owner (or her heirs) to property upon
the death of a life tenant.
Revocable trust A trust that can be undone or changed at any
time.
Revocation The act of disavowing a contract offer, so that the
offeree no longer has the power to accept.
Rule of reason violation An action that breaches the antitrust
laws only if it has an anticompetitive impact.
Rulemaking The power of an administrative agency to issue
regulations.
S
S corporation A corporation that is not a taxable entity.
Sale on approval A transfer in which a buyer takes goods
intending to use them herself, but has the right to return the goods
to the seller.
Sale or return A transfer in which the buyer takes the goods
intending to resell them, but has the right to return the goods to the
original owner.
Scienter In a case of securities fraud, the plaintiff must prove that
the defendant acted willfully, knowingly, or recklessly.
Secondary boycott Picketing, directed by a union against a
company, designed to force that company to stop doing business
with the union’s employer.
Secondary offering Any public sale of securities by a company
after the initial public offering.
Secured party A person or company that holds a security
interest.
Security Any purchase in which the buyer invests money in a
common enterprise and expects to earn a profit predominantly from
the efforts of others.
Security agreement A contract in which the debtor gives a
security interest to the secured party.
Security interest An interest in personal property or fixtures that
secures the performance of some obligation.
Separation of powers The principle, established by the first
three articles of the Constitution, that authority should be divided
among the legislative, executive, and judicial branches.
Series Sub-categories of stock.
Servant An agent whose work is closely controlled by the
principal.
Service mark A type of trademark used to identify services, not
products.
Settlor Someone who creates a trust.
Sexual harassment Unwanted sexual advances, comments or
touching, sufficiently severe to violate Title VII of the 1964 Civil
Rights Act.
Shilling A seller at auction either bids on his own goods or agrees
to cross-bid with a group of other sellers.
Short-swing trading Under Section 16 of the Securities
Exchange Act, insiders must turn over to the corporation any
profits they make from the purchase and sale or sale and purchase of
company securities in a six-month period.
Signatory A person, company, or nation that has signed a legal
document, such as a contract, agreement, or treaty.
Signature liability The liability of someone who signs an
instrument.
Sight draft An order directing someone else to pay money on
demand.
Single recovery principle A rule of tort litigation that requires a
plaintiff to claim all damages, present and future, at the time of trial,
not afterwards.
Sit-down strike Union members stop working but remain at their
job posts, physically blocking replacement workers from taking their
places.
Slander See Defamation.
Sole proprietorship An unincorporated business owned by a
single person.
Sovereign The recognized political power, whom citizens obey.
Sovereign immunity The right of a national government to be
free of lawsuits brought in foreign courts.
Spam Unsolicited commercial or bulk e-mail. (“To spam” is to
send such e-mail.)
Specific deterrence See Deterrence.
Specific performance A contract remedy requiring the breach-
ing party to perform the contract, by conveying land or some unique
asset, rather than by paying money damages.
Spyware A computer program that enters a user’s computer
without permission and monitors and reports the user’s activities.
Stakeholder Anyone who is affected by the activities of a
corporation, such as employees, customers, creditors, suppliers,
shareholders, and neighbors.
Stale check A check presented more than six months after its due
date.
Glossary G17
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Stare decisis “Let the decision stand.” A basic principle of the
common law, it means that precedent is usually binding.
Statute A law passed by a legislative body, such as Congress.
Statute of frauds This law provides that certain contracts are not
enforceable unless in writing.
Statute of limitations A statute that determines the period
within which a particular kind of lawsuit must be filed.
Statute of repose A law that places an absolute limit on when
a lawsuit may be filed, regardless of when the defect was
discovered.
Statutory interpretation A court’s power to give meaning to
new legislation by clarifying ambiguities, providing limits, and
ultimately applying it to a specific fact pattern in litigation.
Straight bankruptcy Also known as liquidation, this form of
bankruptcy mandates that the bankrupt’s assets be sold to pay creditors
but the creditor has no obligation to share future earnings.
Strict liability A tort doctrine holding to a very high standard all
those who engage in ultrahazardous activity (e.g., using explosives)
or who manufacture certain products.
Strict performance Requires one party to perform its obliga-
tions precisely, with no deviation from the contract terms.
Strike The ultimate weapon of a labor union, it occurs when all or
most employees of a particular plant or employer walk off the job
and refuse to work.
Strike suit A lawsuit without merit that defendants sometimes
settle simply to avoid the nuisance of litigation.
Sublease A tenant’s transfer of some of his legal interest in a
property.
Subpoena An order to appear, issued by a court or government
body.
Subpoena duces tecum An order to produce certain documents
or things before a court or government body.
Subprime loan A loan that has an above-market interest rate
because the borrower is high-risk.
Subrogated to The bank can substitute for, or take the place of, a
party.
Substantial performance The promisor performs contract
duties well enough to be entitled to his full contract price, minus
the value of any defects.
Substantive due process See Due Process Clause.
Substantive law Rules that establish the rights of parties. For
example, the prohibition against slander is substantive law, as
opposed to procedural law.
Substitute check A paper printout of the electronic version of a
check, which is legally the same as the original.
Summary judgment Thepower of a trial court to terminate a lawsuit
before a trial has begun, on the grounds that no essential facts are in
dispute.
Supermajority voting Typically, shareholders can approve
charter amendments by a majority vote. However, sometimes
corporations require more than a majority of shareholders (e.g.,
80 percent) to approve certain charter amendments, such as a
merger. These provisions are designed to discourage hostile
takeovers.
Superseding cause An event that interrupts the chain of
causation and relieves a defendant from liability based on her own
act.
Supremacy Clause From Article VI of the Constitution, it
declares that federal statutes and treaties take priority over any state
law, if there is a conflict between the two or, even absent a conflict, if
Congress manifests an intent to preempt the field.
Surplus A sum of money greater than the debt incurred.
T
Takings Clause Part of the Fifth Amendment, it ensures that
when any governmental unit takes private property for public use, it
must compensate the owner.
Tariff A duty imposed on imported goods by the government of
the importing nation.
Tenancy at sufferance A tenancy that exists without the
permission of the landlord, after the expiration of a true tenancy.
Tenancy at will A tenancy with no fixed duration, which may be
terminated by either party at any time.
Tenancy by the entirety A form of joint ownership available
only to married couples. If one member of the couple dies, the
property goes automatically to the survivor. Creditors cannot attach
the property, nor can one owner sell the property without the
other’s permission.
Tenancy for years A lease for a stated, fixed period.
Tenancy in common Two or more people holding equal interest
in a property, but with no right of survivorship.
Tenant A person given temporary possession of the landlord’s
property.
Tender To make conforming goods available to the buyer.
Tender offer A public offer to buy a block of stock directly from
shareholders.
G18 Glossary
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Term partnership When the partners agree in advance on the
duration of a partnership.
Termination statement A document indicating that a secured
party no longer claims a security interest in the collateral.
Testamentary trust A trust created by the grantor’s will.
Testator Someone who dies having executed a will.
Testatrix A female testator.
Third party beneficiary Someone who stands to benefit from a
contract to which she is not a party. An intended beneficiary may
enforce such a contract; an incidental beneficiary may not.
Three-Fifths Clause A clause in Article 1, section 2 of the
United States Constitution, now void and regarded as racist, which
required that for purposes of taxation and representation, a slave
should be counted as three-fifths of a person.
Tied product In a tying arrangement, the product that a buyer
must purchase as the condition for being allowed to buy another
product.
Time draft An order directing someone else to pay money in the
future.
Time of the essence clause A clause that generally makes
contract dates strictly enforceable.
Tort A civil wrong, committed in violation of a duty that the law
imposes.
Tortious interference with a contract A tort in which the
defendant deliberately impedes an existing contract between the
plaintiff and another entity.
Tortious interference with a prospective advantage A tort
in which the defendant deliberately obstructs a developing venture or
advantage that the plaintiff has created.
Tracing When an auditor takes an item of original data and tracks
it forward to ensure that it has been properly recorded throughout
the bookkeeping process.
Trade acceptance A draft drawn by a seller of goods on the
buyer and payable to the seller or some third party.
Trade secret A formula, device, process, method, or compilation
of information that, when used in business, gives the owner an
advantage over competitors who do not know it.
Trademark Any combination of words and symbols that a
business uses to identify its products or services and that federal
law will protect.
Treasury stock Stock that has been bought back by its issuing
corporation.
Trespass A tort committed by intentionally entering land that
belongs to someone else, or remaining on the land after being asked
to leave.
Trespasser Anyone on a property without consent.
Trial court Any court in a state or federal system that holds
formal hearings to determine the facts in a civil or criminal
case.
Trust An entity that separates legal and beneficial ownership.
Tying a product In a tying arrangement, the product offered for
sale on the condition that another product be purchased as well.
Tying arrangement A violation of the Sherman and Clayton
Acts in which a seller requires that two distinct products be
purchased together. The seller uses its significant power in the
market for the tying product to shut out a substantial part of the
market for the tied product.
U
Ultra vires An activity that is not permitted by a corporation’s
charter.
Ultrahazardous activity Conduct that is lawful yet unusual and
much more likely to cause injury than normal commercial activity.
Unconscionable contract An agreement that a court refuses to
enforce because it is fundamentally unfair as a result of unequal
bargaining power by one party.
Undisclosed principal If a third party in an agency relationship
does not know that the agent is acting for a principal, that principal
is undisclosed.
Undue influence One party so dominates the thinking of another
party to a contract that the dominant party cannot truly consent to
the agreement.
Unenforceable agreement An agreement that a court will not
enforce.
Unfair labor practice An act, committed by either a union or an
employer, that violates the National Labor Relations Act, such as
failing to bargain in good faith.
Unilateral contract A binding agreement in which one party has
made an offer that the other can accept only by action, not words.
Unilateral mistake Occurs when only one party enters a contract
under a mistaken assumption.
Unliquidated debt A claimed debt that is disputed, either because
the parties disagree over whether there is in fact a debt or because
they disagree over the amount.
U.S. Trustee, The Oversees the administration of bankruptcy law
in a region.
Usury Charging interest at a rate that exceeds legal limits.
Utter To pass on an instrument that one knows to be forged.
Glossary G19
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V
Valid contract An agreement that satisfies all of the law’s
requirements and is enforceable in court.
Value The holder has already done something in exchange for the
instrument.
Valuation A process by which the Customs Service determines
the fair value of goods being imported, for purposes of imposing
a duty.
Variance An exception from zoning laws that is granted by a
zoning board for special reasons unique to the property.
Veil of ignorance The rules for society that we would propose if
we did not know how lucky we would be in life’s lottery.
Verdict The decision of the factfinder in a case.
Vertical agreement or merger An agreement or merger
between two companies at different stages of the production
process, such as when a company acquires one of its suppliers or
distributors.
Veto The power of the president to reject legislation passed by
Congress, terminating the bill unless Congress votes by a 2/3
majority to override.
Vouching Auditors choose a transaction listed in a company’s
books and check backwards for original data to support it.
Void agreement An agreement that neither party may legally
enforce, usually because the purpose of the bargain was illegal or
because one of the parties lacked capacity to make it.
Voidable contract An agreement that, because of some defect,
may be terminated by one party, such as a minor, but not by both
parties.
Voidable title Limited rights in goods, inferior to those of the
owner.
Voir dire The process of selecting a jury. Attorneys for the parties
and the judge may inquire of prospective jurors whether they are
biased or incapable of rendering a fair and impartial verdict.
W
Warranty A guarantee that goods will meet certain standards.
Warranty of fitness for a particular purpose An assurance
under the Uniform Commercial Code that the goods are fit for the
special purpose for which the buyer intends them and of which the
seller is aware.
Warranty liability The liability of someone who receives payment
on an instrument.
Warranty of merchantability An assurance under the
Uniform Commercial Code that the goods are fit for their
ordinary purpose.
Whistleblower Someone who discloses wrongful behavior.
Winding up The process whereby the assets of a partnership are
sold and the proceeds distributed.
World Trade Organization (WTO) Created by GATT to
stimulate international commerce and resolve trade disputes.
World Wide Web A decentralized collection of documents
containing text, pictures and sound that is accessible from Internet
sites. It is a sub-network of the Internet.
Writ An order from a government compelling someone to do a
particular thing.
Writ of certiorari A petition asking the Supreme Court to hear a
case.
Written consent Instead of holding a meeting, participants may
sign a document approving certain actions.
Wrongful discharge An employer may not fire a worker for a
reason that violates basic social rights, duties, or responsibilities.
G20 Glossary
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TABLE OF CASES
A
Abkco Music, Inc. v. Harrisongs Music, Ltd., 591
Adarand Constructors, Inc. v. Pena, 655n. 21
Aero Consulting Corp. v. Cessna Aircraft Co., 494n. 37
AID Hawai’i Ins. Co. v. Bateman, 306n. 10
Albinger v. Harris, 850–851
Allen v. Beneficial Fin. Co. of Gary, 760n. 5
Allen v. SouthCrest Hospital, 660–661
American Airlines, Inc. v. Wolens, 216n. 1
American Electronic Components, Inc. v. Agere Systems, Inc.,
359–360
American Express Travel Related Services Company, Inc. v.
Assih, 280
Anderson v. Bellino, 710–711
Anderson v. Country Life Insurance Co., 361–362
Anderson v. Schwegel, 389n. 5
Andreason v. Aetna Casualty & Surety Co., 222n. 1
Antuna v. Nescor, Inc., 510
Association for Molecular Pathology v. Myriad Genetics, 808n. 5
AtPac Inc. v. Aptitude Solutions Inc., 796n. 13
Attorney General of New York v. Soto-Lopez, 128n. 27
Authentic Home Improvements v. Mayo, 279
B
Babcock v. Engel, 299
Badger v. Paulson Investment Co., 600n. 13
Baer v. Chase, 240
Bakalar v. Vavra, 457
Barbara’s Sales, Inc. v. Intel Corp., 301n. 3
Barnes v. Yahoo!, Inc., 795n. 11
Basic Books, Inc. v. Kinkos Graphic Corp., 814
Bates v. Dura Auto Sys Inc., 627n. 20
Bi-Economy Market, Inc. v. Harleysville Ins. Co. of
New York, 382–383
Blasco v. Money Services Center, 506
BLD Products, Ltd. v. Technical Plastics of Oregon, LLC, 682
BMW of North America, Inc. v. Gore, 126n. 23, 142-143, 143n. 10
Brandenburg v. Ohio, 119n. 13
Brashear v. Simms, 627n. 19
Brehm v. Eisner, 722
Brenner v. Manson, 809n. 8
Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 744n. 11
Brooks v. Becker, 706–707
Brown v. Board of Education of Topeka, 9n.9, 117n. 10, 645n. 3
Brown v. Card Service Center, 770–771
Brunswick Hills Racquet Club Inc. v. Route 18 Shopping Center
Associates, 365–366
Buckeye Check Cashing, Inc. v. Camp, 508
Burgess v. Alabama Power Co., 837n. 2
Burlington Industries, Inc. v. Ellerth, 651n. 7
Burlington Northern v. White, 652n. 10
Business Roundtable v. SEC, 717n. 9
C
Campbell v. Acuff-Rose Music, Inc., 815n. 13
Camps Newfound/Owatonna, Inc. v. Town of Harrison, 131n. 28
Carafano v. Metrosplash.com, Inc., 794
Career Agents Network, Inc. v. careeragentsnetwork.biz, 824n. 24
Carey v. Davis, 85n. 2, 86
Carlill v. Carbolic Smoke Ball Company, 238
Carnero v. Boston Scientific Corporation, 205–206
Caudle v. Betts, 159n. 17
Centrifugal Casting Machine Co., Inc. v. American Bank &
Trust Co., 200
Cerros v. Steel Techs., Inc., 652n. 9
Chambers v. American Trans Air, Inc., 623n. 13
Chaney v. Plainfield Healthcare Ctr., 651n. 8
Cipriano v. Patrons Mutual Insurance Company of Connecticut,
406–407
Citizens Trust Bank v. White, 263-264
Citizens United v. Federal Election Commission, 120
City of Ontario v. Quon, 789n. 4
CML V, LLC v. Bax, 684n. 7
Colby v. Burnham, 380n. 1
Colonial Life Insurance Co. v. Electronic Data Systems Corp.,
289n. 11
Commonwealth v. Angelo Todesca Corp., 179–180
Commonwealth v. James, 589n. 2
Connecticut v. Doehr, 124n. 18
Conseco Finance Servicing Corp. v. Lee, 547
Coolidge v. New Hampshire, 169n. 7
Corning Glass Works v. Brennan, 656n. 22
Corona Fruits & Veggies, Inc. v. Frozsun Foods, Inc., 538–539
CyberSource Corp. v. Retail Decisions, Inc., 808n. 3
D
Dacor Corp. v. Sierra Precision, 466n. 14
Davis v. Mason, 217-218
Delta Star, Inc. v. Michael’s Carpet World, 433
Demasse v. ITT Corporation, 221
Diamond v. Chakrabarty, 808n. 4
Doe v. C.A.R.S. Protection Plus, Inc., 656n. 24
Doe v. Liberatore, 607–608
Doe v. Mukasey, 170n. 11
Dolan v. City of Tigard, 125n. 20, 839n. 4
Donovan v. Dewey, 99n. 14
Donovan v. RRL Corporation, 306-307
Dothard v. Rawlinson, 655n. 17
Dr. Miles Medical Co. v. John D. Park & Sons, 742n. 8
E
Eales v. Tanana Valley Medical-Surgical Group, Inc., 622n. 10
Earl of Chesterfield v. Janssen, 287n. 7
eBay Domestic Holdings, Inc. v. Newmark, 723–724
T1
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Edwards v. MBTA, 664n. 32
EEOC v. Ohio Edison, 105n. 18
Erie Casein Co. v. Anric Corp., 492n. 33
Eure v. Norfolk Shipbuilding & Drydock Corp., Inc., 331n. 11
Ewing v. California, 174–175
F
Fallsview Glatt Kosher Caterers, Inc. v. Rosenfeld, 226–227
Famous Brands, Inc. v. David Sherman Corp., 261n. 4
Faragher v. Boca Raton, 651n. 7
FDIC v. W.R. Grace & Co., 303n. 6
Federal Communications Commission v. Fox Television Stations,
Inc., 101–102, 108
Federal Trade Commission v. Direct Marketing Concepts, Inc.,
756–757
Fernandez v. Wynn Oil Co., 654n. 16
Fleming v. Benzaquin, 159n. 17
Fleming v. Parametric Tech. Corp., 623n. 12
Flowers v. S. Reg’l Physician Servs., 663n. 31
Ford Motor Credit Co. v. Sheehan, 139n. 6
Foster v. Ohio State University, 244n. 3
Frampton v. Central Indiana Gas Co., 621n. 8
Freeman v. Barrs, 833–834
G
Gaines v. Monsanto, 149n. 12
Galella v. Onassis, 145n. 11
Gallina v. Mintz, Levin, 653n. 13
Gardner v. Downtown Porsche Audi, 286n. 6
Gardner v. Loomis Armored, Inc., 621n. 9
George Grubbs Enterprises v. Bien, 141n. 8
Gilmer v. Interstate/Johnson Lane Corp., 665n. 34
Global Relief Foundation, Inc. v. O’Neill, 170n. 10
Goodman v. Wenco Foods, Inc., 466–467
Granholm v. Heald, 114n. 4
Gray v. American Express Co., 766
Gregg v. Georgia, 174n. 12
Griggs v. Duke Power Co., 92, 93, 648
Griswold v. Connecticut, 133
Gross v. FBL Financial Services, Inc., 657n. 25
Gupta v. Walt Disney World Co., 655n. 18
Guth v. Loft, 710n., 3
H
Hackworth v. Progressive Casualty Ins. Co., 94n. 10
Hadley v. Baxendale, 381–382
Hamer v. Sidway, 258
Harman v. City of New York, 625n. 17
Harmon v. Dunn, 463
Harrington v. McNab, 513n. 3
Harris v. Blockbuster, Inc., 261n. 2
Harwell v. Garrett, 298n. 2
Haught v. Maceluch, 688n. 11
Hawkins v. McGee, 379–380
Hayden v. Hayden, 324n. 8
Hebert v. Enos, 151n. 14
Henches v. Taylor, 266–267
Heritage Technologies v. Phibro-Tech, 408
Hernandez v. Arizona Board of Regents, 147
Hess v. Chase Manhattan Bank, USA, N.A., 304
Hessler v. Crystal Lake Chrysler-Plymouth, Inc., 492
Hill v. Gateway, 77n. 1
Hobbs v. Duff, 260n. 1
Hume v. United States, 287n. 7
Huntsville Hospital v. Mortara Instrument, 486n. 22
I
In re Arthur Murray Studio of Washington, Inc., 755n. 1
In re CFLC, Inc., 534
In re eBay, Inc. Shareholder Litigation, 724n. 16
In re Estate of Claussen, 390n. 6
In re Fox, 577–578
In re Goodman, 574n. 7
In re Grisham, 575–576
In re Lau, 548n. 27
In re Marriage of Cynthia Hassiepen, 688n. 10
In re McGinley, 821n. 20
In re Nuijten, 807n. 1
In re RLS Legal Solutions, LLC, 308–309
In re Roser, 553
In re Schoenwald, 808n. 6
In re Smith, 572n. 6
In re Stern, 573
In re Thompson Medical Co., Inc., 756n. 2
In re Tripp, 574n. 8
In the Matter of Jeffrey M. Horning, 673–674, 674n. 1
In the Matter of Synchronal Corp., 759n. 3
Int’l Airport Centers LLC v. Citrin, 796n. 13
International Shoe Co. v. State of Washington, 55
J
Jackson v. Estate of Green, 835
Jackson v. Goodman, 601n. 15
Jackson v. Holiday Furniture, 567–568
Jakowski v. Carole Chevrolet, Inc., 479n. 7
Jane Doe and Nancy Roe v. Lynn Mills, 140
Jannusch v. Naffziger, 431
Jersey Palm-Gross, Inc. v. Paper, 279n. 3
Jespersen v. Harrah’s, 647–648
Jimenez v. Protective Life Insurance Co., 278n. 2
Johnson v. Weedman, 854
Jones v. Clinton, 67–68
Juzwiak v. John/Jane Doe, 786–787
K
Kanner v. First National Bank of South Miami, 139n. 5
Kassner v. 2nd Ave. Delicatessen, Inc., 659n. 27
Kelo v. City of New London, Connecticut, 125–126
Kennedy v. Louisiana, 116
Kim v. Son, 259
King v. Head Start Family Hair Salons, Inc., 281–282
Klocek v. Gateway, 247n. 5
Kolender v. Lawson, 167n. 2
T2 T A B L E O F C A S E S
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

Kouba v. Allstate Insurance Co., 656n. 23
Kozloski v. American Tissue Services Foundation, 621–622
Krinsky v. Doe, 786n. 3
Kuehn v. Pub Zone, 13–16, 14n. 10, 21
L
Laidlaw v. Organ, 302n. 4
Lapine v. Seinfeld, 813
Lasco Foods v. Hall & Shaw Sales, 796n. 13
Lauderdale v. Peace Baptist Church of Birmingham, 595n. 7
Layne v. Bank One, 541–542
Leegin Creative Leather Products, Inc. v. PSKS, Inc., 742–743
LeMond Cycling, Inc. v. PTI Holding, Inc., 413
Lessee of Richardson v. Campbell, 317
Leuzinger v. County of Lake, 661n. 28
Lew v. Superior Court, 838n. 3
Liebeck v. McDonald’s, 162
Lile v. Kiesel, 486
Lindberg v. Roseth, 331n. 12
Litton Microwave Cooking Products v. Leviton Marketing Co.,
Inc., 236n. 1
Lochner v. New York, 126n. 21
Logan Equipment Corp. v. Simon Aerials, Inc., 470n. 19
Lohman v. Wagner, 440–441
Long v. Vlasic Food Products Co., 596n. 8
Luber v. Luber, 370n. 7
Luke Records v. Navaro, 121n. 16
Luminous Neon v. Parscale, 357n. 2
Lydon v. Beauregard, 316n. 1
M
Marbury v. Madison, 115n. 8, 115, 117
Marks v. Loral Corp., 658n. 26
Marrama v. Citizens Bank of Massachusetts, 579–580
Marsh v. Gentry, 687, 134, 135
Matrixx Initiatives, Inc. v. Siracusano, 736–737
Mattel, Inc. v. Jcom, Inc., 823n. 23
Matthis v. Exxon Corporation, 438
Mayo v. North Carolina State University, 330–331
McCoy v. Spelman Memorial Hospital, 325n. 9
Mesaros v. United States, 237n. 2
Methodist Mission Home of Texas v. N A B, 309n. 14
Metro-Goldwyn-Mayer Studios Inc. v. Grokster, Ltd., 816–817
Metropolitan Creditors Service of Sacramento v. Sadri, 277,
277n. 1
Michelin Tire Corp. v. Wages, Tax Commissioner, 112n. 1
Mickle v. Henrichs, 174n. 13
Midas Muffler Shop v. Ellison, 139n. 7
Milicic v. Basketball Marketing Company, Inc., 391
Miller v. California, 120n. 4
Miranda v. Arizona, 117n. 11, 172
Mishkin v. Young, 844
Monge v. Beebe, 620, 620n. 4
Moore v. St. Joseph Nursing Home, Inc., 623n. 14
Motorists Mutual Insurance Co. v. State Farm Mutual Automobile
Insurance Co., 849n. 8
Mr. W Fireworks, Inc. v. Ozuna, 220
N
Nadel v. Tom Cat Bakery, 242–243
National Federation of Independent Business v. Sebelius, 113
National Franchise Association v. Burger King Corporation, 693
Network Automation, Inc. v. Advanced Systems Concepts, Inc., 822
New York Central & Hudson River R.R. Co. v.
United States, 179n. 20
New York City Transit Authority v. Beazer, 127n. 24
New York Times Co. v. Sullivan, 137n. 3
NLRB v. Babcock & Wilcox Co., 635n. 25
NLRB v. Gissel Packing Co., 635n. 26
NLRB v. Truitt Manufacturing Co., 636
Norton v. Hoyt, 223
O
O’Brien v. Black, 846n. 7
O’Brien v. Ohio State University, 368
The Oculist’s Case, 5
Ohio v. Crowder, 168n. 6
Ohio v. Smith, 169
Oncale v. Sundowner Offshore Services, Inc., 651n. 6
Orbit One Communications Inc. v. Numerexe Corp., 796n. 13
Osterlind v. Hill, 85n. 3
Otsuka v. Polo Ralph Lauren Corporation, 590
P
Palmore v. Sidoti, 128n. 26
Paramount Pictures Corp. v. Worldwide Entertainment Corp., 820n. 18
Penthouse Intern Ltd. v. McAuliffe, 120n. 15
People v. O’Neill, 180n. 23
Pereda v. Parajon, 70
Perfumebay.com Inc. v. eBay Inc., 821n. 22
Peterson v. Exide Technologies, 618–619
Plessy v. Ferguson, 9n.8, 645
Pollack v. Skinsmart Dermatology and Aesthetic Center P.C., 826
Preston v. Sailer, 319n. 3
Price Waterhouse v. Hopkins, 653n. 12
Pridgen v. Boston Housing Authority, 85n. 4
Princeton University Press v. Michigan Document Services,
Inc., 814n. 12
ProCD, Inc. v. Zeidenberg, 247n. 4
Putnam Construction & Realty Co. v. Byrd, 388
Q
Quake Construction v. American Airlines, 404–405
Quimby v. Bank of America, 516
R
R.G. Ray Corp. v. Maynard Manufacturing Co., 478 n. 3
Randi W. v. Muroc Joint Unified School District, 624n. 15
Ransburg v. Richards, 285
Raytheon Co. v. Hernandez, 663n. 30
Red River Commodities, Inc. v. Eidness, 482n. 13
Reed v. City of Chicago, 471–472
Register.com v. Verio, Inc., 249n. 6
T A B L E O F C A S E S T3
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

Reid v. Google, Inc., 657–658
Research Corporation Technologies, Inc., v. Microsoft
Corporation, 830n. 25
Ricci v. DeStefano, 649n. 5
Rice v. Oriental Fireworks Co., 706n. 1
Richardson v. Mellish, 287n. 8
Ridgaway v. Silk, 680
Rodrigues v. Scotts Lawnservice, 627
Roe v. Wade, 7n. 6, 117n. 12
Roger Cleveland Golf Co. v. Price, 795n. 10
Rosenberg v. Son, Inc., 349–350
Roth v. Robertson, 712n. 6
Royal Jones & Associates, Inc. v. First Thermal Systems, Inc.,
489n. 30
Rudiger Charolais Ranches v. Van De Graff Ranches, 452n. 2
S
Sabine Pilot Service, Inc. v. Hauck, 620n. 7
Sakraida v. Ag Pro, Inc., 808n. 7
Salib v. City of Mesa, 121
Sand Creek Country Club, Ltd. v. CSO Architects, Inc., 358n. 3
Sawyer v. Mills, 321–322
Schauer v. Mandarin Gems of California, Inc., 339
Schroer v. Billington, 654n. 15
Scott v. Beth Israel Medical Center Inc., 791
Seabreaze Restaurant, Inc. v. Paumgardhen, 367n. 6
SEC v. Switzer, 739n. 4
Securities and Exchange Commission v. Steffes, 739
Sepulveda v. Aviles, 310
Seton Co. v. Lear Corp., 328
Sherman v. United States, 167n. 3
Shlensky v. Wrigley, 712n. 5
Sides v. Duke University, 620n. 6
Skilling v. United States, 177–178
Smith v. Calgon Carbon Corp., 625n. 18
Smith v. Penbridge Associates, Inc., 490–491
Smyth v. Pillsbury, 628n. 21
Sniadach v. Family Finance Corp., 131n. 30
Snider Bolt & Screw v. Quality Screw & Nut, 268
Soldano v. O’Daniels, 17, 21, 86
Soldau v. Organon, Inc., 250
Specht v. Netscape Communications Corporation, 247–248
Stambovsky v. Acklye, 303n. 7
Stanford v. Kuwait Airways Corp., 589n. 3
State Analysis v. American Financial Services Assoc, 796n. 13
State Farm v. Campbell, 143
State Oil Co. v. Khan, 743n. 9
State v. Carpenter, 371n. 8
Stengart v. Loving Care Agency, Inc., 629n. 22
Stinton v. Robin’s Wood, Inc., 65–66, 141n. 9
Stratton Oakmont, Inc. v. Prodigy Services Company, 793n. 7
Sullivan v. Rooney, 320n. 4
Sunrise Cooperative v. Robert Perry, 323n. 6
Superior Boiler Works, Inc. v. R.J. Sanders, Inc., 436–437
T
Tameny v. Atlantic Richfield Co., 620n. 7
Tarasoff v. Regents of the University of California, 85–86
Tenet HealthSystem Surgical, L.L.C. v. Jefferson Parish Hospital
Service District No. 1, 343
Teresa Harris v. Forklift Systems, Inc., 650
Terry v. Ohio, 168n. 5
Texas v. Johnson, 107n.19, 119
Tiffany Inc. v. eBay, Inc., 797n. 17
Toews v. Funk, 387n. 4
Tommy Hilfiger Licensing, Inc. v. Nature Labs, 821n. 21
Toscano v. Greene Music, 386–387
Totes-Isotoner Co. v. United States, 192–193
Toussaint v. Blue Cross & Blue Shield, 622n. 11
Treadway v. Gateway Chevrolet Oldsmobile Inc., 771–772
Trombetta v. Detroit, 620n. 7
Truong v. Nguyen, 154
Two Pesos, Inc. v. Taco Cabana, Inc., 820n. 19
Tzolis v. Wolff, 683
U
Union Labor Hospital Assn. v. Vance Redwood
Lumber Co., 617n. 2
Union Pacific Railway Co. v. Cappier, 87, 84n. 1
Unite Here Local 30 v. California Department of Parks and
Recreation, 340
United Aluminum Corporation v. Linde, Inc., 483–484
United States v. Alfonso Lopez, Jr., 7n. 7
United States of America v. Warshak, 788
United States v. Bajakajian, 176n. 15
United States v. Biswell, 99, 108
United States v. Brunk, 175
United States v. Dorsey, 176n. 16
United States v. Edge Broadcasting, 131n. 29
United States v. King, 203–204
United States v. Leon, 169n. 8
United States v. Loew’s Inc., 746n. 13
United States v. Lopez, 112n. 3, 117
United States v. O’Hagan, 738n. 3
United States v. Syufy Enterprises, 744n. 10
United States v. Trenton Potteries Company, 741
United States v. Tsai, 191n. 3
United States v. Virginia, 128n. 25
United States v. Waste Management, Inc., 745–746
United States–Import Prohibition of Certain Shrimp and Shrimp
Products, 194–195
United Steelworkers of America v. Weber, 655n. 19
Universal Service Fund Telephone Billing Practices
Litigation, 65n. 5
University and Community College System of Nevada v.
Farmer, 655n. 20
University of Texas Medical School at Houston v. Than, 124n. 19
V
Valley Forge Insurance Co. v. Great American Insurance Co., 455
Vande Zande v. Wisconsin Department of Administration, 662n. 29
Vanlandingham v. Ivanow, 843, 743n. 6
Verizon Communs., Inc. v. Trinko, LLP, 742n. 7
Vermillion v. AAA Pro Moving & Storage, 620n. 7
Viacom Int’l, Inc. v. YouTube Inc., 818n. 16
T4 T A B L E O F C A S E S
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

W
Ward v. Monroeville, 124n. 17
Wards Cove Packing Co. v. Atonio, 93n. 9, 93–94
Warner Bros. Entertainment Inc. v. RDR Books,
814n. 11
Waters v. Min Ltd., 287n. 9
Webb v. McGowin, 269n. 7
Weiss v. Freeman, 286n. 5
Wells Fargo Bank Minnesota v. BrooksAmerica Mortgage
Corporation, 346
Wickard v. Filburn, 112, 112n. 2
Wightman v. Consolidated Rail Corporation,
153n. 15
Wilson v. Southwest Airlines, 669n. 36
Worldwide Insurance v. Klopp, 288
Wyoming.com, LLC v. Lieberman, 681
Y
Young v. Grote, 520n. 4
Yunker v. Honeywell, 149n. 13
Z
Zankel v. United States of America, 606–607
Zeran v. America Online, Inc., 138n. 4
Zion Temple First Pentecostal Church of Cincinnati, Ohio, Inc. v.
Brighter Day Bookstore & Gifts &Murphy Cap &Gown Co., 481
T A B L E O F C A S E S T5
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INDEX
A
abandonment, principal’s liability for
torts, 606
abatement, 838
absolute privilege, defamation cases
and, 138
academic suspension, 124
acceptance
agreements and, 235
by buyers, 485
of collateral, 555
communication of, 249–250
as element of contracts, 215
of gifts, 850
of non-conforming goods, 493
of offers, 244–250
acceptor, 512
accommodation party, 513–514
accord and satisfaction, 266
account, defined, 531
account party, 198
act, value of an, 257
action for the price, 489
additional or different terms,
acceptance that adds, 245–246
additional work, consideration
and, 262
adequate consideration, 259–260
adhesion contracts, 287–288
adjudication, 99–100
by federal courts, 115
administrative agencies, 95–103
adjudication by, 99–100
enabling legislation, 96, 100
investigation by, 98–99
limits on power of, 100–103
rulemaking power of, 96–98
administrative law, 10, 95–103
administrative law judge
(ALJ), 100
Administrative Procedure Act, 100
admissions in court, as binding
agreement, 329
adversary system, 69
advertisements, generally not offers,
237–238
affirm, 74
affirmation of fact, 464
affirmative action, 655
affirmed, 56
after-acquired property, 536
age, misrepresentation of, 297–298
Age Discrimination in Employment
Act (ADEA), 656–659
agencies, administrative. See
administrative agencies
agents (agency relationship),
587–609
consent, 588–589
control, 589
creating an agency relationship,
588–590
crimes committed by, 179
duties of agents to principals,
590–595
duties of principals to agents,
595–596
elements not required for,
589–590
employees as, versus independent
contractors, 604–608
intermediary, 601
liability issues, 599–603
agent’s liability for contracts,
601–603
agent’s liability for torts, 609
principal’s liability for contracts,
599–601
principal’s liability for torts,
604–608
principal’s remedies when the
agent breaches a duty, 594–595
subagents, 601
terminating an agency relationship,
596–598
unauthorized, 603
agreements, 234–250. See also
contracts; offers
acceptance of offers, 244–250
clickwraps and shrinkwraps,
247–249
modification of, 263
noncompete, 218, 281–283
consideration in, 267
sale of a business and, 282
security, 529, 533
unenforceable, 219
void, 219
Akers, John, 27
alcohol and drug use, in the
workplace, 627–628
alimony and child support, Chapter 7
liquidation, 571
alternative dispute resolution (ADR),
52, 75–77
ambiguity, in contracts, 406–407
amendments provision, in contracts,
416
amendments to the U.S.
Constitution, 9, 111, 117–128.
See also specific amendments
incorporation of, 118
America Invents Act (AIA), 808
Americans with Disabilities Act
(ADA), 660–663
disparate treatment, 662–663
analyzing a case, 13–15
annual reports, 715, 735
answer to a complaint, 61
anticipatory breach, 368–369
Anticybersquatting Consumer
Protection Act (ACPA), 823
antifederalists, 111
antitrust law, 740–747
apparent authority, agency
relationship, 600
appeals, 74–75
appeals courts (appellate courts),
55–56
I1
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appeals courts (appellate courts)
(continued )
federal, 58
options of, 74–75
appellant, 56
appellee, 56
Apple, 41–42
appointment, power of, 115
arbitration, 76–77, 416
Ariely, Dan, 32, 36
Arms Export Control Act (AECA), 191
arraignment, 173
arrest
procedure after, 173
search without a warrant, 168
arson, 179
Article 2 of the Uniform Commercial
Code (UCC), 426–443
added terms, 433–437
contract formation, 430–444
enforceable only to the quantity
stated, 432
entrustment, 457–459
failure to allocate the risk, 459
good faith and unconscionability,
429
implied warranties, 465–467
incorrect or omitted terms, 432
insurable interest, 454
intention to create a contract, 435,
437
judicial admission exception, 432
merchant exception, 432
merchants, 429
mixed contracts, 429
modifications, 441–442
open terms, 437–441
output and requirements contracts,
439–440
passing of title, 453–454
scope of, 428–429
specialty goods exception, 432
Statute of Frauds, 431–433
writing requirement, 431–432
Article 3 of the Uniform Commercial
Code (UCC), 502
interpretation of ambiguities, 505
Article 9 of the Uniform Commercial
Code (UCC), 529
scope of, 530–532
terms used in, 529–530
artisan’s lien, 550
assault, 140
assignment of rights, 341–346, 416
assignor, 341
assignor’s warranty, 344
assumption of the risk, negligence
and, 153–154
attachment
of property, 123, 124
of security interests, 532–535
to future property, 535–536
attorney’s fees, 416–417
auctions, 238–239
Internet, 797
authenticate, defined, 530
authority, agency relationship, 599–600
authorization, principal’s liability for
torts, 606
automobiles, search without a
warrant, 168
B
bad faith behavior, discharge under
Chapter 7, 574
bailee, 285, 460
duties of, 853
rights of, 852–853
bailment, 285, 460, 852–854
bailor, 285, 460
rights and duties of, 854
bait-and-switch advertisements, 758
bankruptcy, 562–581. See also
Bankruptcy Code (the Code);
Chapter 7 liquidation
Chapter 13 consumer
reorganizations, 579–581
Chapter 11 reorganization, 576–579
repeated filings for, 574
Bankruptcy Code (the Code)
chapter description, 564
goals of, 564
options available under, 564
overview of, 563–564
rehabilitation of debtor, 563
bankruptcy estate, 568–570
bargain, invitations to, 236
battery, 140
“battle of forms”, 245–246
bearer paper, 507, 508, 517
defined, 505
beneficiaries
incidental, 340
intended, 338–340
of letters of credit, 198
benefit corporations (B corporations),
685
Berne Convention, 818
beyond a reasonable doubt, 71, 166
bilateral contracts, 218
bilateral mistake, 305
bill of lading, 198–199
Bill of Rights, 111. See also amendments
to the U.S. Constitution
bills, 9, 87–88
Bipartisan Campaign Reform Act
of 2002, 120
blind spots, as ethics trap, 35
blue sky laws, 740
boilerplate, in contracts, 415
bona fide occupational
qualification (BFOQ), Age
Discrimination in Employment
Act (ADEA), 659
bona fide purchaser, 455–457
bonds, 705
Bonds, Barry, 35
branches of government, 7
breach of contract, 367–369
anticipatory, 368–369
buyer’s remedies, 489–494
defined in contract, 412
expectation interest, 379–385
impossibility, 369–371
material, 412
remedies for, 377 See also damages
defined, 378
expectation interest, 379–385
identifying the “interest” to be
protected, 378–379
I2 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

injunction, 390–391
reformation, 392
reliance interest, 385–387
restitution interest, 387–389
specific performance, 389–390
seller’s remedies, 487–488
statute of limitations, 369
breach of duty, 149
agency relationship, 594–595
bribes, 177–178
Foreign Corrupt Practices Act
(FCPA) and, 202–204
briefs, 56
British Petroleum (BP), 183
Buffett, Warren, 33
building codes, 843
buildings, 833
burden of proof, 71
bailment and, 853–854
in criminal cases, 166
business judgment rule, 708–709
business organizations, debts that
cannot be discharged under
Chapter 7, 574
business torts, 144–146
buyers
acceptance by, 485
breach of contract, buyer’s
remedies, 489–494
inspection by, 485–486
misuse by, 472
security interests, 545–550
chattel paper, instruments, and
documents, 548–549
consumer goods, 547–548
buyers in ordinary course of business
(BIOC), 457, 458, 546–547
buyer’s misuse, 472
bylaws, corporate, 705
bystander cases, 84–87
C
California, noncompetes in, 283
CAN-SPAM (Controlling the Assault
of Non-Solicited Pornography
and Marketing Act), 792–793
capacity, 296–300
as element of a contract, 215
signature liability, 511
cashier’s checks, 512
categorical imperative, Kant’s, 29, 36
causa mortis gifts, 849–850
causation, negligence and, 149–151
certification marks, 819
certified checks, 512
challenges for cause, 70
Chapter 13 consumer
reorganizations, 579–581
Chapter 7 liquidation, 564–576
automatic stay, 567–568
bankruptcy estate, 568–570
creditors, 566–567
discharge, 572–576
fraudulent transfers, 569
payment of claims, 570–572
trustees, 566–567
Chapter 11 reorganization, 576–579
charter, corporate, 701–704
Chase, David, 240
chattel paper, 532
protection of buyers, 548–549
checks
certified, 512
defined, 502
drawee of, 512–513
checks and balances, system of, 7
child labor, 195
children
Children’s Online Privacy
Protection Act of 1998 (COPPA),
791
trespassing, 148
Children’s Online Privacy Protection
Act of 1998 (COPPA), 791
China, contract workers in, 41
choice of forum provisions, 415
choice of law provisions, 415
Chubb Life America, 289
CISG (United Nations Convention
on Contracts for the
International Sale of Goods), 197
civil law, 10–11
criminal law distinguished from, 165
civil rights, legislation, 88–94
Civil Rights Act of 1866, 646, 664
Civil Rights Act of 1964, Title VII of,
88, 91, 92
employment discrimination and,
646–652
Clarins, 44
class actions, 62
Clayton Act, 745–747
Clean Air Act, 97
clickwraps, 247–249
close corporations, 678–679
closing, of contracts, 418
closing arguments, 73
Cloud Farm, 39
collateral
debtor rights in the, 535
default and taking possession of,
554
defined, 529
disposition of, 554
movable, 544–545
noninventory, purchase money
security interest (PMSI) in,
552–553
types of, 530–532
collateral promise, 322–323
collective bargaining, 635–636
collective marks, 819
comment letter, 734
Commerce Clause, 112
dormant aspect of, 113
commercial exploitation, 145–146
commercial impracticability, 370, 483
commercial law, development of,
425–426
commercial paper, 502–510. See also
negotiable instruments
fundamental “rule” of, 503
negotiable, 503–506
types of, 502
commercial speech, 121
commercial tort claims, 531
commercial transactions, 425, 427,
428
commercial units, 485
commingling of assets, 706
I N D E X I3
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committees, congressional, 87
common law, 5, 9, 84–87
contract law and, 225
employment and, 617
protections, 619–624
landlord’s liability, 847
Statute of Frauds, 319–326
Communications Decency Act of
1996 (CDA), 138, 793–795
community interest companies (CICs),
685
comparative negligence, 152
compensation
agency relationship, 590
for corporate directors and officers,
717–722
compensation consultants, 720
compensatory damages, 140–141
complaints, 60
compliance programs, 183–184
comprehensively regulated
industries, 99
Computer Fraud and Abuse Act of
1986 (CFAA), 796
concerted action, 636–638
concurrent conditions, 361
concurrent estates, 834–837
condemnation of land, 839
condition precedent, 359–360
condition subsequent, 360
conditional promises, 414
conditions, 358–362
concurrent, 361
express, 358–359
implied, 359
types of, 359–362
Conference Committee, House-
Senate, 90–91
confirmation of the plan, Chapter 11
reorganization, 577–578
confiscation, 202
conflict of interest, between two
principals, agency relationship,
592
conformity, as ethics trap, 33
Congress, U.S.
agency power and, 100
override of presidential vetoes,
93–94
powers under the Constitution,
111–112
conscious uncertainty, 305
consent
contracts and, 300
as element of a contract, 215
to search without a warrant, 168
consequential damages, 381–383,
490
consideration, 256–269
adequacy of, 259–260
applications of, 261–265
assignment of rights, 344
as element of a contract, 215
employment agreements, 267–268
illusory promises not considered,
260–261
preexisting duty not considered,
262–265
promissory estoppel and “moral
consideration”, 268–269
rules of, 257
settlement of debts, 265–267
Constitution of the United States, 3,
7, 9, 110–129. See also
amendments to the U.S.
Constitution
amendments to. See amendments
to the U.S. Constitution
congressional power under,
111–113
employment discrimination
and, 646
executive power under, 115
government powers under, 110
individual rights under, 111
judicial power under, 115–117
overview of, 110–111
protected rights under, 117–128
separation of powers under, 111
Supremacy Clause, 114
consumer credit, 759–773
Consumer Leasing Act (CLA),
772–773
contracts, 510
credit cards, 763–766
credit reports, 767–769
debit cards, 766–767
debt collection, 769–771
Equal Credit Opportunity Act
(ECOA), 771–772
home loans, 761–763
identity theft, 769
Truth in Lending Act (TILA),
760–763
consumer deposits, Chapter 7
liquidation, 571
Consumer Financial Protection
Bureau (CFPB), 756
consumer goods
buyers of, 547–548
perfection by, 542–544
Consumer Leasing Act (CLA), 772–773
consumer paper, 510
consumer product safety, 774
Consumer Product Safety Act of
1972 (CPSA), 774
Consumer Product Safety
Commission (CPSC), 774
consumer protection, 754–781
consumer credit. See consumer
credit
Consumer Financial Protection
Bureau (CFPB), 756
Federal Trade Commission
(FTC), 755
overview of, 755
sales, 756–759
contracts (contract law), 214–227.
See also agreements
adhesion, 287–288
agent’s liability for, 601–603
bilateral, 218
breach of. See breach of contract
capacity and, 296–300
conditions, 358–362
consumer credit, 510
defined, 216
destination, 460
development of contract law,
217–218
drafting, 403
I4 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

duress and, 307–309
elements of, 215
employment, 622–623
executed, 219
executory, 219
express, 220
formation of, 430–444
fraud and, 300–305
good faith, 365–367
implied, 220–221
installment, 486
insurable interest and, 278
legality of, 276–289
licensing statutes and, 278–279
mistakes and, 305–307
mistakes in, 403–409
modifications of, 441
output, 242, 439–440
consideration in, 261
performance, 362–367
personal satisfaction, 364
promissory estoppel and, 222–223
quasi-contracts, 224
reading, 403
requirements, 242, 439–440
consideration, 261
rescinding, 263, 296, 300–307, 309,
357, 388
shipment, 460
size of, 216
sources of contract law, 225–227
strict liability and, 156
structure of, 409–418
breach, defined, 412
covenants, 410–414
definitions, 410
introductory paragraph, 410
representations and warranties,
414
title, 409
temporarily irrevocable, 243
that violate a statute, 277–280
that violate public policy, 281–283
time of the essence clauses, 367
tortious interference with, 144–145
torts distinguished from, 135
types of, 218–225
unconscionable, 287–289, 429
undue influence and, 309–310
Uniform Commercial Code (UCC)
and, 225–227
unilateral, 218–219
valid, 219
voidable, 219
capacity and, 296
restitution, 388–389
written. (See written contracts
Contracts for the International Sale
of Goods, United Nations
Convention on (CISG), 197
contributory negligence, 152
control
agency relationship, 589
bailment and, 852
perfection by, 540, 541, 551
security agreements, 533–535
Controlling the Assault of Non-
Solicited Pornography and
Marketing Act (CAN-SPAM),
792–793
conversion liability, 518–519
Copyright Act, 812, 813
copyrights, 812–818
fair use doctrine, 814
first sale doctrine, 814
infringement of, 813–814
international treaties, 818
parody and, 815
term of, 813
corporate executives. See directors
and officers, corporate
corporate opportunity doctrine,
709–711
corporate social responsibility (CSR),
43–44
corporations, 675–691, 699–725
bylaws, 705
charter, 701–704
close, 678–679
death of, 705
directors and officers, 704–705
First Amendment protections, 120
incorporation process, 700–704
limited liability, 675
limited liability companies (LLCs)
compared to, 684
management of, 707–712
piercing the corporate veil,
706–707
professional (PCs), 690–691
promoter’s liability, 700
protected rights, 117
punishing, 183–184
S, 677–678
shareholders of See shareholders
termination of, 707
counter-claim, 62
counteroffers, 243
countervailing duties, 193
course of dealing, 479–480
course of performance, 480
Court of Appeals for the District of
Columbia, 58
court orders, 10
courts
appellate, 55–56
federal, 56–59
powers under the Constitution,
115–117
state, 52–56
systems of, 52–59
trial, 52–54, 57
covenants
in contracts, 410–414
not to compete (noncompete
agreements), 218, 281–283
consideration in, 267
sale of a business and, 282
cover, 491–493
cramdown, 577
credit cards, 763–766
usury laws and, 280
credit reports, 767–769
creditor beneficiary, 338
creditors
Chapter 7 liquidation, 566–567
priorities among, 550–553
creditors’ committee, Chapter 11
reorganization, 576
crimes (criminal cases), 164–184
burden of proof in, 166
I N D E X I5
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

crimes (criminal cases) (continued )
committed by business, 179–184
entrapment in, 167
prosecution of, 165–166
right to a jury, 166
that harm business, 176–179
criminal law, 10, 11
civil law distinguished from, 165
torts distinguished from, 135
criminal procedure, 166–176
conduct outlawed by statute,
166–167
gathering evidence, 167–170
state of mind, 167
cross-examination, 72
crowdfunding, 735
cure, seller’s right to, 480
currencies, 502
cyberlaw, 782–799. See also privacy,
online
crime on the Internet, 795–799
privacy issues, 784–792
spam, 792–793
cybersquatting, 823
D
damages, 140–143
compensatory, 140–141
consequential, 381–383, 490
direct, 381
expectation, 378
incidental, 383, 490
liquidated, 493–494
liquidated damages clause, 378
mitigation of, 392
negligence and, 151–152
nominal, 392
for non-acceptance, 488–489
punitive, 142–143
reliance, 385–386
treble, 182
UCC and, 383–384
de Bracton, Henry, 5
De Legibus et Consuetudinibus Angliae
(On the Laws and Customs of
England), 5
de Tocqueville, Alexis, 3
debentures, 705
debit cards, 766–767
debt(s)
collateral promise, 322–323
corporate, 705
liquidated, 265
settlement of, 265–267
unliquidated, 265–267
debt collection, consumer credit,
769–771
debtor(s)
bankruptcy and See bankruptcy
defined, 529
in possession, Chapter 11
reorganization, 576
rights in the collateral, 535
deceptive acts or practices, 756–757
Decision sections, 15
Deepwater Horizon, 183
defamation, 136–138
of former employees, 623
online, 138
default, secured transactions, 529,
553–556
default judgment, 61
defective condition unreasonably
dangerous to the user, adequate
warnings of any dangers, 155
defects, affirmation of fact, 464
defendant, 14
defendant’s case, 73
deficiency, disposition of the
collateral, 554–556
definiteness, offers and problems
with, 239
definitions, in contracts, 410
delegation of duties, 347–350, 416
delivery of gifts, 849
delivery of goods, 478–479
non-delivery, 493
stopping, 487
deontological ethics, 29–30
deponent, 63
deposit accounts (in banks), 531, 533
depositions, 63, 64
derivative lawsuits, 724–725
description of goods, 464
express warranty and, 464–465
destination contracts, 460
destruction of the goods, 482
destruction of the subject matter,
offers terminated by, 244
“Devil’s Advocate” feature, 15
difference principle, 30
different performance, settlement of
liquidated debts, 265
Digital Millennium Copyright Act
(DMCA), 817–818
digital music and movies, 815–818
direct damages, 381
direct examination, 72
direct lawsuits, 725
directors and officers, corporate,
704–705
compensation for, 717–722
election and removal of, 716–717
disability, discrimination on the basis
of, 659–663
disaffirmance, 296, 297
discharge, 357
Chapter 13 consumer
reorganizations, 581
Chapter 7 liquidation, 572–576
Chapter 11 reorganization, 578
of contracts, 215
of employees
for off-duty conduct, 626
wrongful discharge, 619
disclaimers, warranties and, 468–469
discovery, 63–67, 173
electronic, 65
discrimination, 88–94
employment (See employment
discrimination
dishonesty, discharge under Chapter
7, 574
disparate impact
Age Discrimination in
Employment Act (ADEA), 658
Americans with Disabilities Act
(ADA), 662–663
Title VII of the Civil Rights Act of
1964 and, 648–649
I6 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

disparate treatment, 662–663
Age Discrimination in
Employment Act (ADEA),
656–657
Title VII of the Civil Rights Act of
1964 and, 646–648
dispute resolution, 51–77
dissociation, 688
diversity cases (diversity
jurisdiction), 56–57
dividend rights, stock, 702
documents
as collateral, protection of buyers,
548–549
of title, 530–531
Dodd-Frank Wall Street Reform and
Consumer Protection Act, 625,
721, 761
domain names, 823
donee beneficiary, 338
door-to-door sales, 759
double jeopardy, 174
draft (formal order to pay), 198, 502
drawee bank, liability of, 512–513
warranty liability, 514
drawer of a check, secondary liability,
511–512
due care, bailee, 853
due process, 171
procedural, 123
substantive, 123, 126
Due Process Clause, 122–124
dumping, 193
duress
contracts and, 307–309
parol evidence of, 331
duties, 192
of agents to principals, 590–595
bailee, 853
countervailing, 193
for dumping and subsidizing, 193
duty
of care
agency relationship, 593–594
corporate officers and directors,
712
to cooperate, agency relationship,
596
of due care, 146–149
of loyalty, 709
to maintain premises, 842–844
to mitigate, landlord’s, 846
to return security deposit, 844
E
easements, 319, 837
economic issues, Equal Protection
Clause and, 127
economic loss doctrine, 471–472
e-discovery (electronic discovery), 65
Eighth Amendment, prohibition of
cruel and unusual punishment,
174
elections, labor union, 634
electronic chattel paper, 532, 533
Electronic Communications Privacy
Act of 1986 (ECPA), 628, 790
electronic contracts and signatures,
326
Electronic Data Systems (EDS), 289
electronic discovery, 65
electronic monitoring, of the
workplace, 628–629
Electronic Signatures in Global and
National Commerce Act
(E-SIGN), 326
embezzlement, 179
emergencies, search without a
warrant, 168
eminent domain, power of, 125, 839
emotional distress, intentional
infliction of, 139–140, 624
employee benefit plans, Chapter 7
liquidation, 571
employee handbooks, 622
employee indorsement rule, 519
Employee Retirement Income
Security Act (ERISA), 632
employees
as agents, versus independent
contractors, 604–605
discharge of (firing)
for off-duty conduct, 626
wrongful discharge, 619
financial protection, 630–632
government
`alcohol and drug use, 628
due process before being fired,
124
whistleblowing, 625
payments to, Chapter 7
liquidation, 571
pension benefits, 632
privacy rights, 626–630
replacement workers, 637
whistleblowing, 624–626
employers, duty of care and,
148–149
employment. See also labor unions
common law and, 617
protections, 619–624
historical overview, 617
labor law and, 632–638
pro-union statutes, 632–633
scope of, 605–607
tort law, 623–624
workplace safety. (See Occupational
Safety and Health Act (OSHA)
employment agreements (or
contracts)
consideration in, 267–268
implied contracts, 221
noncompetition clauses in, 218,
281–283
consideration in, 267
sale of a business and, 282
written contracts, 324–325
employment discrimination,
644–666
affirmative action, 655
Age Discrimination in
Employment Act (ADEA),
656–657
Americans with Disabilities Act
(ADA), 660–663
bona fide occupational
qualification (BFOQ), 654–655,
659
Civil Rights Act of 1866 and, 646
I N D E X I7
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

employment discrimination
(continued )
Constitution of the United States
and, 646
defenses to charges of, 654–655
disability, 659–663
disparate impact, 658
enforcement of employment laws,
664–666
Equal Pay Act of 1963, 656
family responsibility, 653
gender identity, 653–654
Genetic Information
Nondiscrimination Act (GINA),
664
historical background, 645
hostile work environment,
658–659, 663
hostile work environment and,
649–652
Pregnancy Discrimination Act, 656
prohibited activities, 646–652
religion, 652
sex, 652–653
sexual orientation, 653
Title VII of the Civil Rights Act of
1964 and, 646–652
employment security, 618–624
employment-at-will doctrine, 619
enabling legislation, 96, 100
encryption, 817–818
English law, 4, 6
Enron Corporation, 177–178
entrapment, 167
entrustment, 457–459
Environmental Protection Agency
(EPA), 97
Equal Credit Opportunity Act
(ECOA), 771–772
equal dignities rule, 589–590
Equal Employment Opportunity
Commission (EEOC), 627,
664–665
Equal Pay Act of 1963, 656
Equal Protection Clause, 127
equitable interest, 379
error of law, 55
escalator clause, 845
ethics, 23–43
applying principles of, 37–42
the organization’s responsibility
to its customers, 40
the organization’s responsibility
to its employees, 39
the organization’s responsibility
to overseas contract workers,
41–42
the organization’s responsibility
to society, 38–39
personal ethics in the workplace,
37
Baer case and, 240
bribery, 204
child labor, 195
choices in the face of unethical
behavior, 42–43
deontological, 29–30
disaffirmance by a minor, 297
introduction to, 24–26
Lincoln during Civil War, 31
lying and, 36–37
reasons for being ethical, 27–28
remedies for breached contracts,
378
role of business in society and,
26–27
theories of, 28–31
traps, 31–36
unethical behavior as costly, 28
utilitarian, 29
ethnicity, Equal Protection Clause
and, 128
euphemisms, as ethics trap, 34
European Convention on Human
Rights, 792
eviction, 842
evidence, rules of, 72
“Exam Strategy” feature, 16
exclusionary rule, 169, 171–172
exculpatory clauses, 284–286
executed contracts, 219
executive agencies, 96
executive branch, 7, 10, 96
executive compensation, 717–722
Executive Order 11246, 655
executive power, 7, 115
executives. See directors and officers,
corporate
executor of an estate, promise made
by, 323
executory contracts, 219
existence of goods, 452
expectation damages, 378
expectation interest, 379–385
expiration of offers, 244
Export Administration Act of 1985,
191
export controls, 191
exporting, 191
express authority, agency
relationship, 599
express conditions, 358–359
express contracts, 220
express warranties, 464–465
expropriation, 201–202
extraterritoriality, 205–206
F
facilitating payments, 203
Facts sections, 14–15
factual cause, 149–150
Fair and Accurate Credit
Transactions Act (FACTA),
767–769
Fair Credit Reporting Act (FCRA),
767
Fair Debt Collection Practices Act
(FDCPA), 770–771
Fair Labor Standards Act (FLSA),
631
fair use doctrine, 814
False Claims Act, 624
false imprisonment, 139
Family and Medical Leave Act
(FMLA), 618–619
Family Entertainment and
Copyright Act, 817
family responsibility, discrimination
because of, 653
Faulkner, Shannon, 126, 127
I8 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

FCPA (Foreign Corrupt Practices
Act), 202–204
federal agencies. See administrative
agencies
Federal Communications
Commission (FCC), 96
federal courts, 56–59
powers under the Constitution,
115–117
federal employees. See government
employees
federal question cases, 56
Federal Sentencing Guidelines,
183–184
Federal Trade Commission
(FTC), 97
Clayton Act and, 745
consumer protection and, 755–759,
761, 769, 770
online privacy and, 789–790
Federal Trademark Dilution Act of
1995 (FTDA), 823
federalism, Iroquois’s system of, 3
federalists, 111
felony, defined, 166
fictitious payee rule, 519
fiduciaries, insider trading and, 738
fiduciary relationship, agents, 589
Fifth Amendment to the
Constitution, 98, 122–126
Due Process Clause, 122–124
protection of criminal defendants,
171
Takings Clause, 122, 124–126
financing statement, 536–540, 542
defined, 530
firm offers, 243
First Amendment, 9, 118–122.
See also free speech
online privacy and, 785–787
first sale doctrine, 814
fitness, warranty of, 467
fixtures, 833
defined, 529
security interest in, 545
flexible-purpose organizations, 685
FOB (free on board), 459
following orders, as ethics trap, 33–34
Food and Drug Administration
(FDA), 98
forbearance, 258
force majeure clause, 371
force majeure events, 418
Ford Motor Co., 146
Foreign Corrupt Practices Act
(FCPA), 202–204
foreign policy, President’s power to
conduct, 115
Foreign Sovereign Immunities Act
(FSIA), 202
forfeiture, 175–176
forgery
employee indorsement rule, 519
signature liability, 517
unauthorized instruments, 520
warranty liability, 514
Form 8-K, 736
formal rulemaking, 97–98
Fourteenth Amendment, 126–128
Fourth Amendment
online privacy and, 787–789
searches and seizures, 167–168
FoxConn, 41, 42
franchises, 691–693
fraud, 176–178. See also Statute of
Frauds
contracts and, 300–305
corporate, 706
defined, 140
insurance, 178
on the Internet, 797–799
parol evidence of, 331
fraudulent transfers, Chapter 7
liquidation, 569
free speech, 118–121
commercial speech, 121
morality and obscenity, 120–121
political speech, 119
time, place, and manner of speech,
120
“free speech zones”, 120
Freedom of Information Act (FOIA),
102–103
fresh start, Chapter 7 liquidation, 572
Friedman, Milton, 26, 43
Front Page test, 30
frustration of purpose, 370
FSIA (Foreign Sovereign
Immunities Act), 202
full warranty, 773
fully disclosed principal, 601–602
fundamental rights, 9
Equal Protection Clause and, 128
G
gambling contracts, 277
gap expenses, Chapter 7 liquidation,
571
gap period, Chapter 7 liquidation,
571
gap-filler provisions, 242
GATT (General Agreement on
Tariffs and Trade), 193–194
gender, Equal Protection Clause and,
127–128
gender identity, employment
discrimination because of,
653–654
General Agreement on Tariffs and
Trade (GATT), 193–194
general intangibles, 531
general partnerships, 685–688
Genetic Information
Nondiscrimination Act (GINA),
664
gifts, 848–851
acceptance of, 850
delivery of, 849
intention to transfer ownership,
848–849
inter vivos and causa mortis,
849–850
good faith, 365–367
buyer in the ordinary course of
business (BIOC), 458
contracts in, 412
Article 2 of the UCC, 429
requirements contracts, 261–262
covenant of good faith and fair
dealing, 622–623
I N D E X I9
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

good faith (continued )
exception to the exclusionary rule, 169
in performance and enforcement,
478
goods
consumer
buyers of, 547–548
perfection by, 542–544
defined, 226, 428, 532
description of, 464
movable, 544–545
nonconforming, 461
government, branches of, 7
government employees
alcohol and drug use, 628
due process before being fired, 124
whistleblowing, 625
government regulation, 732. See also
securities laws
antitrust law, 740–747
blue sky laws, 740
insider trading, 737–740
Internet service providers (ISPs)
and Web hosts, 793–795
of online privacy, 785–792
Children’s Online Privacy
Protection Act of 1998
(COPPA), 791
Electronic Communications
Privacy Act of 1986 (ECPA), 790
European law, 792
Federal Trade Commission
(FTC), 789–790
First Amendment, 785–787
Fourth Amendment, 787–789
state regulation, 791–792
short-swing trading, 737
Gramm-Leach-Bliley Privacy Act of
1999, 769
grand jury, 173
gratuitous assignment, 344
grease payments, 203
gross negligence, exculpatory clauses
to exclude, 284
Gun Control Act of 1968, 99
Gun-Free School Zones Act of 1990,
7, 112
H
hacking, 795–796
Hamilton, Alexander, 111
harmless error, 75
health insurance, 619
Hearst, Patricia, 167
hiring
duty of care and, 148–149
illegal workers, 181
negligent, of independent
contractors, 604–605
holder in due course, 507–509
home equity loans, 762
home loans, 761–763
honest services, theft of, 177–178
hostile work environment, 649–652
Age Discrimination in
Employment Act (ADEA),
658–659
Americans with Disabilities Act
(ADA), 663
House of Representatives, 7, 87
House-Senate Conference
Committee, 90–91
I
ICANN (Internet Corporation for
Assigned Names and Numbers),
823
identification of goods, 452–453
insurable interest and, 454
identifying goods to the contract, 487
identity theft, 769, 798
Identity Theft and Assumption
Deterrence Act of 1998, 798
illusory promises, 260–261
immigration, status of employees,
629
imperfect title, 455–458
implied authority, agency
relationship, 599–600
implied conditions, 359
implied contracts, 220–221
implied warranties, 465–467
disclaimers and, 468–469
of habitability, 843
import controls, 192–193
importing, 191
impossibility, breach of contract and,
369–371
impostor rule, 519
in camera inspection, 64–65
incidental beneficiaries, 340
incidental damages, 383, 490
incompleteness, written contracts,
324–325
incorporation of constitutional
protections, 118
incorporation process, 700–704
incorporator, 702
indemnification of agent by
principal, 595–596, 598
independent contractors, 604–605
Independent Directors Congress,
716
indictment, 173
indorsement, 507
fictitious payee rule, 519
indorsers, 513
inevitable discovery, exception to
the exclusionary rule, 169
informal rulemaking, 97
information
duty to provide, agency
relationship, 594
shareholders’ right to, 714
informational control, 102–103
informed decision, 712
infringement
copyright, 813–814
patent, 810
trademark, 821
initial public offerings (IPOs),
733–734
injunctions, 378
for breach of contract, 390
injury, in slander cases, 137
innocent misrepresentation, 302
insider trading, 737–740
insiders, Chapter 7 liquidation, 569
inspection
by buyers, 485–486
in camera, 64–65
I10 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

installment contracts, 486
Institutional Shareholder Services,
717
instructions, duty to obey, 593
instruments
as collateral, protection of buyers,
548–549
defined, 530
insurable interest, 452, 454–455
insurance
health, 619
insurable interest and, 278
investment, 202
insurance fraud, 178
integration clause, 417
integration clause (integrated
contract), 330
intellectual property, 805–827
copyrights, 812–818
overview, 806
patents, 806–812
trade secrets, 825–826
trademarks, 818–823
intended beneficiaries, 338–340
intentional infliction of emotional
distress, 139–140
Intentional torts, 136–140
physical or nonphysical harm, 608
intentional torts
agent’s liability for, 609
business torts, 144–145
exculpatory clauses to exclude, 284
principal’s liability for, 607–608
inter vivos gifts, 849–850
interests
defined, 378
insurable, 452, 454–455
legal, 451–452
nonpossessory, 837–838
reversionary, 840
security. See security interests
interference with a prospective
advantage, 145
intermediary agents, 601
international law, 190–206
extraterritoriality, 205–206
international sales agreements,
197–200
trade issues, 201–206
trade regulation, 191–196
international patent treaties, 811–812
international sales agreements,
197–200
Internet crime, 795
Internet privacy issues. See privacy,
online
Internet service providers (ISPs),
regulation of, 793–795
interpretive rules, 97
interstate commerce, regulation of,
112
Interstate Commerce Commission
(ICC), 95
intoxication, contracts and, 299
introductory paragraph of contracts,
410
intrusion, 145
inventory, purchase money security
interest (PMSI) in, 552
investigation
by administrative agencies, 98–99
no duty to undertake an, 301
investment insurance, 202
investment properties, 533
investment property, 530
invitations to bargain, 236
invitees, duty of due care and, 148
involuntary petition, Chapter 7, 566
Iroquois, 3
Issue sections, 15
issuer, defined, 502
ITT Corporation, 221
J
Jif peanut butter, 98
Johnson & Johnson (J&J), 28, 203
joint and several liability, 511
joint tenancy, 835
joint ventures, 691
judges, federal court, 58
judgment
default, 61
on the pleadings, 63
summary, 67–68
judgment non obstante veredicto
(JNOV), 74
judicial activism, 117
judicial power, 7, 115–117
judicial restraint, 117
judicial review, 115–116
agency power and, 100
jurisdiction, 52
defined, 52
diversity, 56–57
personal, 54
subject matter, 53–54
jurisprudence, 11–13
jury, voir dire, 69–70
jury instructions, 73
jury trial, right to, 69
in criminal cases, 166
justices, 56
justification, defense of, 144
K
Kant, Immanuel, 29, 30
Kantian Evasion (palter), 36
Kennedy, John F., 88
kickbacks, 177–178
L
labor unions, 633–638
collective bargaining, 635–636
organizing, 633–635
land, 833
land use regulation, 838–839
landlord
duties, 841–844
duty to mitigate, 846
liability of, 847
remedies for nonpayment of rent,
845 real property, duty to use
premises for proper purpose, 846
landlord’s lien, 550
landlord-tenant law, 840
landowners, duty of due care and,
147–148
larceny, 176
I N D E X I11
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

law(s), 3
administrative, 10, 95–103
civil, 10–11
classifications of, 10–11
from colonial era to the twentieth
century, 6
common. See common law
criminal, 10, 11
English roots of, 4–6
fascination with, 3
importance of, 3
morality and, 11
natural, 12
origins of, 4
role in society, 3–4
sources of contemporary, 6–10
statutory, 87–94
lawyer(s), 401
advantages of using, 402
hiring, 402–403
perspective of, 402
right to a, 173
leading object rule, 322–323
leasehold interest, 840
leases, 840, 843
legal interest, 451–452
legal positivism, 11–12
legal realism, 12–13
legality of contracts, 276–289
legislation proposed by the
President, 115
legislative history and intent, 92
legislative power, 7
legislative rules, 97
letter of credit, 198–199
letter-of-credit rights, 533
letters of intent, 236–237
liability
agency relationship, 599–603
conversion, 518–519
employee indorsement rule, 519
impostor rule, 519
for injuries in real property, 847
limited, 675
for negotiable instruments, 511
partnerships, 686
primary, 511
product, 155–156
promoter’s, 700
secondary, 511–512
under Securities Exchange Act of
1934, 736–737
signature, 511
transfer warranties compared to,
517
strict, 154–156
warranty, 514–518
libel, 135, 136
license, 837
licensees, duty of due care and, 148
licensing statutes, 278–279
liens, 838
security interests and, 549–550
Life Principles, 36, 42, 44
life prospects, 30
lifestyle laws, 626–630
limitation of remedy, 469–470
limited liability, 675
limited liability companies (LLCs),
679–684
limited liability limited partnerships,
689–690
limited liability partnerships (LLPs),
688–689
limited partnerships, 689–690
Lincoln, Abraham, 31
liquidated damages, 493–494
liquidated damages clause, 378,
392–393
liquidated debts, 265
liquidation, under Bankruptcy Code,
564
liquidation rights, 703
litigation, 60–69
alternative dispute resolution
versus, 52
answer to a complaint, 61
class actions, 62
complaints, 60
counter-claims, 62
default judgment, 61
defined, 52
depositions, 63
discovery, 63–67
final preparation for, 69
interrogatories, 63
judgment on the pleadings, 63
physical and mental examination,
63
pleadings, 60
production of documents and
things, 63
service of papers, 61
litigator, 52
loans
mortgage, 761–763
Truth in Lending Act (TILA),
760–763
usury laws, 279
Locke, Richard, 41–42
lockouts, 638
long-arm statute, 54
loss, risk of
failure to allocate the risk, 459–463
sale of goods and, 458–459
shipping terms, 459
“lost in a crowd”, as ethics trap, 34
low-profit limited liability companies
(L3Cs), 685
loyalty, 42
duty of, agency relationship,
590–593
lying, ethics and, 36–37
M
Macy’s, 44
Madison, James, 102
Madoff, Bernard, 35
Madrid Agreement, 824
Magnuson-Moss Warranty Act, 773
mail, merchandise bought by, 758
mail fraud, 177
mailbox rule, 249
maker of promissory notes, 502
primary liability, 511
malicious interference with a
developing economic
relationship, 145
managers, corporate, 707–712
mandatory possession, 541
I12 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

marriage, promise made in
consideration of, 323
Marshall, John, 115
material breach, 367–368, 412
material misstatement, 301
mechanic’s lien, 550
mediation, 76
mediator, 76
memorandum, 64
mental disabilities, discrimination on
the basis of, 662–663
mentally impaired persons, contracts
and, 298–300
merchantability, implied warranty of,
465–468
merchants, 429
merchants’ exception rule, 327
merit, defense to charges of
discrimination, 654
Midler, Bette, 146
Mill, John Stuart, 29
minimum contacts, 54–55
minors, capacity of, 296–298
Miranda rights, 172
mirror image rule, 244–245
miscellaneous section, in contracts,
415
misdemeanors, defined, 166
misrepresentation of fact
age, 297
innocent, 302
intentional or reckless, 300
nondisclosure, 302
parol evidence of, 331
mistakes, contracts and, 305–307
misuse by the buyer, 472
mitigation of damages, 392
mixed contracts, 429
model, express warranty and, 465
Model Act, 701, 708
Model Business Corporation Act
(Model Act), 700
modification, of agreements, 263
modification provisions, 415
modifications, under Article 2 of the
UCC, 441
modify, 74
money, as ethics trap, 31–32
money laundering, 182
monopolization, 743–744
moral consideration, consideration
and, 268–269
morality
free speech and, 120–121
law and, 11
mortgage loans, 761–763
mortgagee, 838
mortgages, 838
mortgagor, 838
motions
after the Verdict, 74
to compel answers to
interrogatories, 64
defined, 63
for directed verdict, 72
to dismiss, 63
for a protective order, 64
motor vehicles, security interests in,
544–545
movable goods, perfection of, 544
movies, digital, 815–818
Mudd, Michael, 26
music, digital, 815–818
N
NAFTA (North American Free
Trade Agreement), 10, 196
National Fraud Alert System, 769
National Labor Relations Act
(NLRA), 629, 632–634, 636
National Labor Relations Board
(NLRB), 629, 633, 634
national security letter (NSL), 170
nationalization of property, 201
natural law, 12
necessaries, 297
negligence, 135, 146–156
assumption of the risk, 153–154
bailment and, 853–854
breach of duty, 149
causation, 149–151
comparative, 152
contributory, 152
defenses, 152–154
duty of due care, 146–149
elements of, 146
gross, exculpatory clauses to
exclude, 284
per se, 149
res ipsa loquitur, 151
strict liability, 154–156
unauthorized instruments, 520
negligent hiring of independent
contractors, 604–605
negotiable bill of lading, 198
negotiable commercial paper,
503–506
negotiable instruments, 427,
501–521. See also commercial
paper
holder in due course, 507–509
interpretation of ambiguities, 505
liability for, 511
negotiation requirement, 506–507
notice of outstanding claims or
other defects, 509
presentment warranties, 517–518
types of, 502
negotiation, 75
No Electronic Theft Act, 817
nominal damages, 392
noncompete agreements (covenants
not to compete), 218, 281–283
consideration in, 267
sale of a business and, 282
nonconforming goods, 461
non-delivery, 493
non-negotiable commercial paper,
503–505
nonpossessory interests, 837–838
Norris-LaGuardia Act, 632
North American Free Trade
Agreement (NAFTA), 10, 196
notes (corporate debt), 705
notes (promissory notes)
consumer credit contracts, 510
defined, 502
notice of outstanding claims or other
defects, 509
notices, in contracts, 418
I N D E X I13
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

novation, 349
nuisance law, 838
O
obligor, 341
defined, 529
notice to, 344
obscenity, free speech and, 120–121
Occupational Safety and Health Act
(OSHA), 180, 630
Occupational Safety and Health
Administration (OSHA), 99
The Oculist’s Case (1329), 5–6
offeree, 236
offeror, 236
offers
acceptance of, 244
advertisements generally not,
237–238
agreements and, 235–244
auctions not considered, 238–239
contracts and, 215
definiteness problems, 239–241
firm, 243
making contracts temporarily
irrevocable, 243
statements that usually do not
amount to, 236–239
termination of, 242–244
officers and directors, corporate,
704–705
compensation for, 717–722
election and removal of, 716–717
On the Laws and Customs of England (De
Legibus et Consuetudinibus Angliae), 5
online privacy, 784
regulation of, 785–792
tracking tools, 784–785
online sales, 758
open price, 242
open terms, under Article 2 of the
UCC, 437–441
opening statements, 71
opinions
defamation and, 137
not considered fraud, 300–301
oppression, unconscionable contracts
and, 287
oral express warranties, 468
order for relief, bankruptcy court, 566
output contracts, 242, 439–440
consideration in, 261
outsourcing, 39
overlawyering, 409
Overseas Private Investment
Corporation (OPIC), 202
ownership, legal interest and,
451–452
P
palter (Kantian Evasion), 36
paper currency, 502
Paris Convention for the Protection
of Industrial Property (Paris
Convention), 811, 824
parody, 815
parol evidence, 329–331
part performance by the buyer, oral
contracts, 320
partial acceptance, 485
participating preferred stock, 703
partition by kind, 835
partnerships
general, 685–688
limited, 689–690
limited liability (LLPs), 688–689
limited liability limited, 689–690
Patent and Trademark Office (PTO),
807–810, 812, 819–821, 824, 825
Patent Cooperation Treaty, 811–812
Patent Law Treaty, 811
Patent Prosecution Highway, 812
patent trolls, 810–811
patents, 806–812
application and issuance, 809–812
requirements for, 808–809
utility, 807–808
Patient Protection and Affordable
Healthcare Act, 113
Patriot Act, 170
payee of promissory notes, 502
pension benefits, 632
peremptory challenges, 70
perfect tender rule, 479–484
perfection, 536–545
of consumer goods, 542–544
defined, 530
by filing, 536–540
of movable collateral and fixtures,
544–545
by possession or control, 540–542
performance, 215, 357, 362–367
buyer’s rights and obligations,
485–489
course of performance, 480
perfect tender rule, 479–484
seller’s rights and obligations,
478–484
specific, 491
strict, 363
substantial, 363
periodic tenancy, 841
perjury, 138
perks, executive, 719
permanent injunction, 391
personal injury, privity and, 471
personal jurisdiction, 54
personal performance, substantial
interest in, 348
personal property, 848–854
personal satisfaction contracts,
364–365
phishing, 798–799
picketing, 637
plain meaning rule, 92
plain view, 168
plaintiff, 14
plaintiff ’s case, 71–72
plan of payment, Chapter 13 consumer
reorganizations, 580–581
plan of reorganization, Chapter 11
reorganization, 577
plea bargaining, 173
pleadings, 60
pledge, 540
plurality voting, 716
political speech, 119–120
polygraph tests, 628
Porter, Michael, 43
I14 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

possession
mandatory, 541
perfection by, 540–542, 551
security interests, 533–535
temporary, 451
precedent, 5, 9
appeals and, 74
predatory pricing, 744
predominant purpose, mixed
contracts and, 429, 431
preexisting duty, 262–265
preferences, voidable, 569
preferred stock, 703
Pregnancy Discrimination Act, 656
preliminary injunction, 391
preponderance of the evidence, 71
presentment warranties, 517–518
President, powers of, 7, 9
price discrimination, 747
price fixing, 742–743
price quotes, 236
pricing, predatory, 744
primary liability, 511
priority claims, Chapter 7 liquidation,
571
privacy, 145–146
no expectation of, 168
online, 784
regulation of, 785–792
tracking tools, 784–785
workplace, 626
Privacy Act, 103
private offerings, 734–735
privity, 470–472
strict liability and, 156
probable cause, 168
procedural due process, 123–124
proceeds, of collateral, security
interest in, 536
Procter & Gamble (P&G), 98
product liability, 155–156
product safety, consumer, 774
professional corporations (PCs),
690–691
professionals, duty of care, 148
profits, 837
repatriation of, 201
promisee, 338
promises
collateral, 322–323
conditional, 414
as consideration, 257
in consideration of marriage, 323
by executor of an estate, 323
express warranties, 464
illusory, not consideration,
260–261
promisor, 338
promissory estoppel, 222–223
consideration and, 268–269
exception to the writing
requirement, 320
reliance damages, 386
promissory notes
consumer credit contracts, 510
defined, 502
proof of claim, Chapter 7 liquidation,
566–567
Proposition 187, 12
prosecution, 165–166
prospective advantage, tortious
interference with a, 145
prospectus, 734
proximate cause, 150
proxy, 715
proxy access, 717
proxy advisors, 717
proxy statement, 715
Pub Zone case, 2, 11
public personalities, defamation and,
137–138
public policy, 92
assignments and, 343
contracts that violate, 281–283
delegation of duties, 348
discharge of employees and,
619–622
express conditions, 361
publicity, 145–146
puffery, not considered fraud, 301
punishment
of corporations, 183–184
prohibition of cruel and unusual,
174–175
punitive damages, 142–143
purchase money security interest
(PMSI), 542–543, 552
purchaser representative, 735
Q
quarterly reports, 736
quasi-contracts, 224
restitution, 389
quiet enjoyment, 842
R
race, Equal Protection Clause and,
128
Racketeer Influenced and Corrupt
Organizations Act (RICO),
181–182
ratification
agency relationship, 600–601
of contracts, by a minor, 297
rational business purpose, 712
rationalization, 32
Rawls, John, 30
Rawlsian justice, 30
reaffirmation, under Chapter 7
liquidation, 575
real property, 832–838
estates in, 834–837
land use regulation, 838–839
landlord’s duties, 841–844
landlord-tenant law, 840
liability for injuries, 847
nature of, 833
nonpossessory interests in,
837–838
tenant’s duties, 845–846
types of tenancy, 840–841
zoning, 839
reasonable care, strict liability and, 156
reasonable certainty, written
contracts, 324
reasonable person standard, duty of
care and, 148
Reasoning sections, 15
reciprocal promises, 414
record, defined, 530
I N D E X I15
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deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

redemption, right of, 555
references about former employees,
623–624
reformation, 392
registration statement, 734
regulation. See also government
regulation
land use, 838
of online privacy, 785–792
self-regulation, 785
Regulation D, Securities Act of 1933,
734
Rehabilitation Act of 1973, 659–660,
664
rejection
non-conforming goods, 485–486
termination of offers by, 243
reliance, justifiable, 301
reliance damages, 385–386
reliance interest, 379
religion, employment discrimination
on the basis of, 652
remedies
for breach of contracts, 377 See also
damages
defined, 378
expectation interest, 379–385
identifying the “interest” to be
protected, 378–379
injunction, 390–391
reformation, 392
reliance interest, 385–387
restitution interest, 387–389
specific performance, 389–390
limitation of, breach of warranty
and, 469–470
rent
duty to pay, 845
landlord’s remedies for
nonpayment of, 845
repatriation of profits, 201
replacement workers, 637
reply to a counter-claim, 62
repossession, defined, 530
representations, in contracts, 414
repudiation, 487
improper delegation and, 349
reputation, cost of losing, 28
requirements contracts, 242, 439–440
consideration in, 261
res ipsa loquitur, 151
resale, seller’s remedy, 487–488
resale price maintenance (RPM), 742
rescission
of contracts, 263, 296, 300–307,
309, 357, 388
of mortgage loans, 762
of voidable contracts, 388
restitution, 166, 296
by mentally infirm party, 300
quasi-contracts, 389
voidable contracts, 388–389
restitution interest, 379, 387–389
retaining workers, duty of care and,
149
retaliation, prohibition against, 652
reverse, 74
reverse and remand, 74
reversed, 56
reversionary interest, 840
revocation
of acceptance, 485
discharge under Chapter 7, 574
making contracts temporarily
irrevocable, 243
termination of an offer by, 242–243
RICO (Racketeer Influenced and
Corrupt Organizations Act),
181–182
rider, 415
right of survivorship, 837
right to a lawyer, 173
risk
assumption of, negligence and,
153–154
of loss
failure to allocate the risk,
459–463
sale of goods and, 458–459
shipping terms, 459
Robinson-Patman Act (RPA), 747
Roosevelt, Franklin D., 95
rule of reason, 741
rulemaking
formal, 97–98
informal, 97
power of administrative agencies,
96–98
rules
interpretive, 97
legislative, 97
S
S Corporations, 677–678
sales, 424–449
consumer protection and, 756–759
Uniform Commercial Code (UCC)
See also Article 2 of the UCC
basics, 428
sales agreements, international,
197–200
sample, express warranty and, 465
Sarbanes-Oxley Act of 2002 (SOX),
625, 716
search and seizure, 99
searches, without a warrant, 168–169
searches and seizures, 167–168
secondary liability, 511–512
secondary offerings, 733
secured party, defined, 529
secured transactions, 528–556
securities, defined, 733
Securities Act of 1933, 733–735
Securities Exchange Act of 1934,
735–737
securities laws, 733–740. See also
government regulation
Securities Act of 1933, 733–735
Securities Exchange Act of 1934,
735–737
security agreements, 529, 533
security deposit, duty to return, 844
security interests, 451
agreement required, 533
assignment of, 345
attachment of, 532–535
attachment to future property,
535–536
control and possession and,
533–535
I16 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

debtor rights in the collateral, 535
default, 553–556
defined, 529
filing versus control or possession,
551
insurable interest and, 454
perfection of, 536–545
of consumer goods, 542–544
defined, 530
by filing, 536–540
of movable collateral and
fixtures, 544–545
by possession or control,
540–542
possession and, 534
priorities among creditors, 550–551
protection of buyers, 545–550
purchase money security interest
(PMSI), 542–543, 552
value and, 535
self-dealing, 709
self-incrimination, 171
sellers, rights and obligations of,
478–479
seller’s conduct, express warranty
and, 465
Senate, bills, 87
seniority, defense to charges of
discrimination, 654
separation of powers, 111
service marks, 819
service of papers, 61
settlement of debts, 265–267
severability, 417
sex, employment discrimination on
the basis of, 652–653
sexual harassment, 649–650
sexual orientation, employment
discrimination because of, 653
shareholder activists, 717
shareholders, rights of, 713–724
election and removal of directors,
716–717
enforcing, 724–725
fundamental corporate changes,
722
right to dissent, 723
right to information, 714
right to protection from other
shareholders, 723
right to vote, 714–716
Sheen, Charlie, 38
Sherman Act, 741–744
shilling, 797
shipment contracts, 460
shipping terms, 459
shoplifting, 176
short-swing trading, 737
shrimp and shrimp products,
import prohibition of certain,
194–195
shrinkwraps, 247–249
signature
indorsement, 507
written contracts, 324
signature liability, 511, 517
silence, fraud and, 302–303
sit-down strikes, 637
Skilling, Jeffrey, 177–178
slander, 136
small-business bankruptcy, Chapter
11 reorganization, 579
smoking in the workplace, 626–627
social media, employees and, 629
social regulation, Equal Protection
Clause and, 127
social security, 631–632
socially conscious organizations,
685
society, role of business in, 26–27
software, Article 9 of the Uniform
Commercial Code, 532
sole discretion clauses, 412
sole proprietorships, 674
sovereign, 11
sovereign immunity, 202
SOX (Sarbanes-Oxley Act), 716
spam, 792–793
special appearance, 54
specially manufactured goods,
328–329
specific performance, 378, 389–390,
491
spyware, 792
stakeholders, 708
stare decisis, 9, 84
state courts, 52–56
state regulation, of online privacy,
791–792
status quo rule, 296
Statute of Frauds, 317, 318
common law, contracts that must
be in writing, 319–326
Uniform Commercial Code (UCC),
326–329
statute of limitations, breach of
contract, 369
statutes, 9
statutory law, 87–94
bills, 87–88
stock, 702–703
stock options, 718–719
stop and frisk, 168
stopping delivery, 487
strict liability, 154–156
strict performance, 363
strikes, 636–637
subagents, 601
subject matter jurisdiction, 53–54
subpoenas, 98
duces tecum, 98
subprime loans, 761
subsidized goods, 193
substantial effect rule, 112
substantial impairment, 482
substantial performance, 363
substantive due process, 123, 126
Summa Theologica (Aquinas), 12
summary judgment, 67–68
summons, 54
superseding cause, 150
Supremacy Clause, 114
Supreme Court, United States, 7,
9, 58
supreme courts, state, 56
surprise, unconscionable contracts
and, 287
suspension, academic, 124
sweatshop factories, 41
I N D E X I17
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

T
takeovers, inside information and, 739
Takings Clause, 122, 124–126, 839
tariffs (duties), 192
taxes
Chapter 7 liquidation, 571
corporations, 676–677
limited partnerships, 689
partnerships, 685
taxing power, 113
telemarketing, 758–759
telephone, merchandise bought by,
758
temporary possession, 451
tenancy
in common, 834–835
by the entirety, 837
joint, 835
periodic, 841
at sufferance, 841
at will, 841
for years, 841
tenants, 840
in demesne, 5
duties of, 845–846
tender of goods, 478–482
termination
of agency relationship, 596
of security interest, 556
termination of offers, 242–244
by expiration, 244
by operation of law, 244
by rejection, 243
theft
of domain name, 824
of honest services, 177–178
identity, 769, 798
third parties, 337–350
assignment of rights, 341–346
beneficiaries, 338–340
delegation of duties, 347–350
ownership and, 451
third-party interests, contracts and, 215
Thirteenth Court of Appeals
(Federal Circuit), 58
Thomas Aquinas, St., 12
time of the essence clauses, 367
tippers and tippees, 738–739
title
of contracts, 409
existence and identification of
goods and passing of, 452–453
imperfect, 455–458
insurable interest and, 452
legal interest and, 451
passing of, 453–454
voidable, 451, 456, 473
warranty of, 467
Title VII of the Civil Rights Act of
1964, 88, 91, 92
employment discrimination and,
646–652
tortious interference with business
relations, 144–145
torts
agent’s liability for, 609
business, 144–146
defined, 135
employment-related, 623–624
Intentional
agent’s liability for, 609
business torts, 144–145
exculpatory clauses to exclude,
284
principal’s liability for, 607–608
principal’s liability for, 604–608
strict liability, 154–156
trade regulation, 191–196
trade secrets, 825–826
Trademark Law Treaty, 825
trademarks, 818–823
international treaties, 824–825
transaction value, 193
transfer of ownership
limited partnerships, 690
partnerships, 687
transfer warranties, 515–516
signature liability compared to, 517
transferability of interests, 675
limited liability companies
(LLCs), 681
treaties, 10, 193–196
copyright, 818
patent, 811–812
trademark, 824–825
treble damages;, 182
trespassing, 147–148
trial, 69–74
as adversary system, 69
burden of proof, 71
closing arguments, 73
criminal, 174
defendant’s case, 73
jury, right to, 69
in criminal cases, 166
jury instructions, 73
motion for directed verdict, 72
motions after the verdict, 74
opening statements, 71
plaintiff ’s case, 71–72
rules of evidence, 72
verdict, 73–74
trial courts, 52–54, 57
trustees, Chapter 7 liquidation,
566–567
truth in hiring, employment
agreements, 622
Truth in Lending Act (TILA),
760–761
tying arrangements, 746–747
typos, in contracts, 407–408
U
UDRP (Uniform Domain Name
Dispute Resolution Policy),
823–824
ultrahazardous activity, 155
unauthorized agents, 603
unconscionability, Article 2 of the
UCC, 429
unconscionable contracts, 287–289
undisclosed principal, 602–603
undue influence, contracts and,
309–310
unenforceable agreements, 219
unethical behavior, as costly, 28
unfair acts or practices, 757
unfair labor practices (ULPs), 633
I18 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

unforeseen circumstances,
consideration and, 265
unidentified principal, 602
Uniform Commercial Code (UCC),
225–227, 427, 428
accord and satisfaction by check,
266, 267
Article 2 of. See Article 2 of the
Uniform Commercial Code
Article 9 of the Uniform
Commercial Code (UCC)
scope of, 530–532
terms used in, 529–530
assignments of security interests,
345
“battle of forms”, 245–246
consideration in requirements and
output contracts, 261–262
impact on the common law, 443
modification of contracts, 263
open terms and, 241–242
purpose of, 428
remedies for breach of contract,
383–384
rescinding a contract and then
suing for damages, 302
seller’s rights and obligations,
478–484
Statute of Frauds, 326–329,
431–433
types of contracts governed by,
426–427
unconscionability and, 288–289
Uniform Electronic Transactions Act
(UETA), 326
Uniform Trade Secrets Act (UTSA),
825
unilateral contracts, 218–219
unilateral mistake, 305–306
unions. See labor unions
United Nations Convention on
Contracts for the International
Sale of Goods (CISG), 197
United States Courts of
Appeals, 58
United States District
Court, 57–58
unliquidated debts, 265–267
unordered merchandise, 759
unsecured claims, Chapter 7
liquidation, 571–572
U.S. Trustee, 566
usage of trade, 479
usury, 279–280
utilitarian ethics, 29
utility patents, 807–808
V
vagueness
in contracts, 403–405
written contracts, 324
valid contracts, 219
valuation, import controls
and, 193
value
consideration and, 257–258
security interests and, 535
variance, 839
“veil of ignorance”, 30
vertical maximum price fixing, 743
vertical price fixing, 742
veto, presidential, 7, 9, 87
congressional override
of, 93–94
VIPshop, 28
void agreements, 219
voidable contracts, 219
capacity and, 296
restitution, 388–389
voidable preferences, 569
voidable title, 451, 456, 473
voir dire, 69–70
voluntary act, crime as, 167
voluntary petition, Chapter 7, 565
voting rights
shareholders’, 714–715
stock, 702–703
W
wagers, 277
waiver
of right to jury trial, 69
of sovereign immunity, 202
warranties, 463–467
assignor’s, 344
buyer’s misuse and, 472
in contracts, 414
disclaimers and, 468–469
express, 464–465
implied, 465–467
disclaimers and, 468–469
of habitability, 843
Magnuson-Moss Warranty
Act, 773
presentment, 517–518
of title, 467
transfer, 515–516
warrants, 167–168
searches without, 168
warranty liability, 514–518
Web hosts, regulation
of, 793–795
Whistleblower Protection
Act, 625
whistleblowing, 624–626
wire fraud, 177
workers. See also employees
illegal, hiring, 181
workers’ compensation, 631
workplace
hostile work environment,
649–650
personal ethics in the, 37
workplace crimes, 180–183
World Trade Organization (WTO),
194–195
writ of certiorari, 58
written contracts, 215, 316–331.
See also contracts
agreements that cannot be
performed within one
year, 321
common law Statute of Frauds,
319–326
electronic contracts and
signatures, 326
incomplete or ambiguous, parol
evidence of, 331
integrated contract, 330
I N D E X I19
Copyright 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has
deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

written contracts (continued )
parol evidence and, 329–331
promise made by an executor of an
estate, 323
promise made in consideration of
marriage, 323
promise to pay the debt of another,
322–323
UCC’S Statute of Frauds,
326–329
what the writing must contain,
323–326
when required, 401
written express
warranties, 468
wrongful discharge, 619–622
Y
Yanni, 39
Yoplait, 43
“You Be the Judge” feature, 17
Z
zoning, 839
I20 I N D E X
C o p y r i g h t 2 0 1 3 C e n g a g e L e a r n i n g . A l l R i g h t s R e s e r v e d . M a y n o t b e c o p i e d , s c a n n e d , o r d u p l i c a t e d , i n w h o l e o r i n p a r t . D u e t o e l e c t r o n i c r i g h t s , s o m e t h i r d p a r t y c o n t e n t m a y b e s u p p r e s s e d f r o m t h e e B o o k a n d / o r e C h a p t e r ( s ) . E d i t o r i a l r e v i e w h a s
d e e m e d t h a t a n y s u p p r e s s e d c o n t e n t d o e s n o t m a t e r i a l l y a f f e c t t h e o v e r a l l l e a r n i n g e x p e r i e n c e . C e n g a g e L e a r n i n g r e s e r v e s t h e r i g h t t o r e m o v e a d d i t i o n a l c o n t e n t a t a n y t i m e i f s u b s e q u e n t r i g h t s r e s t r i c t i o n s r e q u i r e i t .

Cover ��
IFC
Title ��
Statement ��
Copyright ��
Contents: Overview ��
Contents ��
Preface ��
Unit 1: The Legal Environment
Ch 1: Introduction to Law ��
Introduction ��
1-1: The Role of Law in Society
1-2: Origins of Our Law ��
1-3: Sources of Contemporary Law ��
1-4: Classifications ��
1-5: Jurisprudence ��
1-6: Working with the Book’s Features ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 2: Ethics and Corporate Social Responsibility ��
2-1: Introduction ��
2-2: The Role of Business in Society
2-3: Why Be Ethical? ��
2-4: Theories of Ethics ��
2-5: Ethics Traps ��
2-6: Lying: A Special Case
2-7: Applying the Principles ��
2-8: When the Going Gets Tough ��
2-9: Corporate Social Responsibility (CSR)
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 3: Dispute Resolution ��
Introduction ��
3-1: Three Fundamental Areas of Law ��
3-2: Court Systems
3-3: Litigation
3-4: Trial
3-5: Appeals
3-6: Alternative Dispute Resolution
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 4: Common Law, Statutory Law, and Administrative Law ��
Introduction ��
4-1: Common Law ��
4-2: Statutory Law ��
4-3: Administrative Law ��
4-4: Power of Agencies ��
4-5: Limits on Agency Power ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 5: Constitutional Law ��
Introduction ��
5-1: Government Power ��
5-2: Overview ��
5-3: Power Granted ��
5-4: Protected Rights ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 6: Torts and Product Liability ��
Introduction ��
6-1: Intentional Torts ��
6-2: Damages ��
6-3: Business Torts ��
6-4: Negligence ��
6-5: Defenses ��
6-6: Strict Liability ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 7: Crime ��
Introduction ��
7-1: The Differences between a Civil and Criminal Case
7-2: Criminal Procedure ��
7-3: Crimes that Harm Business
7-4: Crimes Committed by Business ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 8: International Law ��
Introduction ��
8-1: Trade Regulation: The Big Picture
8-2: International Sales Agreements ��
8-3: International Trade Issues ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��

Unit 2: Contracts ��
Ch 9: Introduction to Contracts ��
Introduction ��
9-1: Contracts ��
9-2: Types of Contracts ��
9-3: Sources of Contract Law ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 10: Agreement ��
Introduction ��
10-1: Meeting of the Minds ��
10-2: Offer ��
10-3: Acceptance ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 11: Consideration ��
Introduction ��
11-1: What Is Consideration? ��
11-2: Applications of Consideration ��
11-3: Settlement of Debts ��
11-4: Consideration: Trends ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 12: Legality ��
Introduction ��
12-1: Contracts That Violate a Statute ��
12-2: Contracts That Violate Public Policy ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 13: Capacity and Consent ��
Introduction ��
13-1: Capacity
13-2: Reality of Consent
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 14: Written Contracts ��
Introduction ��
14-1: Common Law Statute of Frauds: Contracts That Must Be in Writing ��
14-2: The Common Law Statute of Frauds: What the Writing Must Contain
14-3: The UCC’s Statute of Frauds
14-4: Parol Evidence ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 15: Third Parties ��
Introduction ��
15-1: Third Party Beneficiary ��
15-2: Assignment and Delegation ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 16: Performance and Discharge ��
Introduction ��
16-1: Conditions
16-2: Performance
16-3: Breach
16-4: Impossibility
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 17: Remedies ��
Introduction ��
17-1: Breaching a Contract ��
17-2: Expectation Interest ��
17-3: Reliance Interest ��
17-4: Restitution Interest ��
17-5: Other Remedies ��
17-6: Special Issues ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 18: Practical Contracts ��
Introduction ��
18-1: The Lawyer
18-2: The Contract
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��

Unit 3: Commercial Transactions ��
Ch 19: Introduction to Sales ��
Introduction ��
19-1: Development of Commercial Law ��
19-2: UCC Basics
19-3: Contract Formation ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 20: Ownership, Risk, and Warranties ��
Introduction ��
20-1: Legal Interest ��
20-2: Identification, Title, and Insurable Interest ��
20-3: Imperfect Title ��
20-4: Risk of Loss ��
20-5: Warranties ��
20-6: Express Warranties ��
20-7: Implied Warranties ��
20-8: Disclaimers and Defenses ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 21: Performance and Remedies ��
Introduction ��
21-1: Obligation on All Parties: Good Faith ��
21-2: Seller’s Rights and Obligations ��
21-3: Buyer’s Rights and Obligations ��
21-4: Seller’s Remedies ��
21-5: Buyer’s Remedies ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 22: Negotiable Instruments ��
Introduction ��
22-1: Commercial Paper ��
22-2: Types of Negotiable Instruments
22-3: The Fundamental “Rule” of Commercial Paper
22-4: Liability for Negotiable Instruments ��
22-5: Signature Liability ��
22-6: Warranty Liability ��
22-7: Other Liability Rules ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 23: Secured Transactions ��
Introduction ��
23-1: Article 9: Terms and Scope ��
23-2: Attachment of a Security Interest ��
23-3: Perfection ��
23-4: Protection of Buyers ��
23-5: Priorities Among Creditors ��
23-6: Default and Termination ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 24: Bankruptcy ��
Introduction ��
24-1: Overview of the Bankruptcy Code ��
24-2: Chapter 7 Liquidation ��
24-3: Chapter 11 Reorganization ��
24-4: Chapter 13 Consumer Reorganizations ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 25: Agency Law ��
Introduction ��
25-1: Creating an Agency Relationship ��
25-2: Duties of Agents to Principals ��
25-3: Duties of Principals to Agents ��
25-4: Terminating an Agency Relationship ��
25-5: Liability ��
25-6: Principal’s Liability for Contracts ��
25-7: Agent’s Liability for Contracts ��
25-8: Principal’s Liability for Torts ��
25-9: Agent’s Liability for Torts ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��

Unit 4: Employment, Business Organizations and Property ��
Ch 26: Employment and Labor Law ��
26-1: Introduction ��
26-2: Employment Security ��
26-3: Privacy in the Workplace ��
26-4: Workplace Safety ��
26-5: Financial Protection ��
26-6: Labor Law and Collective Bargaining ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 27: Employment Discrimination ��
27-1: Introduction ��
27-2: The United States Constitution
27-3: Civil Rights Act of 1866 ��
27-4: Title VII of the Civil Rights Act of 1964
27-5: Equal Pay Act of 1963 ��
27-6: Pregnancy Discrimination Act ��
27-7: Age Discrimination in Employment Act ��
27-8: Discrimination on the Basis of Disability ��
27-9: Genetic Information Nondiscrimination Act ��
27-10: Enforcement ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 28: Starting a Business: LLCs and Other Options
Introduction ��
28-1: Sole Proprietorships ��
28-2: Corporations ��
28-3: Limited Liability Companies ��
28-4: Socially Conscious Organizations ��
28-5: General Partnerships ��
28-6: Limited Liability Partnerships ��
28-7: Limited Partnerships and Limited Liability Limited Partnerships ��
28-8: Professional Corporations ��
28-9: Joint Ventures ��
28-10: Franchises ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 29: Corporations ��
Introduction ��
29-1: Promoter’s Liability ��
29-2: Incorporation Process ��
29-3: After Incorporation ��
29-4: Death of the Corporation ��
29-5: The Role of Corporate Management
29-6: The Business Judgment Rule
29-7: The Role of Shareholders
29-8: Enforcing Shareholder Rights ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 30: Government Regulation: Securities and Antitrust
Introduction ��
30-1: Securities Laws ��
30-2: Antitrust Law ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 31: Consumer Protection ��
31-1: Introduction ��
31-2: Sales ��
31-3: Consumer Credit ��
31-4: Magnuson-Moss Warranty Act
31-5: Consumer Product Safety ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 32: Cyberlaw ��
Introduction ��
32-1: Privacy ��
32-2: Spam ��
32-3: Internet Service Providers and Web Hosts: Communications Decency Act of 1996 ��
32-4: Crime on the Internet ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 33: Intellectual Property ��
33-1: Introduction ��
33-2: Patents ��
33-3: Copyrights ��
33-4: Trademarks ��
33-5: Trade Secrets ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��
Ch 34: Real and Personal Property ��
Introduction ��
34-1: Nature of Real Property ��
34-2: Estates in Real Property ��
34-3: Nonpossessory Interests ��
34-4: Land Use Regulation ��
34-5: Landlord-Tenant Law
34-6: Types of Tenancy ��
34-7: Landlord’s Duties ��
34-8: Tenant’s Duties ��
34-9: Injuries ��
34-10: Personal Property ��
34-11: Gifts ��
34-12: Bailment ��
Chapter Conclusion ��
Exam Review ��
Multiple-Choice Questions
Essay Questions ��
Discussion Questions ��

Appendix A: The Constitution of the United States
Appendix B: Uniform Commercial Code (Selected Provisions)
Glossary ��
Table of Cases ��
Index ��

Introduction to Law

Power
Strong reach of the law touches nearly everything we do
Everyone will influence and be affected by the law
Importance
Every society with a historical record has had some system of laws
Many societies contributed ideas
Solved the problem of federalism

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Fascination
Television – Offers at least one new courtroom drama to a national audience
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

English roots
Land – Most valuable commodity
Statute of frauds
Landlord-tenant law
Precedent: Tendency to decide current cases based on previous rulings
Common law: Judge-made law

Law in the United States
Some laws were irrelevant in a world that was socially and geographically so different
Changing conditions raised new legal questions
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

United States Constitution – Supreme law of the land
Establishes the national government of the United States – Legislative, executive, judicial power
Creates a system of checks and balances among the branches
Guarantees many basic rights to the American people
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Statute: Law created by a legislative body
Bill – Idea for a new law
Common law
The principle that precedent is binding on later cases is called stare decisis – “let the decision stand”

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
Federal Government 50 State Governments
Legislative Branch Congress State Legislatures
Executive Branch President Governors
Judicial Branch Federal Courts State Courts

Court orders
Judges have the authority to issue court orders
Place binding obligations on specific people or companies
Administrative law
Enforce statutes passed by Congress
Treaties
Constitution authorizes the president to make treaties with foreign nations
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Criminal and civil Law
Criminal law: Prohibits certain behavior
Civil law: Regulates the rights and duties between parties
Law and morality

Philosophy of law
Legal positivism – Law is what the sovereign says it is
Sovereign: Recognized political power whom citizens obey
No room for questions of morality

Natural law
Unjust law is no law at all
Legal realism
Who enforces the law counts more than what is in writing

Kuehn v. Pub Zone
Karl Kuehn – Plaintiff
Plaintiff: The party who is suing
Pub Zone – Defendant
Defendant: The party being sued
Issue – Question being decided
Did the Pub Zone have a duty to protect Kuehn from the Pagans’ attack?
Excerpts – Called the holding, meaning a statement of who wins and who loses
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

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